Paper - Belfer Center for Science and International Affairs, Harvard Kennedy School

Financing the Energy Transition through Cross-Border Investment

| November 2022

A New Model for Article 6 of the Paris Agreement

Article 6 of the Paris Agreement, finalized at COP26 in 2021, was meant as a key tool for financing the energy transition. Through Article 6, emissions reductions in one country count for the climate targets of another. Developed countries receive credit for emission reductions they finance outside their borders, allowing these states to reach ambitious targets they would otherwise miss. Creating avenues for developed states to achieve cost-effective net emissions reductions, wherever in the world, is especially important in light of growing fears around energy security and affordability. On the other side of Article 6, developing nations host infrastructure projects and receive low-cost funding. As access to capital becomes more constrained globally, Article 6 offers a win-win: lowered net emissions for developed states alongside new capital for sustainable development in emerging markets. 
The problem, however, is that our research indicates that Article 6 will not actually be used in practice, and no transaction has yet occurred. Through interviews with over 70 high-level policymakers, we have identified that the prevailing understanding of Article 6 precludes both financing states and host states from engaging with the mechanism. This is because Article 6 is currently understood as a ‘Direct Purchase’, where financing states buy carbon credits from developing countries. Financing states, however, are neither politically nor economically ready to buy credits outright – why spend hard cash on meeting international commitments?  At the same time, host states do not yet have the infrastructure that would generate credits to sell.
To overcome this problem, this paper presents a new understanding of how governments can use Article 6. Instead of direct purchases, we propose two alternative approaches. The first, is the ‘Project Investment’ approach, where financing states invest in projects and receive a proportion of the associated emissions reductions relative to the investment’s impact on project additionality, alongside a financial return. This can derisk projects in developing countries, facilitating private investment. The second is the ‘Private Sector approach,’ where states establish policy infrastructure to outsource the acquisition of Article 6 credits to the private sector, for instance through instituting carbon border taxes paid in carbon credits. 
Key to these approaches is additionality, i.e. whether the emissions reductions would have occurred without Article 6 financing. If a project can sustain a cost of capital, i.e. the return paid to investors, high enough for the private sector or host government to invest without Article 6, then the project is not additional; it could be financed anyway. Many projects in developing countries, however, are not profitable enough to pay returns commensurate with the risk they entail. In this paper, we therefore propose that additionality be quantified relative to Article 6 investment’s impact on cost of capital. This is a radical departure from traditional understandings of additionality as binary, where projects are additional or not. We argues that Article 6 should bridge the gap between the level where the private sector will invest, and what developing states can afford. Financing countries should invest at concessional levels in exchange for carbon credits, lowering the cost of finance to where the private sector will invest, derisking the project. Investment should be considered additional to the extent it lowers the cost of financing.
To support these approaches, we have developed a new adaptable financial model, alongside our paper, for understanding how Article 6 financing effects the cost of capital and creates additionality. Heterogenous financial instruments such as grants, guarantees, debt or equity create variable impacts on financing costs, and these differences are quantified in our Emissions Reduction Allocation Calculator (ERAC). Using the ERAC, policymakers can input financial and environmental data to calculate what proportion of the project carbon mitigation is additional, i.e. financed at a level the private sector would not, and hence the proportion to which a financing state is entitled. 
To demonstrate how our suggestions could work in practice, the paper presents case studies where different financial instruments such as equity, debt, grants and sovereign guarantees create different levels of additionality in heterogeneous projects. We analyze examples of Saudi investment in Jordan, an Israeli sovereign guarantee for Morocco, a Qatari grant to Palestine, and an Emirati loan to Morocco. Our case studies come from the Middle East and North Africa (MENA) region, which combines some of the host countries most in need of financial assistance with hydrocarbon-rich financing states that have recently embarked on efforts to transform their economies and build regional climate networks. Through these MENA case studies, we explore how a major co-benefit of the our approach could be diplomatic progress through collaboration on cross-border investment. 

For more information on this publication: Belfer Communications Office
For Academic Citation: Sandler, Ely and Daniel Schrag. “Financing the Energy Transition through Cross-Border Investment.” Paper, Belfer Center for Science and International Affairs, Harvard Kennedy School, November 2022.

The Authors