If the goal of the Paris Climate Agreement to limit global heating to 1.5 degrees above pre-industrial levels is to be met, mobilisation of capital to fund the necessary green infrastructure is required on a massive scale. Demand from private capital is there, but de-risking is required to mobilise it. By Jonathan Rogers.
It is not just the Paris climate goals that exercise the minds of the 196 countries – most UN members minus the presence of major carbon emitter Iran – which signed up to the agreement in 2015 covering climate change mitigation, adaptation and green finance but also the UN's Sustainable Development Goals which most (191) of the Paris signatories also inked that year, the central mission of which is to eradicate poverty, provide sustainable energy and water resources and decent healthcare.
Government policy among the signatories of the two pacts has, broadly speaking, coalesced around the goals enshrined in them, and the timelines on which various milestones sit – most developed countries have 2025 carbon reduction targets while many developing countries are aiming at 2030 – have created a sense of urgency which has been notably conspicuous in 2023.
The “global stock-take” enumerating progress in reaching the targets is underway and heightens the urgency, comprising data collection and technical assessment and culminating in the COP28 meeting to be held this November in Dubai, where politicians from Paris Agreement signatory countries will vocalise on the state of progress and the medium to long-term outlook for achieving the agreement’s goals.
Taking centre stage of the speeding-up narrative is the Green Climate Fund, which was established in 2010 via the UN Framework Convention on Climate Change to help developing countries meet the challenge of climate change, with a focus on adaptation funding, and which is undergoing a major round of replenishment this year as its four-year funding cycle rolls over.
“Momentum is building. The G20 announcement ahead of COP28 to pursue and encourage efforts to triple renewable energy capacity globally by 2030 and to facilitate access to low-cost financing for developing countries is interesting, as with the UK’s biggest ever US$2bn pledge to the GFC,” said Eugene Wong, founder and CEO of the Sustainable Finance Institute Asia in Kuala Lumpur. “Still, we are in a situation of asking, there are the pledges, but where is the flow of money?”
Wong points out that there is acute awareness of the funding need for green infrastructure: “Urgency around the topic is building with powerful momentum among many governments. But recognising does not, however, equal the ability to deliver. Ironically perhaps, the greatest need and recognition comes from the emerging and developing nations, who are vulnerable, have higher costs of capital, include those with lower credit ratings, currency challenges and the need for de-risking.”
The GCF might be a model of the collaborative effort required to tackle climate change, working as it does with a range of partners including multilateral institutions such as development banks and UN entities.
While its US$12.8bn investment portfolio spread across 129 countries might seem relatively small in relation to the vast capital sums required to build the green infrastructure necessary to meet Paris targets and SDG goals, its modus operandi is a template for the models which must be used to attract and optimise capital.
Equity injection, concessional debt, guarantees and technical assistance are elements of GCF’s approach which apply to other actors in the collaborative arena who can prove instrumental in mobilising capital and cutting across bureaucratic silos.
"There are numerous challenges involved in mobilising capital into the sustainable infrastructure arena. In emerging markets, there is the issue of local knowledge and network, regulatory requirements, poor liquidity and tenor mismatches – given the long tenor of most projects – as well as punitive capital requirement implications for investing capital in at the sub-investment-grade level,” said Nic Wessemius, managing director at the Netherlands’ FMO Investment Management headquartered in The Hague, the asset management subsidiary of Dutch government-owned development bank FMO.
Active since 1970, FMO, the “entrepreneurial development bank” is on average active in more than 85 countries, focusing on Africa and Southeast Asia and increasingly on frontier emerging markets, and an exemplar of how de-risking can mobilise private capital.
“At FMO, we see market creation as core to our progression model by ‘making the unbankable bankable’. Part of this involves offering technical assistance, setting up sector initiatives and engaging with local businesses in developing countries,” said Wessemius.
The FMO’s strategy towards 2030 is described as “Pioneer – Develop – Scale” which is rooted in its progression model and “patient capital”, whereby FMO supports developing world companies with its balance sheet from an initial high-risk phase to the point where commercial investors can take over in full or in part from the Dutch development lender. A crucial component of this is market creation, underpinned by ecosystem building and direct engagement with companies.
“Within blended finance we have been using the A/B loan structure since the late 1990s whereby the B tranche loans are structurally subordinated and repaid earlier. Also, in the collateralised loan market, FMO and other bilateral development banks have invested in junior tranches, which improves the overall risk proposition for senior debt investors. Blended finance is key to attract commercial funding in emerging markets,” said Wessemius.
According to the Blended Finance Taskforce, the BF market is worth over US$50bn and set to grow, with the potential to double in size over the next few years, and for its offerings to enter the financial mainstream.
