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Green finance design and development

Progress is being made in green financing. The Climate Policy
Initiative’s (CPI) Landscape of Climate Finance 2013 reports
that total climate finance investment in 2012 was estimated at
US$ 359bn globally.1 The majority of this total, $224bn (or
62%), was from private sector sources with the public sector
contributing $135bn (or 38%). According to the CPI report,
there was a roughly even split between finance directed towards
developed and developing countries; however, the public sector
made up the vast majority of flows of climate finance from
developed to developing countries.
Despite this progress, green investment continues to be outpaced by investment in fossil fuel intensive infrastructure.
2 As
indicated in Figure 2, the IEA forecasts that a massive but
achievable shift in investment away from fossil fuels to low carbon technology and infrastructure is required to avoid
dangerous climate change. Additional, incremental investment
needs of roughly US$ 1.3tr per year in clean energy infrastructure, low carbon transport, energy efficiency (EE) and forestry
is required to limit global average temperature increase to 2°C
above pre-industrial levels.
3 It is important to note that fuel savings can more than compensate for the additional investment
needs when considered from a life-cycle perspective.
Most of the lessons drawn here relate to renewable energy and
energy efficiency projects or programmes, where the majority of
green finance activities are concentrated. Much of the literature
is focused on these activities, as well as climate finance, particularly with respect to the role of Development Finance
Institutions (DFIs) in supporting developing countries with climate-related activities. Given this, the paper does not attempt
to define what “green” finance is in specific terms, nor does it
distinguish between green finance and climate finance.
In section 2 the barriers and risks to green investments are
reviewed and the role of DFIs in overcoming these is considered.
Section 3 presents a discussion of critical issues in designing
green incentive schemes in developing countries and identifies
criteria for assessing whether these incentives are smart. Section
4 reviews the role of DFIs in the design of green finance incentive schemes, focusing on national, bilateral and international
development banks. In section 5 some real case examples are
drawn upon to assess the advantages and challenges associated
with different instruments that are most commonly used in the
design of green incentive schemes. The analysis is summarised
in section 6 with a discussion of the characteristics of smart
green incentives as related to the identified criteria. The concluding section 7 considers the policy implications for
international processes such as the Green Climate Fund, the
Multilateral Development Banks or the work of the International Development Finance Club.
The term DFI is defined here as any financial institution that
has a mandate to support private sector investments that promote development in developing countries. Multilateral
Development Banks (MDBs) and Bilateral Development Banks
(BDBs) are types of DFIs that are backed by guarantees and capital endowments from one or more developed country
government. A National Development Bank (NDB) is defined
here as a finance institution created by a host developing country to promote economic development objectives within that
country.
2 CPI. (2013) The Global Landscape of Climate Finance. October 2013.
3 WEF (2013) The Green investment Report: The ways and means to unlock private finance for green growth: A report of the Green Growth Action Alliance.
2015
1.6 Additional
investment
Trillion dollars (2011)
Gt
2020 2025 2030 2035
Designing smart green finance incentive schemes: the role of the public sector and development banks Challenges for green finance 6

2. Challenges for green finance
   2.1 Review of barriers and risks to green investments
   Green projects or programmes face a range of barriers and challenges in accessing finance.These may relate both to the fact that,
   as mostly relatively new technologies, they present new and
   uncertain risks to investors, as well as to the underlying investment framework or lack of a supportive enabling environment.
   Generally, barriers and risks for investors will also vary depending
   on the structure of the sector, e.g. private investment in renewable energy generation will likely involve higher risks for investors
   than investment in transmission and distribution systems, which
   are often treated as a regulated asset base, whereby returns on
   investment are guaranteed and subsequently less risky.
   Various studies, including the G20 Development Working Group,
   have identified a number of barriers to green investments in developing countries. Each of these barriers fundamentally relates to the
   risk-return gap4 and to the fact that private investors require confidencein thereturn on investment for therisk undertaken, whether
   such risk is real or perceived. These risks and barriers include:

Technology risks: Green technologies often have higher upfront capital costs which can deter investors. In developing
countries in particular, these may also include operational
or performance-related risks, for example interruptions due
to lack of or poor supporting grid infrastructure systems
which result in lower than expected revenue.
5 Physical risks
leading to financial losses due to adverse weather events can
also be significant for many green technologies.
