Blended finance is helping to fund climate mitigation projects in Asia, but there is still a huge funding gap and some other social development initiatives are struggling to attract capital.
Blended finance involves marrying concessionary money from development banks or philanthropic organisations with commercial finance, often requiring a concessional tranche to accept more risk or a lower return than the private sector tranche. It can encompass concessional loans, guarantees, or equity or bond investment.
The International Energy Agency and International Finance Corp estimated in a report in June that ASEAN will require US$13bn of concessional financing per year between 2026 and 2030 to crowd in enough private sector capital for its clean energy investments, while India will need US$12bn.
Development finance institutions define blended finance as the use of concessional financing from third parties alongside their own accounts or private capital, while blended finance network Convergence defines it as the use of public or philanthropic capital to catalyse private sector investment in sustainable development.
Under its own definition, Convergence has recorded 206 closed deals targeting the APAC region, representing aggregate committed financing of US$33.18bn as of June. Asia accounted for 36% of global blended finance transactions in 2020, according to a Convergence report.
The IFC estimates that every US$1 of concessional donor funding brings in US$7 of additional finance on average, rising to as much as US$10 for climate-related transactions.
“We use blended finance to buy down the cost of capital for the private sector, and reach the tipping point where it becomes viable for them,” said Warren Evans, climate change envoy of the Asian Development Bank.
In 2011, Thailand’s Solar Power Company Group received blended finance loans from providers like IFC to fund the construction of two 6MW plants. After the projects showed that solar power could be a viable investment the industry was able to attract commercial financing.
More recently, the ADB helped support investment in electric buses and charging stations in Vietnam by EV maker VinFast by mobilising about US$135m in financing, alongside other development finance institutions and private sector institutions.
“ADB looks at both quantitative and qualitative arguments for why a project needs concessional finance,” said David Barton, principal investment specialist, private sector operations department, at the ADB. “Is it new and different, is it the first of its kind, what will be the demonstration impact, and what is the potential for replication and scale-up? We definitely look to see the second, third, and fourth deals in that market have a reduced need for concessional financing over time.”
ADB structures blended transactions and invests in them to earn market returns, rather than providing concessional funding.
“We price to market, we will not crowd out private capital,” said Bart Raemaekers, ADB adviser and head, guarantees and syndications unit, private sector operations department. “Essentially we are a price taker, getting the same price as the private sector.”
The presence of institutions like ADB on transactions can give commercial institutions comfort and allow pricing to be tightened. Raemaekers said its blended deals are often multiple times oversubscribed, with participation from commercial banks, institutional investors, impact investors, and other DFIs.
“We usually go a few years longer than private capital, and those few years make a big difference to the viability of a project,” he said. “One of the reasons these deals are oversubscribed is because we’re there.”
In Europe and the US, banks’ costs of funds are relatively high, making it difficult for them to provide long-term financing. In Asia though, Japanese and Singaporean banks are active providers of US dollars and the biggest markets are in local currency, where domestic banks and local branches of international banks are keen to participate.
“Asia is a bit different from other regions because many jurisdictions have deep local currency markets and you can get very long tenors in currencies like the Philippine peso,” said Raemaekers. “We regularly see tenors over 20 years. That’s a big contrast to markets like Latin America and Africa.”
Not only are Asia’s local currency markets deep, but pricing is competitive.
“We see spreads are really tightening,” said Raemaekers. “Depending on the project, loan spreads were in the mid-200s, but are now in the low 200s or in some cases below 200bp.”
Part of that increasing demand is due to banks’ needs to hit their own targets – whether for returns or for deploying sustainable finance.
“We don’t have a specific target for blended finance,” said Amit Puri, global head of sustainable finance at Standard Chartered. “Our guiding sustainability target is our commitment to mobilise US$300bn in sustainable financing between 2021-2030, which can include a combination of different financing structures, including blended finance.”
Blended finance structures can raise returns for other investors as well as reducing project risk to a level that makes a transaction investable for banks. Since many climate-related projects use relatively new technology, there is no track record to model things like default rates, making it hard for banks to know how much risk weighting to apportion.
“Our overall sustainable finance business including trade, capital markets and lending gives returns in line with our overall corporate, commercial and institutional banking targets,” said Puri. “Blended finance can support our return on tangible equity targets depending on the specific structuring.”
Filling a niche
Sitting between commercial banks and development finance, a new entrant is also originating and investing in blended finance deals for marginally bankable clean infrastructure projects in Asia.
Pentagreen Capital, a joint venture between HSBC and Singapore state investment company Temasek Holdings, has US$150m of initial capital and aims to deploy it in over US$1bn of loans within five years to crowd in private capital.
It is focused on South-East Asia initially, and transactions in renewable energy, clean transport, and water and waste management, though will consider areas like agriculture and climate adaptation in future. Pentagreen has partnered with the ADB and Singapore-based infrastructure financier Clifford Capital, which will help with origination and provide technical support.
