This article was originally published on WRI.
Rapidly growing emerging markets and developing countries need new infrastructure: roads, power plants, water systems. There is an opportunity to develop this infrastructure in a sustainable and climate-compatible way — or not. The path we choose could make or break the chance at a decarbonized, sustainable and climate-resilient future.
But building all this infrastructure requires a tremendous amount of capital. According to the United Nations, the gap between the demand for investment and its supply is vast, and still widening. According to the IEA, annual clean energy investment alone in developing countries needs to increase more than 7 times, from less than $150 billion in 2020 to $1 trillion by 2030. These figures don't include adaptation costs.
Everyone knows about this gap. So why isn't it being filled?
Public capital in the form of domestic resources, donor contributions and multilateral development bank support in developing countries simply cannot meet the massive scale of investment needed. And while private investors command substantial resources, the incentives and mindset under which they operate often inhibit them from making investments in climate-smart infrastructure. They operate based on the concept of risk-adjusted returns — a measure that puts returns in the context of the amount of risk involved. And in too many instances, climate investments, especially those in developing countries, are just not attractive enough.
But what if there was a way to reduce the risk associated with such investments? What if the careful application and deployment of public capital could encourage and reassure other investors that it is safe to invest?
This is where the concept of "de-risking" can play a role.
Understanding the risks of investing in low-carbon infrastructure
In an investment context, risk is the probability that the performance of an investment will be different from expected. Because high risk implies high uncertainty, investors typically demand what is known as a risk premium, which reflects and accounts for risk involved in an investment. This risk premium directly affects the cost of capital. In other words, lenders (investors) will charge higher interest rates to borrowers undertaking riskier projects. The risk premium is why, for example, established companies can borrow at a much lower interest rate than a money-losing start-up.
Risks, of course, are always partially in the eye of the beholder. Private investors in developed countries, where most private capital sits, may be unfamiliar with emerging and developing economies. And the risks they perceive about doing business outside their comfort zone can drive up risk premiums, potentially making the project non-bankable, or non-viable, for investors.
Climate-smart infrastructure investments in developing countries present a variety of risk factors. Let's take a renewable energy project as an example:
- Political risk: The country where the project is to be located may have an unstable political environment or change energy policy priorities whenever new leadership comes in.
- Regulatory risk: The regulatory environment may not be conducive to private investments due to insufficient or contradictory enabling policies, weak legal frameworks and limited enforcement capacity, or frequent changes to regulations that create instability.
- Capital market risk: Financial markets may be fragmented, inefficient and suffer from frequent currency fluctuations.
- Technology risk: The technology itself may have specific associated risks, such as underperformance, limited in-country expertise in construction and operation and inadequate supporting infrastructures such as transmission and distribution.
How to de-risk climate-smart investments
De-risking means reallocating, sharing or reducing the existing or potential risks associated with climate investment. For our purposes, we can divide de-risking into two categories: policy de-risking and financial de-risking.
Policy de-risking mitigates risks through policy measures, enacted by policymakers or through policy-based support by external donors or multilateral institutions. These efforts establish the rules of the game. They can be general, such as a law clarifying corporate governance. Or they could be specific, such as a law strengthening renewable power mandates that would, in turn, provide greater certainty to developers and investors that they could sell solar energy power in the future.
Financial de-risking, by contrast, deploys financial measures to avoid or reduce the risk associated with projects. Typically, this involves public entities such as donor governments, multilateral development banks, development financial institutions and climate funds encouraging private investors to deploy capital by offering to bear a share of the risk. De-risking can be achieved through a range of measures such as debt, equity and guarantees, spreading the risk between participating parties or transferring the risk to a third party.
Public financial institutions play a critical role in de-risking, as they provide the de-risking capital, instrument or mechanism. When public resources are deployed strategically, a previously unbankable project can attract and mobilize capital from commercial and institutional investors.
3 examples of de-risking low-carbon investments
Here, we describe three cases currently operating to illustrate how de-risking can work to catalyze additional private capital. The first case presents how a climate fund's participation as an equity investor can attract private capital. In the latter two cases, public finance ultimately backstops private investors — in the second case through reinsurance and in the third case through equity and guarantee.
1. Espejo de Tarapacá
The Espejo de Tarapacá is an innovative large-scale power project that uses the unique geographic characteristics of Chile's Atacama desert. It is sited on a coastal cliff with natural surface concavities ideal for the storage of seawater. The project consists of two power plants: a 300-megawatt pumped-storage hydroelectric plant using the Pacific Ocean as its lower reservoir, and a 561-megawatt photovoltaic solar plant.
The project is essentially a large electricity storage system that will counterbalance the intermittency of renewable energy. As the first renewable bulk energy storage facility in Latin America using seawater, the project contributes to both climate mitigation and adaptation, supporting energy sector resilience, water security (via its own desalination plant) and diversification of the local economy.
