With the right support, there are significant long term financial returns to be made from developing low carbon cities

Reducing greenhouse gas emissions from cities offers the potential for significant environmental improvements and real financial returns.

This could also deliver a range of other benefits such as significant local employment in the low carbon goods and services sector, and significant reductions in energy bills and, in turn, fuel poverty. (See here.)

Despite this, investments in low carbon cities have yet to be made at scale. The most obvious reason is the sheer scale of investment required. For example, for the Leeds city region, it is estimated that there is a commercially attractive case for £4.9bn of investment in low carbon options. This equates to approximately four years of what the UK’s new low carbon Green Deal programme is expected to deliver. 

Private capital

Given the difference between the potential demand for capital and the likely availability of public money, the question is whether private investors can bridge this gap. At present, institutional investors (pension funds, investment managers, insurance companies) are increasingly interested in the potential for infrastructure-type investments (a category that includes energy efficiency and low-carbon infrastructure) to offer them the long-term returns that they need to meet their future liabilities.

However, investors have a number of concerns about the financial and risk characteristics of these investments which has, to date, meant that they have been reluctant to invest their capital.

The first set of concerns relate to the financial characteristics of the projects that are to be funded, and whether these align with investors’ risk-return expectations. The returns that institutional investors require depend on whether they see these as being at the riskier end of infrastructure investments (where investors tend to look for returns of 10-15% per annum) or whether they see them as lower risk (ie more akin to utility-type investments) and where they tend to accept somewhat lower rates of return.

In either case, it is possible to build portfolios of investment opportunities that would satisfy investors’ demands on risks and returns. Many low carbon investment opportunities offer significantly higher returns than those sought by investors.

The second set of concerns relate to the dependence of many low carbon projects on public policy (eg emission reduction targets, carbon prices, carbon taxes, subsidies) to make them viable. While these have helped to support investment in low carbon options at the city scale, the possibility that they could be withdrawn creates investment risk.

Policy uncertainty

This dependence on public policy support, in turn, means that investors pay even more attention to public policy in relation to low-carbon investments than when investing in the energy sector more generally.

Concerns about policy risk are exacerbated by political uncertainty and changing rules. For example, changes to feed-in tariff regimes for solar have been widely highlighted as undermining investor confidence in government policy more generally.

The third set of concerns relate to the repayment timeframes (which can be four to seven years for individual projects and may be 10 to 15 years if some sort of revolving fund is established) for many low carbon investments. Over these timeframes, markets can have a huge impact on the financial characteristics of these investments.

Of particular concern in this regard are changing interest rates, where higher interest rates could significantly diminish the financial attractiveness of many energy efficiency investments, and future changes in energy prices, in particular if long-term energy prices are lower than predicted.

Despite these concerns, it is clear that institutional investors are interested in the opportunities presented by low carbon cities; the central question for policy-makers is how to convert this interest into real investments in real projects.

Pooling resources

There are a number of practical actions that local authorities can take: they can work together, creating scale though the pooling of projects and resources; they can engage with investors to better understand the investment returns being sought and the risks that they might accept in return; they can broker partnerships between the public (local, regional and national government) and private sectors.

Perhaps most interestingly, they could encourage local authority pension funds, many of whom already have significant infrastructure investments, to catalyse investment in low carbon cities more generally (eg through investing in a UK-wide local authority bond if such an investment product was available).

There is a compelling logic underpinning this proposal: by investing in low carbon cities, local authority pension funds should be able to deliver better long-term investment performance, support local economic development and make a huge contribution to reducing greenhouse gas emissions.

Phil Webber is a visiting professor at the University of Leeds and a non-executive director of Yorkshire Energy Services CIC. Rory Sullivan is a senior research fellow at the University of Leeds and strategic adviser, Ethix SRI Advisers. Andy Gouldson is director of the Centre for Climate Change Economics and Policy at the University of Leeds.

This article is based on Funding Low Carbon Cities: Mapping the Risks and Opportunities published by the Centre for Low Carbon Futures and the Centre for Climate Change Economics and Policy.