Tahir: Right. Look, we've got quite a few questions in the queue here, so let's see how many we get through. But to start with, Akash, we have a question here saying or asking, "How do you value the additional climate benefits and how do you get the private sector and banks to agree to that?"
Deep: Right, that's an important question. And the two features that we need to put in place in implementing the Green Swap are one, contractually separating the two impacts, the development impact and the climate impact, which means benefits, costs and risks. And then being able to value those climate benefits. I mentioned the separation first, because the value of those climate benefits will very much be a function of how we bring about that separation. And what we will need is markets or mechanisms that will value those benefits. Now, that valuation is at a much more advanced stage in compliance markets, it is at a more preliminary stage in voluntary carbon markets. It might be valued using other mechanisms such as Article 6 credits, and that market will need to be developed, it is also much more fragmented at this point in time.
But that is the manner in which it will need to be valued if we are looking to draw private financing to these investments. If on the other hand we are looking to draw financing from countries or from public sources, that valuation is somewhat easier to do than if we were to draw private financing. And that is one important prerequisite for mobilizing any kind of private financing for climate infrastructure or green infrastructure.
Tahir: Akash, another couple of questions which from our perspective are related. How do you accurately identify theoretical brown investment? And related to that, what is the role that MDBs might play in the orchestration of the Green Swap? And the question continues both from the sovereign and non-sovereign side.
Deep: Right. Yes, and the two are indeed related. So, identifying that brown project clearly is critical to this whole exercise and the definition of the Green Swap, right? And this is where creating a credible contractual benchmark is important, and that's where we believe is the role for MDBs. Just think for a moment about the examples that I showed you about Indonesia. If today Indonesia were to generate the next megawatt of power, there is an 80% chance that it would come from a fossil fuel based resource. That is the portfolio of energy investments that is planned for an Indonesia or many other emerging market economies. And again, it is because of the high cost of capital, the urgent need for more power, and the high cost of renewable energy investments. The realistic benchmark is that there's an 80% likelihood that this will be fossil fuel based power, and that is something that the development institutions such as MDBs know very well.
And that is where the role of the MDBs comes in, establishing the credibility of that benchmark and the financial structure, the benefits, the costs, the risks of that benchmark have to be contractually defined so that the green project can utilize that as to define the increment that the green investor would provide. Again, both in terms of the climate benefits, the climate costs, as well as the risks that are embedded in that project.
Tahir: Great, thank you very much, Akash. Another question here is, "Any comments on the differences in financing solar versus nuclear?" And to make it a bit more broader, what is the applicability of the Green Swap across types of renewables, and whether it's applicable more broader than that?
Deep: So, we believe that the applicability of the green swap idea is the more straightforward for those green options where the brown option can be defined more clearly. So, if counterfactual, we would get the power from fossil fuel based project as opposed to a nuclear project, then it is as applicable for nuclear projects or as a renewable if it is generating the climate benefits that are important here. There can be other areas in which it is harder to specify that counterfactual. Let's move away for a moment from power generation to transport, for example. The counterfactual for green transport is a little bit harder. It might include both switching fuels to more greener fuels, but it might also result in model shifts. Or it might come from avoided demand. And in those situations when defining the counterfactual is more complicated, using the Green Swap becomes more challenging.
Or think about, and even yet another problem, adaptation. Disentangling development in climate impact is going to be harder for adaptation. We are not saying that the Green Swap can be applied to every last dollar of climate financing that needs to be mobilized, but we believe that for a large part of the climate financing mobilization problem, particularly as it relates to infrastructure and a power generation in particular, the Green Swap is going to be a powerful mechanism to mobilize that finance.
Tahir: This is possibly one for you, Henry, and this is within the backdrop of what's happening in U.S. politics, but we have a question here asking, "How would you apply this approach in the U.S. given the shift to fossil-based investment under the new administration?"
Lee: Well, to be perfectly honest, whether the present administration would embrace this, I have some skepticism. But the reality is that we're trying to come up with an option that for the long haul and we'll address this on a global basis. So, where our audience is as much the EU, the World Bank, the Asian Development Bank, than it is the Trump administration. But it's the concept, and is the concept going to be viable? Akash has done a very good job of pointing out some of the remaining challenges that we are going to be working on in the next year, particularly how to develop a value for our carbon emission reductions that is going to be commercially viable. Right now the voluntary market is extremely small. And there are a number of other things that we can look at, but there's no magic bullet to this.
I think that if the United States pulls back on all foreign aid, as it did in a memo earlier this week, this might be a little bit more difficult, because that basically infers that we're not going to be pouring money into the multilateral banks or other similar institutions. But it doesn't detract from a concept that we have outlined here this morning.