Yet the project faced difficulties attracting capital for the final development phase. Traditional private investors were not willing to enter due to the associated risks. These included acquiring permits, establishing energy contracts, engineering and design tests, community engagement and cash funding for guarantees required to participate in power purchase agreement (PPA) processes.
That's why the Green Climate Fund (GCF), a multilateral climate fund, provided $60 million in direct equity, which helped cover last-stage development expenses, put a PPA in place and attract private investment for final implementation. GCF's participation as an "anchor" equity investor — the first investor to make a substantial capital commitment — represents a stamp of approval that, in turn, helped mobilize private capital that would otherwise have sat on the sidelines. GCF's investment served as an indicator of quality to private investors, including those that are more risk-averse or less experienced. With the support of GCF, the project is expected to raise $1 billion from the private sector.
2. Africa energy guarantee facility
Sub-Saharan Africa remains the least electrified region in the world. Yet investors are reluctant to make the investments necessary to build out the region's sustainable power generation capacity. Due to unpredictable regulatory frameworks and an unfavorable investment environment, the risk-premium investors demand is simply too high.
This is where the Africa Energy Guarantee Facility (AEGF) comes in. The AEGF was created with contributions from several public- and private-sector parties — the reinsurance company Munich RE, the Nairobi-based insurance underwriter African Trade Insurance Agency (ATI), the European Investment bank (EIB) and German Development Bank KfW — to insure and reinsure sustainable energy projects. It is the first risk-sharing facility that insures primary insurers to reduce the risk of their portfolio in the African energy sector. AEGF aims to enhance access to finance for energy projects by eliminating potential risks faced by energy sector investors through a system of backstops and insurance tools.
Here's how it works:
- Primary insurers such as ATI assume a portion of the risk related to green energy projects, mobilizing resources from lenders and investors.
- Through AEGF, primary insurers get re-insured by Munich RE, one of the world's largest and best-rated reinsurers, to increase their capacity to insure and better address the risks and timelines of green energy projects.
- KfW and EIB, in turn, issue dedicated guarantees to Munich RE to cover certain risks such as non-payment under a power purchase agreement, expropriation, breach of contract, currency inconvertibility and civil unrest. By doing so, these guarantees increase Munich RE's reinsurance capacity.
With this chain of relationships, the primary insurers can expand their capacity to provide insurance to energy access, energy efficiency and renewable energy projects at a reasonable price. The AEGF is expected to facilitate around $1.4 billion of private investment for energy access, energy efficiency and renewable energy projects in Africa.
3. Climate Investor Two
Climate Investor Two (CI2) is a "whole-of-life" financing facility that consists of three funds to finance each stage of an infrastructure projects lifecycle. CI2 has used various de-risking techniques, including tranching, to catalyze greater investments into the climate adaptation and resilience sectors in developing and emerging countries.
Here's how it works: equity commitments to the Construction Equity Fund (CED) are allocated into three individual tiers or tranches. Each tranche offers a different risk-return profile provided to investors.
- In Tier 1, public donors such as the European Commission and Nordic Development Fund, who do not expect their capital to be recouped, provide a first loss buffer.
- Commercial investors and development finance institutions provide equity capital for Tier 2, secure in the knowledge that losses up to a certain point will be borne by tier 1 investors. Their investment is thus substantially de-risked.
- Tier 3 provides an even greater level of protection — it is a senior equity tranche with guaranteed returns and is marketed to institutional investors.
A tranche structure that divides tiers by risk, time-to-maturity and type offers a distinct risk-return profile for each tier of capital, making it easier to market to investors and their individual needs. Without the provision of Tier 1 capital, the investment proposition would have been considered too risky for mainstream commercial capital.
With the target of raising $1 billion for CED, CI2 is expected to catalyze $2.5 billion in private sector funds at the construction phase. Projects under CI2 include a seawater desalination project in Thailand where seasonal water scarcity affects local populations, a solar-powered desalination project in Kenya, and a marine ecosystem management project in Africa and Latin America.
De-risking climate-smart investments: Doing more with less
As these cases illustrate, de-risking in various shapes and forms has the potential to make previously risky climate infrastructure projects attractive enough for private investors to join in. De-risking strategically uses public capital to mitigate investment risks that are discouraging the flow of private capital. With innovative approaches, small amounts of public capital can be leveraged to catalyze much larger sums from the private sector.
That being said, de-risking to mobilize private capital isn't for every project and every circumstance. For example, some projects or sectors are best funded by public finance alone, such as the provision of basic infrastructure, research and development, and strengthening the enabling environment.
The ultimate goal of using public resources to de-risk is not just to finance individual climate infrastructure projects. These practices can also contribute to building a database for leveraging the private sector, facilitate learning, provide demonstrations, build investor familiarity with the sector, and achieve economies of scale so that eventually, standalone private activities are possible. While no single initiative will be able to achieve these far-reaching goals on its own, replicating and scaling successful and innovative de-risking initiatives can help close the climate investment gap and accelerate the transition to a low-carbon, climate-resilient world.