Rethinking MDBs
At a conference convened in Paris in June, representatives of developing island economies, led by Barbados’ prime minister Mia Mottley, proposed at a summit jointly hosted with France an updated iteration of the so-called Bridgetown Initiative first mooted at the COP26 conference held in Glasgow in 2021 and unveiled in July last year in a summit in the Barbadian capital.
Back then, the call was for the World Bank to receive US$100bn of fresh capital to drive climate and development finance in order to help smaller and less wealthy nations tackle climate change.
The initiative demanded a fundamental shift in the MDBs’ attitude to risk and a willingness to provide capital at concessionary financing rates for poorer countries and to facilitate risk mitigation by attracting private capital utilising the MDBs’ Triple A credit ratings.
Fresh capital for the World Bank? Perhaps not, although Germany has suggested it is open to the idea.
But guarantees, yes. In July, the World Bank launched a US$5bn guarantee programme whereby member countries will pledge to cover default on loans to poorer countries, in a move which will leverage the bank’s Triple A rating and increase funds available for lending to developing countries – estimated by bank officials to potentially release US$30bn – to help them tackle climate change.
Meanwhile, the “Bridgetown 2.0” consultation document presented at the Paris summit states that the IMF and other MDBs should provide US$100bn per annum in currency risk guarantees to attract private sector investment into climate change mitigation and adaptation projects in developing countries to facilitate the transition to low-carbon economies.
“The Bridgetown currency risk guarantee proposal could boost private sector capital investment in developing country infrastructure. There is already the ability to hedge long-tenor currency positions of up to 15 years in “exotic” emerging market currencies such as Laotian kip via the Currency Exchange Fund (TCX), so the market mechanism is there,” said FMO Investment’s Wassemius.
New assertiveness
The Bridgetown Initiative exemplifies the increasing assertiveness of the developing world on the subject of climate change, in which a “blame game” underscores developing countries' efforts to mitigate and adapt to that change.
“A growing sentiment within many emerging and developing countries is ‘we didn’t cause it – we inherited it’ and, in ASEAN, for example, there is the paramount need for transitions, minus the social and economic dislocations and that are just and affordable,” said SFIA’s Wong.
“A lot of the emerging and developing countries are still recovering from Covid, and asking them to decarbonise rapidly is a huge challenge, especially if they are not guided with a clear and realistic pathway.
"But, within that, it is worth remembering that ASEAN is forecast to be the world’s fourth-largest economic bloc by 2030, albeit with significant divergence in GDP per capita, economic and social structures and access to natural resources, and as such is an important region to consider.”
Blended finance presents as the great hope for green infrastructure capital mobilisation and the “dream scenario” involves the recapitalisation of the MDBs and their assumption of a much more aggressive approach to de-risking by accepting first-loss pieces in the lending capital structure to lure in private capital senior investors.
At the IMF/World Bank spring meetings held in Washington in April, John Kerry, the US’s special envoy for climate, threw down the gauntlet to the MDBs on capital mobilisation with a blended finance plan that, although perhaps derisory in terms of hard cash, exposed the potential benefits of de-risking via first-loss tranching.
The plan was to use US$15m of US State Department funds, plus US$35m from philanthropic foundations including USAID to produce a combined US$50m first-loss tranche to fund climate projects in less wealthy countries.
Kerry suggested in a Financial Times interview that the risk mitigation tranche could attract senior funding from private sector asset managers to the tune of up to US$1bn. Potential capital providers are the members of the Glasgow Financial Alliance for Net Zero, who will be pitched at COP28. The next obvious place to look for senior tranche investors is among the deep-pocketed sovereign wealth and state pension funds.
Another blended finance potential template model was provided in May by the European Bank for Reconstruction and Development, which unveiled a US$300m collaboration with the EU and Dutch pension asset manager ILX whereby projects organised by the EBRD and ILX will be guaranteed by the EU. Again, the ticket size is diminutive, but if the pilot proves fit for purpose, it will serve as a model for capital mobilisation at scale.
But the first-loss idea perhaps loses conceptual grip when placed in the context of equity financing within the capital structure, as clarified by Jang Ping Thia, lead economist and manager of the Asian Infrastructure Investment Bank’s economics department in Beijing.
“AIIB operates on sound banking principals. The bank has invested in many projects with direct and indirect equity financing and these are essentially first-loss types of investment. The key is to have adequate mitigants against risk, and to be compensated for risk. What banks and investors cannot do is to take risky positions without returns. At the end of the day, the only way out is to reduce the overall risk of the projects through better macroeconomic management and regulatory improvements.”