“Our involvement needs to be meaningfully additive,” said Marat Zapparov, CEO of Pentagreen. “A key part of our mandate is to enlarge the universe of deals that can get financed rather than chasing the same deal everyone else is chasing.”
For now, that means structuring and financing deals, although Zapparov anticipates that eventually advisers will start to structure tranches specifically for Pentagreen.
“We cast the net wide, and talk to developers, sponsors, project promoters," he said. "We might do deals that banks and multilateral development banks can’t do off their own balance sheet because of a different risk appetite and remit.”
Pentagreen will take a differentiated tranche – for instance, investing in subordinated debt with no guarantees while other institutions get senior debt with guarantees.
In its first transaction, announced in September, Pentagreen structured a mezzanine construction green loan for solar power projects from Citicore Renewable Energy in the Philippines. Pentagreen has committed an initial US$30m tranche, which will provide funding for four greenfield projects and two that have recently been completed. The facility can be expanded to as much as US$100m if there is additional demand from other investors, which would grow the portfolio to more than 1GW.
“We tested the Citicore deal with some private credit investors,” said Zapparov. “If the portfolio was largely operational and generating cash, it could be a classic private credit deal, but because it’s greenfield, the private credit players may not have appetite and the multilateral development banks may not want subordinated or mezzanine debt. This is the gap we have to fill.”
Zapparov said Pentagreen will probably do two more deals this year and two or three in H1 2024.
“There are return expectations for Pentagreen," he said. "The plan is to scale this vehicle, and we will need to have a kind of tiered capital stack to give different returns.”
Scalability has been tough to achieve in blended finance, with development banks generally looking at projects individually and spending 12-18 months to bring a blended transaction.
“We are suggesting institutions to aggregate several transactions in form of a fund/facility which has the potential to be scaled versus individual transactions, as blended finance takes longer time frames,” said Ritesh Thakkar, senior adviser for Asia Pacific at Convergence. “It’s important to look at blended finance in a programmatic way versus an ad-hoc approach.”
Donors may also need to adopt new skills, as in the past they often gave concessional money as grants. Now, they may expect returns on principal, albeit at a lower-than-market rate, and recycle capital back into a fund. For instance, the ADB manages a fund with the Australian government, the Australia Climate Finance Partnership, where the ADB deploys capital as loans, equity investments, guarantees, grants, and technical assistance, and returns are paid back into the fund, rather than being remitted to the donor.
“Blended finance calls upon a partnership approach,” said Thakkar. “This requires different skill sets and thinking within the organisations and thus calls for a different approach leading to change management on the fund deployment strategy.”
Donors rethink funding
Tighter liquidity conditions have also contributed to a rethink of donor funding.
“Higher US Treasury rates have made a big difference,” said the ADB’s Evans. “It’s much more challenging to get bilateral government funds because donor countries’ funds are much tighter now. The tendency now is for us to get guarantees from donor countries, rather than get grants.”
The US, UK, Japan, Denmark, Sweden, Italy and South Korea will be providing guarantees to the ADB, minimising the amount of cash they have to budget. For instance, the US is looking at providing a US$1bn guarantee, but only needs to budget US$84m for the risk, since the ADB has a default rate of less than 1% in its sovereign lending and tends to be the first to be repaid.
“Donors have low risk for having to spend that money,” said Evans. “We still service the loans, this just takes the risk away from the ADB and puts it with the donors.”
The ADB uses those guarantees to carve out part of its existing sovereign loan portfolio, freeing up its own cash.
“Taking that off our books frees up capital, and we get US$4 or US$5 of climate finance for every US$1 guarantee,” said Evans. “We are hoping for guarantees of US$3bn.”
Climate mitigation projects are able to attract plenty of concessional money from government organisations due to their commitments to the Paris Agreement and international aid obligations, but other social projects may find donor funding harder to come by.
“For other, non-climate sectors such as financial services (including SMEs and microfinance), healthcare and education, agribusiness and food security, gender lens investing, and information technology and communications, there appear to be fewer drivers for foreign governments to commit funding,” said the ADB’s Barton. “Philanthropic organisations and family offices are interested in non-climate sectors, but they are not yet operating at the same scale as government agencies in most parts of the world.”
StanChart’s Puri agrees that it is time for blended finance to address other social goals too.
“I’d like to see the thematic moving from climate mitigation to adaptation,” he said. “There are lots of other sustainable development goals to meet by 2030. We need to come back to some of these SDGs by using blended finance for things commercial banks wouldn’t do by themselves.”
The ADB’s Evans argues that modern investment objectives require investors to rethink the whole notion of bankability and what constitutes a reasonable return.
“Bankability still uses a decades-old definition,” he said. Evans noted that investing in fossil fuels used to provide high returns, but those investments now have a high potential to become stranded assets. “The return on renewable investment may not be the same, but the days of those high returns on fossil fuel investments may be gone too. Pension funds and institutional investors are recognising this already, recognising that they are going to have lower returns.”