Editor’s note: This piece is based on research from a forthcoming paper to be published by the Climate and Development Knowledge Network.
The Debate: Should International Climate Finance be Used to Directly Catalyze Private Investment?
At this year’s United Nation’s Climate Change Summit in Durban, South Africa, negotiators will be faced with the question of whether and how international public-sector climate finance should be used to catalyze private investment in the developing world—one of the more contentious issues within the climate negotiations. What is at stake? Some 95 percent of the growth in greenhouse gas emissions over the next 25 years is expected to come from developing countries. Significant investment in new clean technologies and sustainable land use practices to help move these countries onto climate compatible pathways will be needed. Even if climate action succeeds in maintaining an environment at no more than two degrees celsius over pre-industrial levels—a goal which may already be out of reach given emission growth trajectories—developing countries will still need to cope with the impacts of climate change. Economies will need to transform to meet these mitigation and adaptation challenges. The public sector has a critical role in setting goals, building the enabling environment, and investing in research, development and public infrastructure in ways that support the transition. However, businesses and households will be responsible for the bulk of the required investments. Yet significant barriers to that investment exist.
Private sector investors will deploy their capabilities and capital on low-emission investments only to the extent that risk-adjusted returns are positive and competitive. Investors look to countries with good investment climates and well-developed capital markets where the regulatory environment and pricing signals are clear and stable. These elements are not in place in many developing countries where country and currency risks, uncertain sector regulations, execution risks, and capacity and knowledge gaps deter investment. Even if these barriers to investment can be addressed through risk reduction mechanisms, technology cost gaps between high and low-emission alternatives remain in many sectors, particularly in the absence of a price on carbon. Thus far, international public funds have been used to provide subsidies to the private sector through concessional loans or grants to close the technology cost gap, but in amounts far below what is needed. While increased funding will be needed as an important bridge, this approach will not be sustainable over the longer term. Climate finance that focuses on closing the cost gap should have a clear transformative intent of achieving sufficient scale to reach environmental, economic and financial sustainability. In doing so it can accelerate the reduction in technology costs while also providing a pathway for policy and/or international markets to price carbon so as to fully internalize environmental costs associated with greenhouse gas emissions.
While recognizing these barriers, developing countries are still deeply suspicious of the use of international public climate funds to directly catalyze private investments. Many see a push by contributing countries to use public funds to leverage private investment as a way to dodge their own pledges to contribute $100 billion per year in climate finance by 2020. Lower-middle income and least-developed countries worry that their relatively weaker investment climates would deter private investment, and leave them without access to funding. Some object in principle to private sector involvement in key sectors of the economy, like energy, and other developing countries worry that local private sector actors will be cut-out of business by large multinational financial concerns. On the other hand, many potential contributing countries are looking for ways to direct their scarce public funds in ways that maximize private sector investment, and are looking to the GCF as one important vehicle for this. They argue that leverage of private capital is critical to mobilizing funding sufficient to meet the investment needed to support a low-emission transformation.
Threading the Needle: A Green Climate Fund Private Sector Facility
Over the last seven months, the Transitional Committee (TC) charged with developing a detailed design for the Green Climate Fund grappled with this issue. It found a compromise in its proposal to create a dedicated private sector financing facility as one feature of the proposed GCF governing instrument that is up for approval at the upcoming climate talks in Durban. The facility would operate separately from financing windows for mitigation and adaptation, and would directly and indirectly finance private sector mitigation and adaptation activities at the national, regional and international levels. Responding to the concerns from the developing countries, the TC’s design emphasizes that the facility’s operations need to be consistent with a country-driven approach and promote the participation of local private sector actors in developing countries, including small and medium-sized enterprises and local financial intermediaries. The facility will also support activities to enable private sector involvement in Small Island States and Least Developed Countries. Beyond these principles, the detailed design was left to the GCF Board, once created.
Making It Work: Design For Scale
The TC proposal is good news. The creation of a dedicated private sector facility presents a strong opportunity to partner with the private sector in ways that could significantly scale up private investmentbut how it does this will matter. The facility can provide differentiated tools and approaches for countries that are still developing an enabling environment for climate compatible investment, but also focus on business models which meet the needs of countries with stronger investment climates. It can also scale up a number of promising experiments aimed at tapping into pools of private capital. In doing so, it will need to accept a reasonable level of risk, since not all of the investments will succeed. The design of the facility should focus on results, placing a premium on scaling up what what works well while being open to new approaches. The following discusses three of the design challenges that will face the GCF Board as it moves to create the private sector facility: adopting differentiated approaches to meets varying needs of countries; designing a governance structure that includes private sector representatives; and focusing on learning, knowledge and partnership as essential elements in achieving lasting results.