Policy and regulatory risks: Policy and structural barriers
affect the viability and economic attractiveness of low carbon
options. The threat of policy and regulatory changes, for
example to feed-in tariffs or renewable portfolio standards, is
a fundamental risk that can deter investors. In addition, fossil
fuel subsidies still exist in many countries and most countries
lack a carbon price that would incentivise green investment.
Market risks: In addition to general market risks, such as
country or currency risk, green investments carry additional
risks relating to the immaturity of the market. These may
include high first-mover costs and risks related to unproven
commercial application of a new technology.
6 For example,
deal flow problems may result from an insufficient number
of commercially attractive deals, making diversification in
investment portfolios difficult.
Scale of Investment Barriers: In addition to project specific
barriers, a further challenge, particularly for investment in
green infrastructure, is delivering the necessary scale of investment at the pace that may be required to meet green policy
targets and objectives. On the opposite end of the spectrum,
for small-scale green investments other barriers are more common, forexample uncertainty of the credit-worthiness of local
service providers making it impossible to raise equity, as well
as end-users that have poor or non-existent credit profiles.
These lead to high transactions costs making the cost of the
investment high relative to the benefits provided.
Capacity constraints: For most developing and emerging
countries there is a lack of awareness and capacity of green
technologies and activities across the policy and investment
spectrum. A lack of understanding of the technologies by
policy-makers, project developers and financiers may lead to
inappropriate measures of support and/or high levels of perceived risk. However, often entities that are best positioned
to assume risks such as energy service companies (ESCOs)
do not have access to affordable capital.
Studies
7 have acknowledged that many of the above risks are
common to most forms of infrastructure investments, but that
these are exacerbated for green technologies, which are often subject to extensive timing uncertainty across the development,
demonstration and deployment stages, in turn increasing the
strategic and financial risk. Similarly, during demonstration and
deployment stages, the technologies are more financially vulnerable than conventional alternatives to variations in weather,
changes in level of policy support, and operational failure due to
system complexity and immature supply chains. Furthermore, as
green technologies are more capital intensive, requiring greater
levels of upfront financing, the financial risks are exacerbated.
2.2. Challenges for governments pursuing green growth
As these barriers and risks can all contribute towards making
finance, whether debt or equity, unaffordable and/or on unfavorableterms,
8 they present a considerable challengefor governments
that are pursuing green growth-related objectives at the most
affordable cost to either the public sector (if publically financed
or subsidised) or consumers (where costs are passed on).
The degree and type of risk will generally impact on the cost of
capital as the higher the risk of return on the investment, the
higher the cost of capital set by lenders or returns required by an
equity investor for taking such risk. Whilst financiers do not seek
a risk-free environment, they do require familiarity with the risks
so that they can assess whether they are acceptable and how to
manage them most effectively.
The OECD (2012) identifies three key investment conditions
for attracting private sector investment that can be addressed
through public interventions, notably:
I. Existence of investment opportunities;
II. Return on investment, including boosting returns and
limiting the costs of investment, and;
III. Risks faced over the lifetime of the project.
4 IEA (2013) Redrawing the energy-climate map. WEO special report.
5 IFC Climate Business Group (2012) Private investment in inclusive green growth and climate-related activities: key messages from the literature and bibliography. Prepared
for: G20 development working group. June 2012.
6 WEF (2013) The Green investment Report: The ways and means to unlock private finance for green growth: A report of the Green Growth Action Alliance.
7 World Bank IFC, Climate Finance: Engaging the Private Sector. A Background Paper for “Mobilizing Climate Finance”, A report Prepared at the Request of G20 Finance Ministers.
8 Kaminskaite-Salters, G., DFID, (2009) Meeting the Climate Challenge: Using Public Funds to Leverage Private Investment in Developing Countries: Section 4- Spending
public finance to leverage private investment: specific instruments for specific challenges. September 2009.
Designing smart green finance incentive schemes: the role of the public sector and development banks Challenges for green finance 7
Governments with green policy and investment goals therefore
need to focus on all three of these challenges through activities
that create green markets and measures to foster supportive
enabling environments, which increase the certainty of return on
investment and reduce the overall costs of green options. Such
governments should also consider use of public instruments for
sharing risk with the private sector.Investment Grade Energy Policy
The term “Investment Grade” energy policy9 has been developed
to reflect on the role of policy in overcoming barriers to private
investors. Through a review of various case studies of public sector interventions, the Capital Markets Climate Initiative (CMCI)
has developed five core principles to be considered in delivering
investment grade policy and projects.
