Financing the energy transition: Cash flows for a climate-neutral world

The last world climate conference in Baku (COP29) once again emphasized the urgency of global defossilization. In view of the advancing climate crisis, the international community has reaffirmed its commitment to limiting global warming to a maximum of 1.5°C. This challenge requires not only technological innovation and political determination, but above all massive financial investment – a key theme of COP29 – and a fundamental redirection of global financial flows.

In this series of articles, we look at which investment needs arise for which technologies and sectors and provide an overview of the basics of financing. The first article deals with the global cash flows required to achieve the climate targets.

Although investments in renewable energies and sustainable technologies are increasing worldwide, enormous amounts of money continue to flow into the development and production of fossil energies. In recent years, investments in fossil energy sources have even increased again (Figure 1).

In addition, global capital flows into green technologies are still insufficient and unevenly distributed [1]. In this context, key questions arise: How much must be invested in the future in order to achieve the 1.5 degree target? How are current capital flows distributed worldwide and across different areas, and what changes in the framework conditions are associated with the energy transition and climate change?

The forecasts for the annual financing volumes required in the International Energy Agency’s (IEA) Net Zero Emission by 2050 Scenario (NZE) vary considerably and range from around EUR 3 to 10 trillion per year (Figure 2). These deviations are due to different approaches and assumptions in the analyses. The studies vary in terms of which expenditure is included. Some focus exclusively on the additional investment requirements for the energy transition, while others also take other cost factors into account, such as expenditure for the acquisition of low-emission consumption technologies or compensation payments for the premature decommissioning of fossil fuel infrastructure, so-called “stranded assets” [2]. In addition, the different levels of analysis – by sector, technology or end application – make it difficult to compare the results. However, there is agreement that the need for capital is considerably higher than the investments currently being made, which underpins the need for significant efforts in climate financing. [2-5]

Significant regional differences can be seen worldwide with regard to investments made in the energy transition. Industrialized countries – 38 states that make up around 14% of the world’s population – have continuously increased their investments in the energy transition and climate protection in recent years. A similar but much slower trend can be observed in developing countries. China’s growing share of global financing volumes for climate protection measures is particularly noteworthy. As an individual country, China is now making a significant contribution, the scale of which has continued to increase in recent years. Germany’s share of global investments amounted to 5.8% in 2023, which corresponds to the third-largest share of investments in climate action measures. The aforementioned differences in investment volumes show that the distribution of climate financing continues to be strongly influenced by the economic performance and political priorities of individual countries. [5]

The financial resources required to achieve the global climate targets are available in principle, but require strategic reallocation and realignment. As described above, the estimated annual need for measures to mitigate the effects of climate change and adapt to its consequences is between EUR 2.86 and 10.23 trillion (Figure 2). According to current analyses, however, global capital flows of around EUR 1.62 trillion have only been reached by 2023.

The financing gap is considerable, but a comparison with global spending on other areas shows that it is possible to close it. For example, global military spending in 2023 amounted to around EUR 2.32 trillion, while EUR 2.09 trillion was invested in the digital transformation [8]. Overall, the global capital markets manage considerable assets, reaching around 109 trillion euros by the end of 2022 [3]. These figures underline the fact that the challenge lies less in the availability of financial resources and more in their effective mobilization and targeted use for climate protection.

Investment requirements in the various areas of the energy transition

The difference between current investment in green technologies and future demand is significant and will be discussed in detail in the other articles in this series.

Significant absolute increases in investment are required, particularly in electrified transport and renewable energies, including battery storage systems. In order to achieve the climate targets, investment in electrified transport must be increased by 230% and in renewable energies by 110%. These areas are crucial for the defossilization of transport and energy supply and for a sustainable future.

According to forecasts, electrified transport will account for the largest share of investments for a climate-neutral future. This includes both private and commercial means of transportation. Annual investment must increase from around 602 billion euros/year to around 2,000 billion euros/year. [6]

A large increase in investment is also required in the area of renewable energies and storage systems. Annual investments totaling 1,425 billion euros are required for the energy sector. Of this, around 1,225 billion euros will be spent on expanding emission-free power generation capacities and 200 billion euros on improving grid flexibility through battery storage and seasonal storage systems. [2]

The infrastructure sector includes key measures such as the expansion of electricity grids, the development of interconnected grids and increasing grid flexibility through digitalization and demand-side management in order to ensure a reliable and efficient energy supply. This also includes the massive expansion of the charging infrastructure for electric vehicles and targeted support for their market launch. By 2050, this sector will require an annual investment of around 675 billion euros, which represents a significant increase compared to the current annual investment of 362 billion euros. [5]

