Can regulation open the floodgates for green finance?

The world's 30 biggest listed financial firms collectively provided $740bn to the fossil fuel industry in 2020 and 2021.

Across the UK, the sight of an electric Tesla, Kia or Volkswagen gilding silently through town has become commonplace as the number of electric vehicles on the road continues to rise sharply. Despite overall vehicle sales reducing in 2022 and the withdrawal of many of the UK’s EV subsidies, EV sales have continued to soar, increasing to 16% of the UK car market and surpassing diesel last year.

This rapid rise in sales can be largely attributed to the UK’s ambitious electric vehicles target enshrined in government regulation: from 2030 onwards it will no longer be possible to purchase a new car powered solely by petrol or diesel. Instead, after this date, drivers will need to purchase electric or hybrid vehicles, moving to entirely zero-emission by 2035.

Certainty and trust in these EV rules – coupled with a long lead time – is giving private financiers the confidence to make transformative investments into the necessary EV infrastructure at a viable cost of capital. Financiers know the market will continue to grow, manufacturers have confidence to introduce new ranges and the government advances a key component of transport decarbonisation, all without having to spend large swathes of taxpayer money. As a result, across the country, manufacturers are growing their electric product offerings and charging infrastructure is being rolled-out, financed by the private sector. More may still need to be done, and further government subsidy may yet be required, but the UK is in a strong place to advance the EV transition, bringing with it reduced carbon emissions, much-improved air quality and reduced reliance on imported fossil fuels.

This approach – well-crafted regulation driving economy-wide transformation – is proven to work and must now be applied to the other areas of the economy that need to rapidly transition to net zero. These include heavy industries, aviation, food and agriculture, and construction.

In many of these sectors, some of the necessary technology exists – new buildings can be fitted with heat pumps and solar panels, steel manufacturers can replace coal-fired blast furnaces with electric arc furnaces – but moving from incumbent business models to lower carbon alternatives involve new costs, business risks and uncertainty. Not a proposition that some shareholders or financiers are typically happy with. This is particularly true when the gain – increased sales from customers motivated more by their desire to reduce their carbon footprint than by the lowest price – has yet to materialise at scale, hampered further by the current cost-of-living crisis.

Imagine for example that you are the chief executive of a company manufacturing concrete or steel. You and your shareholders know that at some point your company needs to make the transition to net zero. However, you also suspect that if you made that transition today, ahead of your competitors, the negative consequences may well outweigh the positives. To recoup the investment made, your products may suddenly become more expensive and, knowing that your customers primarily prioritise price in their purchasing decisions, you stand likely to lose market share from being less competitively priced than your peers.

Attracting investment or lending to make this shift possible is therefore likely to prove very difficult. Rightly, potential investors or lenders will question how likely they are to see a return on their investment.

Heavy industries, like many others, suffer from ‘first-mover disadvantage’, where going first may be the right thing to do and is technologically possible, but where the immediate commercial benefits from doing the right thing cannot be realised. Of course, lowering emissions can reduce operating costs and these investments should be made as a matter of course. Equally, some customers are willing to pay a premium for sustainability and this should be applauded, however, we have not yet reached a critical mass where multiple companies across various sectors are prepared to make the transition at scale. Furthermore, typical investment time horizons often do not extend far enough to allow investors to factor in the point in the future where operating in a net-zero way will pay huge dividends.

In an era of government deficits and reducing government expenditure, governments cannot be relied upon to subsidise the economy’s transition through tax breaks and cash handouts. This is particularly true in the UK, where the current fiscal situation means any response to the substantial tax credits and incentives introduced in the US through the Inflation Reduction Act is most likely to take the form of actions to ease doing business, such as planning reform, or refocusing of university research rather than new money.

However, a key approach open to government is to make better use of the government’s immense power as a regulator to unlock the private capital needed.

The enacting of a government regulation, for example, requiring all concrete sold in the UK to meet a specific sustainability or net-zero objective by a certain date, could drive and direct capital flows almost immediately. Companies will approach lenders or investors for the capital needed to enable their continued legal operation and, with a levelled playing field, competition remains intact.

This approach to regulation can be repeated across the economy. The key ingredients are trust and timing. Preferably coupled with the creation of a positive enabling environment, such as making it easier for wind farms or solar parks to receive planning permission and grid connections, building the skills needed to retrofit buildings or supporting universities to research new technologies.

This approach works even better when the world is aligned and multiple governments work together to develop a set of common regulations and expectations on the carbon intensity of key industries, although countries must act in advance of global agreements.

It’s worth noting that, in common with all other climate solutions, corporate regulation is not a silver bullet. We cannot fix all problems this way. Governments, companies, financiers and citizens must be doing everything in their power to advance a rapid transition to a sustainable future. The most obvious, and likely most effective, market-based solution would be to introduce carbon pricing across the economy. Such a system, coupled with international agreements or border adjustments, would similarly unlock flows of capital for the transition, in a blunter and more widespread fashion.

Either way, the government alongside other actors, such as investors and financial institutions, must act now. Taxes and regulation require many years of consultation, a pre-warning and parliamentary process to enact. The 2020s, the decade where climate action must rapidly accelerate, are slipping away. Getting back on track with net-zero requires concerted action which must transform the levels of private finance flowing into the transition.