G20 pledges USD 100 billion for climate finance: What needs to be done for its effective deployment.

At the recently concluded G20 conference, a climate finance initiative of USD 100 billion was pledged by the G20 countries to help developing economies meet their net zero objectives.

This is really good news.

However, more needs to be done, much more!

For this capital to flow, effective risk mitigation is key.

In any financing opportunity risks have to be correctly allocated to the entity most capable of handling that risk.

The borrowing entity cannot be saddled with risks it cannot effectively mitigate, for banks will then not lend. In any privatization initiative, the above-mentioned risks need mitigation at three levels.

At the first level lies the design of an effective Public Private Partnership (PPP) framework under which private capital needs to be deployed.

PPP is a powerful tool to attract private capital, whereby the State or Sovereign entity that needs to borrow capital cannot do solely on the strength of its balance sheet; hence, a partnership is needed with a private entity under the aegis of a PPP structure. Many governments have implemented PPP policies so far but the results have been chequered.

The reason being that sometimes PPPs have been implemented without correct unbundling of the infrastructure chain.

What does this mean?

Let’s use the example of the power industry where maximum renewables and energy transition capital will be needed.

The power sector consists of the generation, transmission and distribution sectors. Many a times these are embedded in monolithic bundled utilities. These need to be broken up, or “unbundled” into separate entities - one for generation, one for transmission and another for distribution. Private capital then flows into these separated entities. Unbundling is key as the transmission sector is monopolistic in nature as it is capital intensive and barriers to entry are high, whereas in the generation and transmission sector, it is not as free markets determine price.

Once unbundling is done, effective regulation needs to be implemented.

Regulation should only be imposed on that element of the chain which is monopolistic in nature - like transmission in the power sector. In other elements of the power chain ie generation and distribution, the price should be determined not by regulation but by market forces as barriers to entry are low.

There are two types of regulation techniques that can be used - the US “Cost Push” style where cost of capital determines price; or the “UK CPI-X” - where inflation dictates the price.

The jury is out as to which method has been more effective- the needle of advantage points to the UK CPI-X model. It has to some extent now outlived its utility and needs modification but fundamental principles are still relevant.

Many privatization programmes have had setbacks as unbundling was not done correctly and regulation was improper.

The UK example of its rail privatisation is a classic example of how “vertical unbundling“ of the rail infrastructure was done . The tracks across the entire country were given to one operator, the signals to another and the rolling stock to a third operator. A complete lack of coordination between the three private operators has resulted in delays, accidents and poor delivery.

Argentina, on the other hand, followed horizontal unbundling wherein the three elements were given geographically to different operators; coordination was better and this resulted in better efficiencies.

A judicious choice between horizontal and vertical bundling needs to be made before the onset of any privatisation programme.

Once correct unbundling is done and effective regulation imposed, private capital will flow. In an ill-conceived PPP programme, without giving credence to these two fundamental points,

it will be difficult to attract private capital. This is why some PPP programmes have struggled.

In any Privatisation programme there will be winners and losers! Everyone cannot win! Hence, it is important to ensure a right risk return for the investor with a cost and value benefit to the consumer, thereby justifying the need for the government to privatise.

This is where the “true value of money” calculation becomes critical for the Privatisation programme and it needs to be constantly evaluated at the time of implementation and throughout the tenure of the PPP framework.

The Thames Water privatisation programme went wrong on this score; whilst initially a success,

?over time it became a challenge as profit motives of private equity disturbed the true value of money equilibrium which was correct at the onset. Hence, regulators must constantly keep an eye on this parameter.

The second layer of risk comes at the project level wherein typically an SPV is formed and risk allocation is done in such a way that there is no unallocated residual risk that lies in the Special Purpose Vehicle (SPV).

Typically risks like construction risk are effectively mitigated with a strong EPC contractor with adequate level of liquidated and delayed damages built into the contract; the operating risk is mitigated with a strong operation and maintenance contract with an acceptable operator; and lastly a strong off take agreement needs to be executed. All agreements have to be implemented back to back.

The project finance industry knows this like the back of its hand, so it’s easy to execute and implement limited recourse project finance deals to attract private capital.

Political risk mitigation can also be effectively done with the tried and tested MIGA 4.0 cover, IFC - B loan structures and the World Bank Partial Risk Guarantee Programme. These institutions will continue to play a critical role as we deploy capital to help transition to clean energy to fight climate change.

The third risk, which is the most difficult and complex one to mitigate is technology risk .

In the past two decades project finance was effectively deployed, as technology risk was not significant, and instruments to mitigate political risk and project risk were very successfully developed.

However, with transition finance wherein risks to a great extent in Hydrogen, battery storage, carbon capture and direct air capture etc, where the technology is not proven, the risks are high and it becomes difficult for banks and other capital providers to understand and price these deals.

This is where “efficacy insurance” comes into play. The insurance industry along with its battery of excellent engineers understands this risk (provided it is not at laboratory chemistry level) and can understand and in turn price this risk which it will take so that banks don’t have to bear it.

For example if a battery does not perform to specifications, the insurer via the “efficacy insurance“ will service the debt and return on equity as it stood behind the performance of the battery via the insurance agreement.

This is a very powerful tool and one of the key ways to ensure transition finance flow into renewable projects into emerging economies. The banking and insurance industry thus need to work hand in hand to make this a success.

The recent announcement augurs well for our fight against climate change.

Capital has been made available; with effective risk mitigation as described above capital will flow, and the fight against climate change can be won…. It will be won!

Long live Project Financiers and Impact Capital Investing professionals.