Tahir: And we have a couple of related questions. What types of investors would you target for the climate component? What is that investor base? Where are they located? Yeah, so that's a question to you, Akash, do you have a view?
Deep: Sure. And as I said, that market needs to be developed in a way that brings in more investors. What we have seen based on the few examples of these investments outside of compliance markets is demand from corporate investors, for their own, Microsoft for example, has been a significant investor in some of these kinds of projects. We also expect there to be investment from portfolio investors. And that we believe is a market that would grow in the future, but it does require a series of, shall we say, policy measures or regulatory measures to be able to provide value to private investors through these investments. And so, we believe that there is policy work that needs to be done. We believe that some of that policy work has been slowed down in part because of the challenge of establishing the integrity of carbon markets. And that's where we think the role of regulatory measures, MDBs, to be able to create that integrity is going to be important.
Once we have some kind of a viable credible source that is vouching for the credibility of these we believe that that market will be much bigger. But let's look at the broader picture here. We believe that from the abatement benefits that green infrastructure will provide, we believe that those investments are desirable from a global perspective, from a worldwide perspective to be able to meet the goals that we want to achieve in terms of reduced emissions. If that is indeed the policy position that we have collectively in the world, that means that there is a consensus overall that the value from those green investments is significant. The idea, the goal behind creating carbon markets is to be able to articulate those benefits and to transmit them to a set of investors with sufficient volume and credibility so that they would be willing to make the investments that are required.
Let me also, Wasim, if I may, address two issues that I just read here in the comments and it's important to clarify. There's a question that says, "So, are you saying that MDB should continue to invest in brown projects?" And not at all. Again, the brown project is a benchmark. It will not get invested in. The only project that will happen is the green project. The brown project is the benchmark that will be used to decide how much is of this green project's costs are going to be borne by the local investor and the balance will be borne by the development investor. By the same token, it will decide how much of the risks of the project are going to be borne by the local investor. So, there's another question about the assumption of the lower cost of capital at which the incremental green finance will come in.
And the reason we believe that that can happen is because the contractual structure will keep all of the development-related risks, the political risks, the regulatory risks, the tariff risks, the economic risks, they are all linked to development and they will stay with the development investor. That's why the position of the swap perspective is useful, because the global investor owns the green project, but it owes the brown project. And when you net out those two positions, the risks of development goes squarely back onto the development investor. Only the incremental risks that arise from the greening of the brown infrastructure project stay with the global investor.
Tahir: Thank you, Akash. And related to that we have another question, which is something we get from time to time when we present this work. And from Justine who says that, "Climate change is the defining human development issue of our time. Climate is and has always been an integral part of development. Is it reasonable to decouple the two?"
If I can quickly give my spin on this, which is that the project that gets created is still going to tackle both, right, climate and development, it's going to climate benefits and development benefits. But what we're trying to do is provide a framework for systematically disaggregating and quantifying the two. Climate benefit and the development benefit.
And by doing that, what you can do is you can allocate and optimize financing flows against those benefits. And if you optimize financing flows, then by default you then optimize the cost of capital and the hope is you optimize the cost of capital to an extent that it brings the overall weighted average cost of capital down to a point where it's viable. So, that's my elevator pitch for the Green Swap. And I don't know if you want to add to that, Akash?
Deep: No, that's absolutely right, Wasim. And I think the question is right that these, climate is one of the defining issues of our time, but at the same time we have to keep in mind is that development is ... There are a very large number of countries that are developing very fast. And if we expect that for the adverse climate impact that that development might create we should slow down that development or stymie that development in some manner that is not the right solution. And indeed, that has been a bone of contention between advanced economies and developing economies about where are the emissions coming from and who has, let's say, generated more emissions in a bid to grow faster. And now that it is the turn of developing economies, they have decided that they want to grow fast. And some of them have said, "We will think about climate a little bit later." And that's why various countries have set their net-zero goals not at 2050, but let's say 2060 or even 2070.
And we believe that instead of looking at this as backwards as saying whose emissions caused the problem, we should look forward, and looking forward is the logical way to look at this. Because the benefits of green infrastructure in emerging economies has benefits across the world. But just putting a climate, let's say filter on development is not the way to go. It is sort of co-financed, rather than a conditionality that is put on development. And that co-financing then tells us how we should share that responsibility. To us in this project the obvious way to do that is in proportion of how the benefits of that green choice will be shared across local and global investors. And that's the reason why putting those together, it's not about separating the two, it's about separating the impact to be able to source the financing, which will then come together to finance the green infrastructure and make it more viable. Indeed, I can even say, make it more fair for emerging markets to make green investment choices rather than brown investment choices.
