The amount of capital required to transition energy systems to low-carbon futures is large, yet analysis of energy systems change has been quiet on the role of capital markets in financing energy transitions. This report suggests this is due to a lack of suitable theory to supplant neoclassical notions of capital markets and innovation finance. This research draws on the three domains of planetary economics’ proposed by Grubb, et al. (2014) which suggests that the economic responses to the challenges of climate change requires understanding sustainable development as being constituted by three ‘domains’.

1. Studies that focus on individual behaviours/ cognition are classified as first domain approaches;
2. Studies that assume rational actors and market efficiency are classified as second domain approaches; and
3. Studies that address evolving structural and institutional effects on system change are classified as third domain approaches.

The paper argues that assessing the financial element of energy policy must occur across all three domains, but is currently only rooted in the first two, which leads to an inefficient market.

Theory/ research design & methodology

• The adaptive market hypothesis (AMH) proposes that the investment environment, along with investor behaviour, can change over time; investors’ carefully developed heuristics must adapt to new realities in periods of turbulence or change.
• The authors predict how the AMH can better describe capital markets for energy finance under four conditions:
  1. Investors in energy are boundedly rational.
  2. The energy investment environment (policy, regulation, incentives, technology characteristics) changes over time, forcing incumbent firms and investors to adapt to new conditions.
  3. The structures of financial vehicles and wider capital markets affect the submarkets of energy finance.
  4. These behavioural, environmental, and structural characteristics co-evolve, so individuals, firms, and institutions active in the energy investment space enter and exit over time, characterising a turbulent market for energy finance.
• The paper analyses developments in the UK electricity sector through the lends of the AMH and investigates whether conditions 2, 3, and 4 from above can be satisfied.

Summary of findings

The paper proves the conditions 2,3 and 4 are satisfied based on the assessments of the UK renewable energy (RE) market. Therefore, the capital markets for energy finance can be seen as illiquid, characterised by lumpy investments, subject to shifting policy and regulatory constraints, are composed of incumbents and new actors, and require substantive structural and institutional change to sufficiently finance RE transitions.

Adopting an adaptive markets approach therefore, can demonstrate how changes to energy policy, market regulation, capital availability and financial crises, create external structural constraints that complement the internal behaviour behavioural constraints on investors’ cognition and decision making. As such, there is a risk of energy policy operating under an efficient market lens, which does not provide the conditions for financial capital to adapt quickly enough to transition to a decarbonised energy system. By adopting an AMH framing, policy can be designed to better account for the irregularities in the market so that efficient decarbonisation can occur.

1. The amount of capital required to transition energy systems to a low-carbon economy is large. This research draws from 'Planetary Economics: Energy, climate change, and the three domains of sustainable development'.
2. The three domains of planetary economics are used to argue that established literatures exist on the effects of both first- (behavioural and organisational) and second- (neoclassical/
   welfare) domain theories on financial markets in the energy transition, but there is a gap in the literature on third-domain (evolutionary and institutional) treatments of investment and financial markets.
3. UK energy policy, and wider structural shifts in the utilities sector and capital markets, are affecting the market for RE finance, and this has implications in the transition to a low-carbon economy.
4. The International Energy Agency (IEA) has estimated that up to US$53 trillion of investment is required by 2035 to meet projected energy demand within a credible emissions framework. In recognising the investment challenge, much scholarship to date has focused on market
   incentive tools, such as RE subsidies, emissions trading mechanisms, and the relative merits of pricing carbon. However, these studies treat the availability of capital for system transitions as given.
5. Other studies treat the availability of capital for system transitions as given; if only the right risk and return ratios can be created by energy policy, low-carbon transitions will present profit opportunities, which finance capital will exploit. Current energy policy, with its emphasis on supporting low-carbon technologies, relies on this assumption that market mechanisms will drive widespread deployment.
6. This study asks whether the availability of capital for energy system transition can, in fact, be assumed. It does so in light of emergent understandings of financial markets as behaviourally and structurally constrained, a departure from neoclassical assumptions of markets as efficient resource allocators.
7. Adaptive market hypothesis (AMH) is more compatible with existing literature on transformational change. By adopting an adaptive markets approach, we can strengthen behavioural critiques of perfect rationality, with an understanding that structural constraints affect the ‘action space’ in which investors operate.
8. Energy finance can be better described as an adaptive, rather than efficient market. The paper suggests that using this framing provides a more suitable theoretical toolkit with which to build future energy policy.
9. By adopting an adaptive markets approach, we can ask whether our energy and climate policies are rational strategies for an irrational world.