10 These include:
Early and on-going managed dialogue with institutional
investors and local and international private sector;
Clear, long term and coherent policy and regulatory frameworks;
Pricesignals in the market, including subsidies and carbon price,
should support the deployment of low carbon alternatives;
Underpinning economic drivers that should be realigned to
support sustainable growth; and
National governments having active programmes of public
climate finance to support, underpin and develop investment
grade projects that mobilise private capital.
In essence, the challenge for governments is to provide long-term
certainty through a stable regulatory environment and policy
framework.The goal should be first to reduce policy-related risks
through, for example, climate change legislation, and then to
increase rewards by providing premium price guarantees or tax
incentives.
11 Whilst this presents the ideal situation, in most
cases, particularly within developing countries, policy-makers
and legislators may not be fully convinced of the affordability
and/or benefits of newer and low carbon options. Hence, most
green incentive schemes are designed in the absence of a supportive enabling environment where “investment grade policy” exists.
A range of policy and financial instruments can also be used to
de-risk investments, particularly in the early stages, to build
understanding of the risk-reward profile of green investments.
Public sector instruments used within green incentive
schemes
There are many public sector instruments available for encouraging green investment and selecting the right instrument or mix
of mechanisms can be a challenge. The appropriate instrument
will depend on the type of risk that is preventing private sector
investment. Generally public sector instruments are designed
either to reduce risk or to increase return and the response will
vary depending on sector and country context. UNDP12 identifies two categories of de-risking instruments:
Policy de-risking instruments: policies or other interventions that address the underlying barriers that cause risks.
A policy de-risking approach might involve streamlining the
permitting process, clarifying institutional responsibilities,
reducing the number of steps and providing capacity building to programme administrators.
Financial de-risking instruments: do not directly address
underlying barriers but rather transfer risks that investors face
to public actors such as development banks.Theseinstruments
can include concessional loans, guarantees and use of insurance
and public investment capital of equity co-investments.
The UNDP illustration below (Figure 2) considers how such derisking measures may work in combination with each other as
well as with more direct financing measures.
Instruments that have demonstrated considerable success and
often serve as the foundation for other complementary policy
and financial de-risking instruments are called ‘cornerstone’
instruments. These may be necessary, yet are often insufficient to
mobilise private sector investors at the scale and pace that is
required to meet green related policy objectives. A range of other
policy, regulatory and financial instruments are likely to be
needed. This paper focuses on financial de-risking instruments that are being used to provide green incentive schemes
within developing countries. However, given the intrinsic relationship between the relative success of these instruments and the
broader enabling environment, these instruments need to be
considered in light of how they are integrated with policy measures, which may be cornerstone instruments and/or policy
de-risking instruments, as well as direct financial incentives.
9 Hamilton, K. (2009) Unlocking Finance for Clean Energy: The Need for ‘Investment Grade’ Policy Chatham House December 2009.
10 Jones, A. (2012) Principles for Investment grade policy and projects. A report produced for the Capital Markets Climate Initiative. May 2012.
11 UNDP (2011) Catalyzing Climate Finance: A Guidebook on Policy and Financing Options to Support Green, Low-Emission and Climate Resilient Development. April 2011.
12 UNDP (2013) Derisking Renewable Energy Investment: A Framework to Support Policymakers in Selecting Public Instruments to Promote Renewable Energy Investment
in Developing Countries.
Figure 2: Public instrument selection for large-scale renewable energy
Source: UNDP 2013
Select Cornerstone Instrument
+
Select Policy Derisking Instruments Select Financial Derisking Instruments
Direct Financial Incentives
(if positive incremental cost)
Feed-in tariff
Long-term RE targets
Streamlines permits process
Improved O&M skills
Public loans
Partial loan guarantees
Political risk insurance
FiT/PPA price premium
Tax credits
Carbon offsets
PPA-based bidding process
Designing smart green finance incentive schemes: the role of the public sector and development banks Designing smart green incentives in developing countries 8

3. Designing smart green incentives in developing countries
   Mobilising green finance in developing countries
   By one estimate, public finance has the potential to mobilise
   four to five times its contribution from private sources. If public
   sector investment increased to US$130bn it could mobilise private capital in the range of US$570bn.
