Even as industrialized nations gradually rein in their greenhouse gas emissions, developing countries’ growth continues to rely largely on fossil fuels. The International Energy Agency (IEA) projects that by 2050, without some intervention, the decarbonization of advanced economies will be almost entirely negated by increased emissions from emerging and developing economies. The reason is simple. In a developing economy, a green energy project, such as a wind farm or a solar power station, might produce electricity less expensively over the long run, but its upfront capital costs are typically greater than those for an equivalent coal-fired plant. To go green, in other words, a greater proportion of the capital costs (such as acres of turbines or photovoltaic arrays) must be financed at the outset. Although the cost of capital is relatively low globally, it is commonly twice as high in emerging economies, where investors must contend with greater regulatory, economic, and political risks. That financing barrier frequently tips the scales toward “brown” projects, explains Harvard Kennedy School (HKS) senior lecturer in public policy Akash Deep, whose “green swap” is an ingenious solution to this problem.
In the green swap, local developers give up carbon credits (averted emissions of carbon dioxide that are tradeable in international markets) to global investors, who cover the incremental costs of transforming a dirty power project into a clean one. The global investors in exchange give up their rights to all the local risks and rewards of a project, including the value of the plant’s energy output. The swap solves an important dilemma facing rapidly developing economies hoping to make clean energy investments: Do they go green and sacrifice economic growth to support global emissions targets? Or do they choose development projects with the lowest upfront capital costs to promote improved standards of living for their populations? The empirical answer, explains Deep, an expert on global infrastructure finance and capital market reform, is that half the new power projects under development in countries such as India, Saudi Arabia, and Vietnam—where sunshine is abundant—rely on fossil fuels.
As Deep and his coauthors explain in a recent Belfer Center for Science and International Affairs working paper, the green swap “allows local investors to fund the basic costs of infrastructure while global climate finance covers the incremental costs and risks associated with green technologies,” tapping the lower global cost of capital “to make green projects financially viable.” The result is to bridge “the gap between development and climate goals” to finance construction of sustainable infrastructure. (Deep’s coauthors are senior lecturer and director of the HKS Environment and Natural Resources Program Henry Lee, HKS research fellow Wasim Tahir, and HKS graduate student Joshua Doyle.)
Here’s how infrastructure investments usually unfold: imagine that a country wants to construct a subway system in its largest city, taking cars off the road, increasing urban population density (thus protecting rural areas from sprawl), and accelerating economic growth. A development bank might wish to finance such a project, Deep elaborates, but stipulate that the power to run the electric trains come from green energy sources. If local authorities balk at the higher projected costs, the bank might commit additional scarce development dollars to ensure the project can be made green. Absent such funds, the project could be shelved, or it might back conventional financing with local revenues—generating the subway system’s electricity via lower-cost, fossil-fuel-fired power plants.
Deep’s idea is to instead disentangle the local benefits and risks of such projects from the global risks and rewards. The primary focus of development finance, he argues, should be “unlocking the mostly local social, economic, political, and cultural growth that we call development. It should pay only for the cost of development. And it should bear all the risks of development.” By extension, he continues, “climate finance should only pay for the incremental cost and additional risks of making development green. And it should do so in anticipation of reaping the mostly global climate benefits that arise from making green investments.” (The atmosphere integrates CO2 emissions regardless of their place of origin.)
A geothermal energy development project built in Indonesia in 2014, for instance, demonstrates how explicitly valuing the emission reductions that could be sold in global markets can transform a climate-friendly but financially unviable project into an attractive investment from both local and global perspectives. “There were two options for this project,” Deep explained during a recent presentation: a brown, coal-fired plant that would cost $523 million; and a green, geothermal plant that would cost $658 million. The coal-based project generated externalities, both local (negative impacts on health and the environment, for instance) and global (primarily greenhouse gas emissions). The global externalities alone—largely emissions of CO2—were valued at about $150 million. At the time, Deep explains, the question was, “How do we get Indonesia to choose the geothermal plant?” The solution was to provide revenue and financing subsidies from the World Bank and other institutions.
The green swap is a different approach, with the added benefit of freeing scarce development dollars by creating a role for global investors. “The incremental cost of the geothermal plant is $135 million,” Deep notes. The local investor, in exchange for the development benefits (the sale of the generated electricity), would pay the amount that equals the cost of the brown project, while the global investor would pay for the projected value of the abated carbon emissions.
These credits, issued as CO2 equivalents based on the plant’s electricity production, can be sold in global carbon markets, where buyers can offset their own emissions by purchasing them. In Deep’s example, a metric ton of averted carbon emissions is worth $20. (The current value in global markets is $23 per metric ton, which means the value of the avoided emissions accruing to the global investor would be more than $150 million. Notably, the Biden administration estimated that the true value of a ton of carbon—taking into account the impacts of rising seas and temperatures, increasing storms and wildfires, and ensuing impacts on agriculture, insurance premiums, etc.—is closer to $200 per ton.)
The power of this approach is that it unlocks international capital at favorable rates to pay for global benefits. The cost of capital in the emerging economy is much higher given the inherent risks of investment there. That means global investors could pay for the incremental costs of making the project green in exchange for the future abated emissions at rates unavailable within the local economy.
This disaggregation of development projects into local and global components does face at least one obstacle. In order to establish how much carbon a project has abated, the swap requires a “brown” alternative. Without this counterfactual, global investors and carbon markets would not be able to establish the true value of the green investment. But Deep hopes that international development organizations such as the World Bank, which already have a presence in developing economies and the ability to verify the incremental carbon benefits of clean development projects, will test the green swap. If his idea works, it could favorably alter the course of efforts to change the global energy economy.
