Bridging the Gap How to Finance the Net Zero Transition 2025

The market-led nature of the global economy suggests that market instruments are a critical component in plugging the transition finance gap. Market instruments include the following: –Sustainable debt –Tradable certificate schemes –Performance-based financing mechanisms –Sustainable investment funds These instruments offer a means of incentivizing sustainable practices and directing capital towards environmentally beneficial projects. They have been shown to be effective as economic instruments that can help drive innovative responses to environmental challenges while preserving economic benefits that might otherwise be sacrificed under a command-and-control approach. For example, Stavins108 estimates that the US Acid Rain programme implemented in 1995 led to $250 million in annual savings in contrast to the command-and-control alternative, while Carlson et al.109 report that the programme allowed for annual estimated savings of about $1 billion in comparison to savings that the direct regulation alternative would have afforded. This welfare effect was achieved while also recording a decline in sulphur dioxide emissions by US electricity producers of more than 35% to 10.2 million tonnes in 2005. Thus, by integrating market mechanisms into global and local strategies, the complexities of climate finance can be addressed, making it more accessible and effective for a broad range of stakeholders. Incentive-based market instruments Incentive-based instruments include the following: –Carbon taxes –Cap-and-trade systems –Baseline-and-credit schemes These instruments are designed to change behaviour. In the context of climate change, they create conditions that encourage consumers to substitute away from emission-intensive products. Theoretically, the broad economic and behavioural changes driven by these instruments could be realized by applying them to either producers or consumers at any stage of the value chain. However, incentive-based tools like cap-and-trade are predominantly used at the producer level, where producers must participate in the trading of permits or allowances. Regulating producers is practical because they are better placed to bear the costs of trading emission permits in a cap-and-trade scheme. Furthermore, governments can more easily enforce regulations on hundreds or thousands of companies rather than millions of individuals. Thus, in an incentive-based system the cost of compliance is expected to be passed through to consumers. Specifically, what consumers pay for products is driven by the emission-intensity of the products. Naturally, consumers will limit their consumption of the more emission-intensive products or, in extreme cases substitute away from emission-intensive products altogether, assuming there are alternatives. Internal combustion engines and EVs are a good example. Incentive-based regimes simply require consumers to react to pricing, thereby not adding extra cognitive load to their decision-making. Moreover, since consumers can express their preferences, these tools theoretically enable the system to find the most efficient method to reach targeted emission levels without dictating specific changes in consumption behaviour. Following the adoption of the Kyoto Protocol in 1997, cap-and-trade schemes such as the EU Emissions Trading Scheme (EU-ETS) and baseline-and-credit schemes such as the Clean Development Mechanism (CDM) and Joint Implementation (JI) emerged as the core market instruments for driving emission reduction (see Figure 1). Incentive-based instruments such as the CDM, JI and EU-ETS operate using tradeable certificates, permits and allowances. Examples include renewable energy certificates (RECs), issued for renewable electricity produced, and carbon credits, allowances and permits, which are traded as “permissions to pollute”. Implementing tradeable certificate schemes requires stringent regulatory measures to ensure certificate integrity, prevent fraud and manage market supply and demand. This underscores the need for a clear monitoring, reporting and verification (MRV) process to ensure the schemes’ effectiveness and credibility.2.2 Market instruments Bridging the Gap: How to Finance the Net-Zero Transition 16