Tahir: Henry, one for you on the carbon markets. Is there some applicability here to combine this with the EU's efforts such as on the CBAM? And also is there a way to use Article six credits as well and link that to the Green Swap?
Lee: Well, as you know, the European trading regime does not allow for credits, carbon credits to be used to meet the requirements of the trading regime if that credit was developed in an emerging market outside of Europe. And there were reasons, because there was grave doubts on the credibility of the carbon reductions made in a lot of those markets. We believe that if you cannot reduce the incentive to go with the brown plants in those markets over the next 10 years, and Akash is right, in the long term they intend to go green, but they're saying, "We can't go green right now because we have all of these issues of poverty and development that we must address. And if the cheapest option to address it is a coal plant, they'll go with a coal plant. And we're trying to provide an alternative to that." I think that same argument if presented to the European Union would at least hopefully stimulate a second look at this restriction. Because that is going to be a major barrier.
Now, the other argument is working the other way with CBAM. That CBAM is going to, you have a situation in which Japan, for example, steel company cannot reduce. It's very expensive for them to reduce their carbon. So they go and invest in a carbon reduction project in Indonesia, they then go back to Europe and say, "We want to count the Indonesia project as meeting the CBAM requirement." It's highly doubtful that Europe is going to let that happen in the present regime, in the present mentality, simply because the whole idea here of CBAM is to protect European steel companies and European heavy manufacturing. And if you're in a situation in which you're allowing in Japan to not have to pay the full price of the reduction while the German steel company has to, that's going to be hard political sell in the present European regime. So, I am not fully persuaded that CBAM is going to stimulate a lot of carbon credit, a larger carbon credit market. I think there's still a lot of challenges ahead if we're going to realize that.
Tahir: Right. Great, thank you, Henry. I think there's a question, we've covered the applicability around this in terms of sub-sector, renewables, adaptation. There's a question around whether this is applicable in middle-income countries only, low-income countries as well, in countries would only somewhat develop some market system in place. Did you have a view on that, Akash, as to what type of country this would be applicable to?
Deep: Yeah, my sense is that, let's think about where the problem is the most significant. I showed a graph earlier about fast growth, economic growth per capita, remember that picture on the horizontal axis, and carbon dioxide emissions per capita on the vertical axis. And it is those countries that are growing the fastest, and they tend to be middle-income countries. So, I would say that those are the countries that are probably the most obvious candidates for doing this. I'm just looking for chart that I showed you. This is the chart that was there. And if you look at this chart, you will notice that look at the countries which are on the upper right side. I mean, India is for example, very good candidate other Asia Pacific, that's where the Indonesias, the Vietnams are in there, Eastern Europe, et cetera. I mean, those are the big countries where this is.
The countries in which growth is not that rapid is not good news from an economic perspective, but it will not result in the emissions, high rate of emissions either. I would also say that in part based upon some of the questions earlier, it is correct to say that there is some carbon market infrastructure that is required to be able to mobilize this financing. And at this point much of that, those mechanisms are much more based upon individual countries, we don't have an integrated global market. So, the policy effort, if it is going to be put into creating those kinds of carbon markets within individual countries, they will fetch much greater impact in an Indonesia and India or Brazil or Vietnam than in many other countries, simply because the size of the problem is much more significant. That's the reason why I believe that it's these fast-growing middle-income countries, which are probably the most obvious, the lowest-hanging fruit in this effort.
Tahir: All right, look, thank you, Akash. We've got two minutes to go, so I think it's time, we should probably bring this to a close. And I appreciate we have a lot of questions still outstanding. We do have a publication on the Green Swap. Akash, do you want to show the link to that?
Deep: Sure.
Tahir: Yeah, look, here's the paper, we've published it. Please take note of the website link. There's a QR code there as well to scan it, and there's a lot more information contained within that document. And you can also find our contact details available through Google search if you want to reach out to us about this topic. Akash, Henry, any closing remarks?
Lee: Yeah, I just would like to thank all of you for joining us this morning, and I would also like to thank Liz Hanlon who did all of the work to put this together, and we are very, very grateful. If you have questions or you want more information on this, please look at the paper, The Green Swap, and get in touch with us. We've given you Akash's and Wasim's email address. We are going to continue work on this, particularly trying to deal with the challenges of developing a stronger carbon emission reduction market. And so this is only the first step in a larger climate finance effort here at the Kennedy School and the Belfer Center. So I'd like to thank you all, and you have a good day.
Deep: Thank you everybody.