Differentiated approaches. The facility can adopt differentiated approaches to the needs of lower-middle income countries, least developed countries, and small island states versus those of rapidly industrializing countries with developed capital markets. This differentiated approach should be underpinned by a broader GCF goal of supporting all countries as they put in place the enabling environment critical to meeting their climate and development objectives in a sustained way. Two complementary approaches should be considered by the facility:
- Support early movers. The objective is to reduce the barriers for early market entrants, so that later investors, developers and financial intermediaries will subsequently enter the market without additional support. Risk mitigation tools – like subordinated debt, guarantees, and equity— with concessionality as needed to bridge the technology cost gap, could support individual projects or groups of projects, working directly with project sponsors. Performance based instruments have not yet been part of these types of funds, but should be considered. These include proposals to use climate finance subsidies to cover feed-in-tariffs—a substitute for up-front capital subsidies. Project sponsors for large, signature projects could apply for funding directly, although this would mean that the facility would need to develop project appraisal and under-writing capabilities. Or, they could be asked to select from a list of qualified public International Financial Institutions, which could both provide appraisal services to the facility while also providing complementary financing where required. Funds could also be channeled through local banks and other domestic financial intermediaries, with the added objective of meeting the needs of small and medium scale investors, while building capacity of the domestic banking system to appraise and price low-emission projects.
- Scale up through leverage by tapping pools of private capital. This strategy focuses on the private sector as an investor and would build on a number of ideas that are familiar to capital markets and are currently being tested for their suitability for climate investments. These may hold promise especially for those countries and sectors where early movers have demonstrated the feasibility of investment and where capital markets are more mature. Examples include investing public funds in private equity funds that invest in mitigation or adaptation using either pledge or challenge mechanisms. These could encourage public-private partnerships with public development institutions such as the International Finance Corporation, Regional Development Banks, or international bilateral or domestic development finance institutions. Some of the funding could be used to invest alongside private clean venture funds that focus on developing countries. Alternatively, the facility could deploy its resources to support an export-credit program, or to fund incentive mechanisms, such as underwriting Carbon Emission Reductions. Finally, it might support the development of green bonds, with GCF funding backstopping first losses of early issuances.
Under this second modality, instead of designing ex ante business models, the facility can emphasize competitive processes to seek and test these new approaches. By using challenge fund approaches it would issue periodic calls for proposals and evaluation against criteria that align with GCF and facility goals. These could be organized as regional, sectoral or global calls. The proposals would then be screened and assessed, with those that hold the most promise for leveraging the private sector and achieving results and impact selected. A reverse auction might also be used to minimize the need for subsidies, although this will be complex given the heterogeneity of eligible countries and sectors.
The balance of funds between these two approaches within the facility could shift over time. In early years, the first modality might be needed more, especially in countries with weaker investment climates and nascent enabling environments for climate compatible investments. As the market matures, funding could shift to the more wholesale, indirect mechanisms outlined in the second modality. Care would need to be taken in resource allocation mechanisms to ensure that funds are not unreasonably concentrated in support of a limited set of countries. Finally, in line with current climate finance experience, most of the private sector operations would initially be likely for mitigation in the clean energy space. However, this facility could begin to experiment with promising private sector investment for land use, land use change and forestry and adaptation solutions as well.
The facility should have a governing body which would be designed to tap private sector skills and knowledge. The facility board should be a decision-making body, and should include a balance of respected individuals from the private sector in both the developed and developing world. It should also include representatives from the public sector—again balanced between contributing and recipient countries—who will be concerned about the proper use of public funds. Including private sector stakeholders on the board will help ensure that the facility has an eye on innovation and results. It would also help ensure that the facility is attractive to the private sector by calling for processes that lower transaction costs and ensure timely decision-making. To avoid conflicts of interest, private sector representatives should no longer be directly active in the climate-related investment field. A facility board that combines both public and private sector members will help take a considered view toward its risk appetite. Using a challenge fund approach, the facility will be experimenting with new business models, not all of which will succeed. The facility board may decide to encourage innovation, and lead the way by piloting some of these new approaches. Alternatively the facility may wish to position itself to scale up promising experiments that are now underway once they have shown results. The latter approach might appeal to governments that are more risk averse. It also recognizes that there will be some time before the facility is actually funded to learn from the experiments now underway.
Learning, Knowledge and Partnership.
The GCF private sector facility could become a premier vehicle for partnership with the private sector, building into its charter an expectation for rapid learning and knowledge management that takes into account not only the results from the initiatives it supports, but also from the broader set of private sector initiatives that will be carried out by players in this space. It will be critical that the private sector be accountable if it is to have access to public funds. Therefore, transparency, monitoring and reporting will be key. The GCF private sector facility should reinforce this by developing the needed metrics. These could include a consistent way of calculating leverage of public sector funding and reporting on levels and impacts of subsidies. The facility could become become the industry standard bearer, and become a repository of cross-country/sector metrics. A world class set of metrics that provide transparency and support accountability would serve not only GCF contributors, recipients and civil society stakeholders, but also help drive results and impact in the broader climate finance landscape.
Message for Durban
Reaching agreement on the governing instrument for the Green Climate Fund will be one of the critical tasks for climate negotiators in Durban. While some developing countries are still uneasy, if the language submitted by the Transitional Committee is accepted the GCF will have the ingredients to support a scale-up of private climate compatible investment in the developing world. But the details will matter, and as the GCF is operationalized, its board should give the private sector facility a mandate to both support early movers and to use its funding to scale-up access to private capital. It should ensure that the facility will be governed by respected individuals who will bring a good mix of public and private perspectives from both the developing and developed worlds. And it should set a high expectation that the facility becomes a premier vehicle for partnership with the private sector. It can do this by focusing on the development of world class metrics so that it and other players in the international climate finance architecture can build on and scale-up those innovations that are most successful.