A common language
“The solution to attracting capital inflows in ASEAN is to build an ecosystem, and that is in the works, via the inputs of key stakeholders including the region’s policymakers and the private sector,” said SFIA’s Wong.
“You must have a common language – a taxonomy. You must understand what transition in ASEAN means, and that will be very different from one in Germany or the UK. ASEAN cannot have the level of stringency of the EU Taxonomy due to the stage of the region’s economic development and social structures. Finally, we need to have a disclosure framework that is useful and practical.”
ASEAN’s standout characteristic is its economic reliance on micro to small to medium enterprises (MSMEs), of which there are estimated to be more than 70 million spread throughout the region, and which according to ASEAN’s website account for 85% of employment, 44.8% of GDP and 18% of national exports. The process of decarbonising these businesses across the emissions spectrum – from Scope 1 direct emissions through to Scope 3 emissions on a company’s supply chain – is an immense challenge.
Taxonomies are crucial to meeting this challenge and it is acknowledged that given ASEAN’s diversity of economic and social structure, wide range of GDP per capita – from Singapore’s US$74,000 to Cambodia’s US$1,600 – and access to natural resources as well as basic utilities, developing a one-size-fits-all taxonomy for ASEAN will be an incremental process involving a tiered approach with longer timelines for the least developed and the shortest for the most developed, but agreement on principles and technical screening.
This process is underway in ASEAN under the auspices of the ASEAN Taxonomy Board – hosted by the SFIA – which comprises the region’s central bank governors, capital market and insurance regulators and finance ministers – 40 members in total.
“The distinguishing feature of the ASEAN Taxonomy is that it is intended to facilitate transition and, as part of that, allows for time to remediate the harmful aspects of an activity. It has a principles-based component called the Foundation Framework and a technical screening criteria (TSC) component known as the Plus Standard,” said SFIA’s Wong.
“To cater for member states’ different starting points, the TSC for each economic activity can have up to three thresholds that allows for a scale-up of ambition, unlike the EU Taxonomy that only has one. The ASEAN Taxonomy is voluntary and looks to self-discipline, market discipline and regulatory discipline working together to optimise its application.”
Scaling down
With an eye to decarbonising those 70 million MSMEs, it is clear that blended finance has a role to play. Here, it is not so much a case of scaling up but one of scaling down.
The Innovative Financing Lab, an initiative under the UN Development Programme, in April produced a policy brief titled “Developing Blended Finance to Broaden Financial Access for MSMEs” which highlighted challenges facing the sector, including information gaps, regulatory frameworks and access to capital.
The policy recommendation was to use “catalytic capital” to facilitate access to financing, including from the private sector, private credit and philanthropic sources. A collaborative ecosystem comprising government, banks, NGOs, social enterprises, donors and funders linked via digital platforms can facilitate blended finance at the MSME level with the goal of decarbonising the sector.
Banks might seem crucial to this ecosystem – they proved their worth within ASEAN with social initiatives, direct funding and debt moratoriums during the Covid-19 pandemic – but as bank lending appears to be in secular decline globally thanks to heightened credit risk aversion, rising non-performing loans and capital requirements, alternative sources of capital are stepping up.
“Alternative capital, with its flexibility and ability to underwrite quickly, is increasingly a quality partner taking over the spot left by traditional banks,” said Michel Lowy, founder, CEO and global co-portfolio manager at alternative asset manager SC Lowy in Milan.
“The capital needed to tackle today’s interconnected crises is beyond the capacity of the public or private sector alone. That said, there is great potential and a need to increase private investment and finance. The private sector – including asset owners and managers – can bring dynamism and alleviate existing fiscal space constraints in financing the transition, which includes green infrastructure,” said David Atkin, CEO of the UN-supported Principles for Responsible Investment in London.
Collaboration and heavy lifting
One “magic bullet” proposed to mobilise climate change-related development capital has been collaboration between the MDBs, and there are signs that this might start to become a significant method of working.
“The G20 has made many calls for MDBs to work with the private sector and with each other. This is happening,” said AIIB’s Thia.
“Recently, AIIB entered into an agreement to provide guarantees to US$1bn of the World Bank’s projects. This frees up the World Bank’s capital and diversifies AIIB’s portfolio at the same time, allowing both institutions to scale up lending. This is a win-win-win transaction that shows the power of working together. MDBs also co-finance many private sector projects, providing direct support and also crowding in the private sector.
“Where MDBs are most catalytic is when we work with clients to realise challenging but transformational projects, develop new instruments and markets with the private sector, and provide a source of countercyclical financing during stressful periods.
"One can imagine the country policymaker and the private sector as the weightlifters and MDBs as the helpful trainer working alongside. It is also not surprising that MDBs do more heavy lifting during periods of macroeconomic stress.”
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