   13 This is only likely to
   be achieved with a sufficient level of understanding of how best
   to overcome risks and barriers within the local context. This creates a considerable burden for public policy and finance
   decision-makers in developing countries, not least because these
   risks will be in addition to broader social and economic development challenges such as providing education, job creation and
   development of local domestic markets.
   Generally relatively limited institutional capacity may therefore
   be unable to address the challenges associated with designing
   green incentive schemes that make best use of public resources
   for mobilisation of private sector green investment. At the same
   time, there may be limited private sector knowledge of green
   investments in developing countries, further constraining potential for development of green domestic markets and realising the
   growth opportunities these could provide.
   3.2 Risks in using green incentive schemes
   Concern over the potential for market distortion is common when
   designing green financeincentiveschemes, particularly with regard
   to the use of concessional finance and grants for investments.
   A market distortion occurs when a public intervention or subsidy changes the economics of the market. The term tends to be
   used in a negative sense, relating to the crowding-out of other
   finance providers, particularly those in the private sector. This
   would clearly represent a failure of an incentive scheme that was
   designed with the intent of mobilising new sources of green
   finance. One further risk when designing an incentive to reduce
   technology or operational risks is moral hazard, whereby project
   developers are cushioned from failure to the extent that they
   may fail to take appropriate precautions. Specific project implementation risks must therefore be taken into careful account to
   avoid the potential for such an effect. Market distortions can,
   however, be referred to in a more positive light, as may be the
   case in the use of measures to incentivise investment in renewable energy and energy efficiency. Such use of subsidies is
   justified on the basis that social and environmental externalities
   are not priced within the market.
   There are often differing views on the potential for an incentive
   to have a distortional impact. Forexample, in consideration of the
   EU Blending Mechanisms
   14
   , financiers and the European Commission disagree on the use of interest rate subsidies. Whereas
   financiers find them straightforward and useful, the Commission
   notes that they may be distortiveto theeconomy. Wherefinancial
   markets are weak the potential for interest rate subsidies to distort
   the market is generally thought to befairly low. However, for markets with a functioning commercial banking system, investment
   grants may be considered more appropriate as they encourage the
   participation of local financial institutions.
   The use of grants or concessional finance with a green incentive
   scheme therefore needs to be justified. A common way of interpreting this is by assessing if the grant or concessional element
   is essential for a project to exist. However, it is difficult to ascertain if a project would or would not have taken place under
   commercial market conditions. An ODI working paper on
   designing public sector interventions to mobilise private participation in low carbon development provides a 20-question
   toolkit. On the issue of avoiding market distortion it identifies
   three main issues, which are broadly:
   Need to understand the policy context and barriers, costs
   and risks to be overcome through the use of a public finance
   incentive;
   Ensuring additionality of the public financeincentive provided;
   Tailoring concessionality carefully to provide just enough
   incentive for the investments to take place.
   All of the above activities are important in designing green
   incentives and the extent of risk-coverage to be provided. These
   are therefore key factors that will influence whether a green
   incentive is smart or not, and the extent to which it can help
   ensure green market development and the potential for creating
   competition within such markets.
   Defining a “smart” green incentive
   As one of the key risks in the use of green incentive schemes is
   that of crowding out other investors, particularly the private sector, ‘smart’ incentives need to focus specifically on crowding in
   other investors. In other words it is important to ensure that the
   overall goal of a green incentive scheme is the development of a
   domestic green market for production and consumption of
   green technologies and/or services. Building on the literature
   above, the following issues are identified here as important criteria in the design of smart green incentives:
   Integration with the policy context
   The literature and the case studies all indicate the importance
   of understanding the policy context, specific barriers, costs and
   risks that may need to be overcome. As set out above, the targeted deployment of public finance has potential to mobilise
   five or more times its contribution from the private sector
   (WEF, 2013 and IDFC, 2012). However, this mobilisation will
   only result where public finance, in combination with other policy and regulatory measures, can mitigate the range of financial
   and non-financial barriers facing private sector investors. As policy contexts will be unique and determined largely by the
   political economy of a country, the level of real risks and the
   extent to which risks may be perceived will also vary.