In the building sector, annual investment will have to increase from around 261 billion euros today to around 475 billion euros in 2050. This includes around 215 billion euros for retrofitting buildings to increase efficiency (e.g. better insulation) and around 260 billion euros, including 140 billion euros for heat pumps, for a renewable heat supply. [2]

The smallest sector in terms of share is hydrogen and the defossilization of industry. However, this is where investment must increase the most in relative terms, with an increase of 300%. This area primarily comprises the production, transportation and storage of hydrogen. In the area of defossilization of energy-intensive industries such as chemicals, steel, cement or aluminium, around 67 billion euros are to be invested annually in the future, with the focus on technologies such as CCS, pyrolysis and hydrogen-based DRI plants. [2]

The risk of stranded assets

While discussions about investments to defossilize the global economy are often characterized by investments in clean alternatives to current production and manufacturing processes, the risks of stranded assets must also be taken into account. “Stranded assets in the context of defossilization are primarily those plants that are deprived of their business base due to the switch to low-carbon processes. The operation of these plants can be prohibited by regulation at a political level or indirectly controlled economically through market mechanisms such as CO₂ pricing in the ETS.

Industrial plants in particular, as well as power plants operated with fossil fuels, have a useful life of several decades. After it was discussed at the beginning that, in addition to the accelerated expansion of renewable energies, investments in fossil-fuel power plants, especially coal-fired power plants, have also increased in the post-Covid phase, these plants are heading for confrontation with the net climate targets set worldwide in the medium to long term.

In Germany, the coal phase-out was therefore discussed and enshrined in law at a comparatively early stage in order to signal to the market that investment in new coal-fired power plants would no longer be approved due to the mandatory shutdown by 2038 at the latest [9]. In other countries, this is not always discussed to this extent in preparation, which ultimately leads to politicians and plant operators heading towards a “stalemate situation”. Developing countries in particular have a young fossil fuel power plant fleet, which makes phasing out fossil fuels appear uneconomical due to a lack of monetary incentives [4]. According to current calculations, 40 GW of coal capacity per year is at risk of ending up as a stranded asset by 2050 if climate targets are to be met [10]. Compensation payments are being discussed to encourage plant operators to stop operating these plants. A rigorous shutdown of the plants would result in insolvencies, loan defaults and, due to the investment sums involved, repercussions for the entire financial system [4]. These compensation payments are particularly important for coal-fired power plants. Due to their high specific emissions in electricity generation, the premature shutdown of these power plants is a strong lever for reducing CO₂ emissions quickly and at an annual cost of 25-50 billion euros [10]. The financial compensation payments would be low in relation to the total investment in climate protection measures. While Germany has decided on compensation payments by law and handles them within Germany, these payments for developing countries would presumably have to be made by other industrialized countries [2].

Business-as-usual more expensive than consistent climate protection

The need for massive investments in defossilization becomes particularly clear when considering the long-term socio-economic consequences (see Figure 6).

The global economic losses occurring in a “business as usual” scenario make it clear how important measures to curb global warming are. Nevertheless, it should be noted that even in a 1.5 degree scenario, high annual losses are to be expected and the intensity of environmental disasters such as floods, droughts and forest fires will increase. However, the gap between the annual losses of the 1.5 degree scenario and the “business as usual” scenario is almost 17 trillion euros, which is greater than the necessary annual investment in climate protection measures. This shows that measures to mitigate climate change also make economic sense.

Literature

[1] International Energy Agency (IEA). World Energy Investment 2024; 2024.
[2] Energy Transitions Comission. Financing the Transition:: How to Make the Money Flow for Net-Zero Economoy; 2023.
[3] Climate Policy Initiative. Global Landscape of Climate Finance 2023; 2023.
[4] McKinsey & Company. The net-zero transition: What it would cost, what it could bring; 2022.
[5] International Renewable Energy Agency (IRENA). World Energy Transitions Outlook 2024:: 1.5°C pathway; 2024.
[6] BloombergNEF. Energy Transition Investment Trends 2024: Tracking global investment in the low-carbon transition; 2024.
[7] IDC: The premier global market intelligence company. Worldwide Spending on Digital Transformation is Forecast to Reach Almost $4 Trillion by 2027, According to New IDC Spending Guide. 2024. https://www.idc.com/getdoc.jsp?containerId=prUS52305724. Accessed 2 Dec 2024.
[8] Stockholm International Peace Research Institute (SIPRI). Trends in World Military Expenditure, 2023; 2024.
[9] Bundesamt für Justiz. Gesetz zur Reduzierung und zur Beendigung der Kohleverstromung und zur Änderung weiterer Gesetze (Kohleausstiegsgesetz) Nichtamtliches Inhaltsverzeichnis: KohleAusG; 2020.
[10] International Renewable Energy Agency (IRENA). Stranded Assets and Renewables:: How the energy transition affects the value of energy reserves, buildings and capital stock; 2017.