Innovations in climate finance give hope for our future

Ben Caldecott

Planetary resilience requires the rapid transformation of energy systems, which in turn requires investment at a scale not seen before in renewable and low-carbon infrastructure. We also need to dramatically improve our resource efficiency, which will involve thinking about how our economies work in a much more holistic, integrated way. Two innovations presented by Climate Change Capital to the recent Durban climate change meeting could represent a real breakthrough for climate finance for developing countries.

The transition to a sustainable, low-carbon economy is going to be complex and challenging. As we go through a sustained process of creative destruction, significant value will be both created and lost throughout the global economic system. We will move from a system based on low capital expenditure and expensive, finite inputs with dangerous externalities, to one with higher capital expenditure, but much lower marginal costs and a fraction of the environmental impact. The role of progressive investors must be to support value creation in sustainable sectors and stop condoning harmful ones. That’s central to our mission at Climate Change Capital.

One of the core functions of the international climate change negotiations – in addition to tackling the free-rider problem – is to create frameworks for capital to flow in a way that supports this transformation, particularly in the poorest developing countries. To enhance the impact of these and of limited public funds, we propose two significant innovations. The first is a new way of deploying low interest rate climate finance to enhance its impact, while the second can cost effectively generate the real cash flows needed to make environmental and developmental projects viable.

Perpetuity funds – better concessional finance

Concessional finance – loans with interest rates and terms better than those available on the market – can help address the serious problem of capital availability and cost in developing countries generally, and for climate projects in particular. Without lower-cost capital, climate-compatible development projects that need to happen won’t.

Unfortunately, traditional mechanisms for providing this, particularly though institutions like the World Bank, are often criticized and viewed with cynicism in developing countries. The perpetuity fund concept – which Climate Change Capital has begun developing with Fauna & Flora International, among others – could be part of the answer. Perpetuity funds are mission-driven revolving funds which could provide concessional finance (debt and equity) – for example, for solar energy in Sub-Saharan Africa, forestry in Indonesia or adaptation in Bangladesh. All returns would be reinvested in each fund, together with compounded interest, so the fund’s value would steadily build up, like a pension pot.

As with a pension, there would also be an end beneficiary – for example, the communities or country that hosted the financed projects. The beneficiaries would receive the value of the fund once it reached maturity, which would be when the fund completed its defined mission (for instance, financing 1 gigawatt of solar energy or 1 gigatonne of emission reductions) or its allotted timespan. In addition, because each perpetuity fund would be established with gifted money, its required rate of return would be relatively low, so projects not able to achieve market-rate returns could still attract capital.

For example, a perpetuity fund could have a mission to finance decentralized renewable energy projects in Kenya over a 20-year period. If it were seeded with $100 million of aid money, it could then start to provide capital (debt and equity) for viable projects at below-market rates.

The fund would still need to make an annual return on its investments, otherwise it would not grow. If it achieved a target return of, say, 7 per cent after costs and inflation – a rate achievable in many developing countries – then the real value of the $100 million fund would grow to $197 million after 10 years, to $276 million after 15 years and to a final value of $387 million after 20 years. Over this period it would also have catalysed many more millions of private investment into its funded projects.

After 20 years, the fund would be wound up and the proceeds shared equally among a number of beneficiaries, which could include the local community that had hosted financed projects plus local and central governments. The beneficiaries would be required to spend this windfall on things that further support sustainable development and climate change objectives.

Beneficiaries

Under this model, the beneficiaries not only get cheaply financed renewable energy projects contributing to clean development, but also gain a significant stake in the future success and value of each project. This ensures properly aligned interests between those that lend money, the organizations that develop projects and the communities and governments that host them. For climate change-related projects, this alignment is absolutely essential if projects and programmes are to succeed.

There are also significant advantages for a developing country in having a fund created to work over the long term with a clearly defined mission, since it allows the fund to build better and longer-term relationships within the country, as well as to develop and retain appropriate expertise.

Through such fund structures, government donors would be making a meaningful contribution to their climate finance commitments in a way that delivers ongoing value for money and high levels of leverage over many years. Donors could also top up successful funds and could potentially mobilize co-investment into perpetuity funds from other donors, philanthropists and even private investors.

Philanthropic money put into a perpetuity fund on the same basis as the original donor money would increase its size and impact. Social investors could also deploy their capital alongside this gifted money, with the difference being the expected return, which could be realized when the fund reaches maturity or at pre-defined ‘exit’ points.

There are a number of different ways to structure private co-investment into perpetuity funds once they are established, potentially with senior or junior tranches available to appeal to a range of different investors. It might also be possible to aggregate capital from small-scale donations and/or retail investors to crowd-source investment into perpetuity funds.

Because the perpetuity fund model is inherently flexible – its mission, beneficiaries, targeted rate of return and sources of capital can all be tailored to the needs of donors, investors and recipients – it can be used successfully in a huge range of different contexts, in developing and developed countries alike.

Results-based climate finance

Another instrument that could help to produce the income streams needed to make climate change projects economic, and therefore financeable, are Emission Reduction Underwriting Mechanisms (ERUMs). ERUMs would provide payments for emission reductions in developing countries based on results. The guaranteed revenue streams involved would enable public and private actors in developing countries to raise capital against them. Again, these mechanisms would be tailored to the needs of countries, technologies or sectors. ERUMs could be offered for themes throughout the developing world, for specific countries or regions, or for sectors in countries or regions.

As an example, the Green Climate Fund (GCF) – the new fund created by the international community to deliver $100 billion per annum of investment into climate change mitigation and adaptation in developing countries by 2020 – could offer an ERUM for 100 megatonnes of reduced emissions from forestry (REDD+) in Indonesia. Different public and private partnerships would bid to win the ERUM as part of a tendering process. If the successful bid is, say, $5 per tonne of CO2 abated and the contractors are paid by GCF for its achievement, this suddenly creates a visible, predictable and long-term revenue stream that can be invested against.

As a result, public money and private risk capital can be deployed, knowing that it will be remunerated on performance in the future. All this is achieved through a transparent tendering process, ensuring that emissions reductions are secured by the GCF at the lowest possible cost, which is absolutely essential given the state of public finances in developed countries.

Again, under this model philanthropists and social investors could co-invest with donor funds on the same or a different basis. This would increase the number of emissions that could be paid for and reduced. For private investors, participating in an ERUM could be a way to hedge against future carbon prices if an ERUM was linked to the production and delivery of tradable carbon credits.

Sustainability for the environment and the beneficiary organization

Both of these innovations – perpetuity funds and results-based payments – could be transformative and catalytic for capital flows, and can be structured so as to blend philanthropic money or private investment from non-governmental sources. Together this would make a significant contribution to mobilizing investment into climate mitigation and adaptation actions in developing countries.

Ben Caldecott is the head of policy, advisory at Climate Change Capital (CCC) and directs the CCC ThinkTank. Email thinktank@c-c-capital.com

For more information
http://www.climatechangecapital.com


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