FINANCING THE GREEN TRANSITION: ADDRESSING BARRIERS TO CAPITAL DEPLOYMENT.

• Author: Monaca, Sarah La

INTRODUCTION

Combating climate change at a global scale requires dramatic mobilization of capital markets. The International Panel on Climate Change (IPCC) estimates that $2.4 trillion--approximately 2.5% of global GDP--would need to be invested in the energy system every year through 2035 in order to limit climate change to 1.5[degress]C. (1) The International Energy Agency (IEA) estimates that more than $3.5 trillion must be invested annually in energy supply and efficiency to achieve 2050 climate targets laid out in the Paris Agreement. (2) Abroad suite of financial strategies--including debt instruments, derivatives for risk mitigation, and asset securitization strategies--will be critical to facilitating the transition of clean energy infrastructure.

This paper focuses on hurdles to financing green infrastructure projects and considers financial solutions developed by the private sector as well as ways in which public intervention can serve as a catalyst for unlocking or scaling private funds. We examine financial solutions in two major categories: strategies for risk management that enable growth of the project pipeline, and strategies for aggregation and securitization for deploying capital at scale. We first note the important role of green bonds as a sustainable asset class and identify key hurdles to growing the burgeoning green bond market. Though a highly successful young asset class, green bonds primarily serve as a refinancing tool and are not sufficient to meet the range and scale of capital deployment necessary to meet global climate goals. Thus, we outline additional financial solutions that will be essential to unlocking clean energy investment, such as project preparation facilities (PPFs), development finance institution (DFI) co-lending, aggregation, and securitization.

TWO KEY BARRIERS TO CAPITAL DEPLOYMENT: PIPELINE AND SCALE

The volume of public funding available to finance renewable energy, energy efficiency, and clean transport projects is limited, which means that unlocking private sector investment at scale is critical. According to the International Renewable Energy Agency (IRENA), available public funding may amount to just 15% of the financing required to meet decarbonization targets. (3) Capital markets and private sector investment will need to be fully engaged to supply the remaining capital required. Fortunately, the capital appetite for environmental and clean energy investing is considerable: the Global Sustainable Investment Alliance estimates that environmental, social, and governance (ESG) investing totaled $30.7 trillion of assets under management (AUM) (of which $1 trillion is specifically classified as sustainability-themed) at the start of 2018, representing a 34% increase over the preceding two years. (4) A group of European institutional investors recently launched the Climate Endowment, aiming to deploy up to [euro]40 billion of capital from pension funds and insurance companies in sustainable businesses and technologies. (5) In the United States, the New York State pension fund is an example of a similar program with investment targets of up to $20 billion. (6) Initiatives such as the United Nations-led Principles for Responsible Investment, whose members include asset owners, investment managers, and service providers with $90 trillion AUM, indicate the ambition of mainstream financial institutions to continue to grow ESG investment practices. (7)

These anecdotal examples are indicative of the oft-repeated notion that a "wall of capital" is available for sustainable investments. The challenge is to efficiently match that capital to projects that are not only attractive from the perspective of would-be investors, but are also climate-impactful. Both public and private sector advances are imperative to achieving emission reduction targets. Ideally, comprehensive policy interventions designed to monetize the full social benefits of green energy and infrastructure projects--i.e., explicit pricing of greenhouse gas emissions--would correct current market failures. However, in their absence, this paper focuses on financial innovations that will help push the increasingly competitive economics of clean energy assets over the finish line.

Barriers to green finance vary across sectors and geographies; the financing environment in developed markets, for instance, is very different than in emerging markets, while the financing challenges facing renewable energy projects can be very different from those in the electric vehicle sector. Still, there are common themes in the obstacles to sustainable finance that span numerous geographies and sustainability-linked sectors. The most critical financial barriers to maximizing private sector capital deployment toward clean energy development are 1) those that limit the pipeline of projects available to investors and 2) those that limit the scale of their investment even in commercially-viable projects.

First, sustainable assets like renewable power generation continue to have difficulty accessing early-stage financing due to the risks inherent to the pre-construction phase of projects. This is often a major inhibitor of the pipeline of projects. As noted above, public funding will comprise a small percentage of the capital ultimately deployed, but its strategic use will be essential to accessing and leveraging the private capital necessary to fund the green transition. Early-stage financing is just one example of how relatively small amounts of strategically-placed public funding can be an important catalyst for attracting much larger amounts of private sector investment. McKinsey & Company estimates that development capital and the use of risk-mitigation mechanisms have the ability to mobilize $1.8 to $2.8 trillion over 15 years. (8)

Public funding for sustainable sectors can come from many sources, including development finance institutions (DFIs) and publicly-capitalized green banks, or directly from governments themselves. While some public finance interventions target social or policy objectives via "concessional" financing (i.e., investments that, by definition, yield below-market returns), those are outside of the scope of this discussion. The focus here is on financially-viable private sector investment, and public finance interventions that facilitate the development of unproven or early-stage market segments and put them on a path to sustained private funding. This is in line with the self-identified primary objective of many public finance institutions such as; the International Finance Corporation (IFC), the private investment arm of the World Bank Group; from 2014 to 2016, "creating markets" was the rationale for approximately 97% of the IFC's blended public-private financing." (9)

Second, many green infrastructure assets, such as small-scale renewable generation or residential energy efficiency, are disaggregated and heterogenous, leading to high transaction costs and a lack of asset liquidity. The illiquid nature of these assets, whether due to scale or risk profile, prevents the erstwhile wall of capital from being easily or quickly deployed. A lack of standardization and accountability in some asset classes also creates a risk that capital intended for sustainable purposes will instead be diverted to projects that do not have true climate impact.

GREEN CAPITAL INSTRUMENTS: THE RISE OF GREEN BONDS

Financial products are a critical tool for enabling investors to explicitly allocate funding to green projects. Green bonds are one of the most accessible low-carbon financial instruments currently available for matching investor preference for sustainability with relevant projects. According to the Global Sustainable Investment Alliance (GSIA), fixed-income (debt) made up 36 percent of sustainable asset allocation in 2018. (10) Green bonds are fixed-income securities intended to finance environmentally-beneficial or climate-aligned projects. Structurally, they are similar to conventional bonds, and are most often held as senior secured or unsecured debt, though in recent years, green debt obligations have increasingly been packaged into derivatives, including mortgage-backed securities (MBS) or asset-backed securities (ABS). Green bonds are used to finance a wide range of activities, from large-scale wind and solar generation, to energy efficiency upgrades in multi-family buildings, and mass transit or electric vehicle fleet transitions.

The green bond market has grown dramatically since the World Bank issued the first green bond in 2008. (11) Over the subsequent decade, the World Bank has issued more than $ 15 billion in green bonds, with nearly 70 percent of current commitments dedicated to renewable energy, energy efficiency, and clean transportation projects. (12) Global green bond issuance in 2018 totaled over $182 billion, which, when paired with the full range of sustainable debt products, brought green lending to nearly $250 billion. (13) Cumulative global green bond issuance now stands at over half a trillion dollars, with more than 60 percent of bonds supporting renewable energy and sustainable transport. (14) Once dominated by public issuers (national governments, municipalities, and development banks), the green bond market has seen a large expansion of...