THE OLD ORDER CHANGETH, YIELDING PLACE TO NEW…

• Development finance and Climate finance are separate asset classes but they will metamorphose into one. Lord Tennyson’s famous words “The old order changeth yielding place to new…” could not be more apt as new risk mitigation tools will come to the forefront and Private debt will play a catalysing role.
• Development finance, at its core, is geared to fund sustainable development (in sectors such as infrastructure, energy, healthcare, education, and others) in developing and emerging countries. On the other hand, Climate finance aims to support the transition to low-carbon economies (with a focus on mitigation and adaptation to climate change) and has emerged as a key focus area in the decade leading up to 2030.
• The annual demand for development finance is currently estimated at USD 3.0 -3.5 trillion and is projected to increase to USD 4.0-4.5 trillion annually to meet SDG goals by 2030 (Source: UNCTAD). The path to net zero by 2050 requires low carbon investments to rise to USD 5 trillion annually (2023 to 2030) from the existing USD 1 billion levels (for emerging and developing countries) (Source: IRENA, UNFCC).
• ?Both development finance and climate finance currently draw financing from a combination of public (Government budgets, Official Development Assistance, DFI's et al), private (institutional investors, capital markets et al) & blended capital sources. It is well acknowledged that the "traditional funding sources for development finance are insufficient, necessitating greater private sector investment" (World Economic Forum). The current annual development finance gap (in developing countries to meet SDGs) is estimated at USD 2 trillion and is projected to increase to USD 3 trillion by 2030 (Source: UNCTAD, World Investment Report 2023). The annual climate financing gap currently stands at USD 4 trillion (Derived from CPI/ BNEF estimates).
• Addressing this financing gap in both development finance and climate finance requires new sources of funding. This can be achieved if the bankability concerns and risks in such projects are suitably mitigated. If appropriate risk mitigation is achieved, new funding sources such as Private Debt can be unlocked and play a significant role in addressing the financing gap in both these asset classes.
• From a financing perspective, development finance is comparatively a more evolved asset class compared to climate finance. Development finance has been traditionally provided by development finance institutions, multilateral agencies & international banks. These financiers have relied on the tested project finance risk mitigation frameworks to develop bankable financing structures for project delivery. Climate finance carries a higher magnitude of technology risk (as compared to development finance projects) and this needs to be mitigated to attract more capital.

Project finance structures and Risk Mitigation -A Key pillar for development finance

• Project finance deals have historically exhibited lower default rates compared to broader corporate sectors. It is estimated that during the period from 1981 to 2022, infrastructure projects had a two-year average cumulative default rate of 0.9%, significantly lower than the 3.7% rate for global nonfinancial corporates (Source: S&P Global Ratings). Further, projects in emerging markets showed a 10-year cumulative default rate of 1.1%, while those in developed markets had a rate of 0.4% (Source: Moody's).
• The aforementioned low default rates in project finance are largely attributed to robust risk mitigation structures designed to protect stakeholders and ensure project viability.
• The typical project finance approach (non-recourse / limited recourse) is based on the foundation of the project's cash flows and assets for repayment and this necessitates a stringent project evaluation and subsequent monitoring. The entire financing structure is based on the appropriate allocation of risks between various project stakeholders.
• In this exercise, the risks (e.g., construction, operational, and market risks) are allocated to parties (such as contractors or operators or other counterparts) best equipped to manage them. The contractual arrangements (eg power purchase agreements or concession or offtake agreements) provide predictable revenue streams and also build in sufficient comforts to lenders / sponsors to address various unforeseen scenarios (during the project life cycle) such as scope change, change in law or taxes, political or other force majeure events. The facility structures developed by lenders further build in tailored repayment profiles, creation of reserves for debt service or maintenance to address unexpected contingencies.
• The aforementioned combination of project and financing structures enhances creditworthiness and minimizes the likelihood of defaults. This approach has helped in the evolution of development finance as a stable asset class for financiers and investors.

But Climate finance has higher magnitude of technology risk & Insurance can be a game changer

• In Climate finance, Technology has played a crucial role in driving down costs. As costs are driven down, these climate-related technologies become more accessible & affordable and adoption spreads. Solar panel technologies have led to a 70% decrease in costs over the last decade (Source: NREL Report). Another case in point is the battery cost curve. The average cost of lithium- ion batteries has reduced from USD 1100/ kwh (in 2010) to USD 139/ kwh (in 2024; Source: Bloomberg NEF) and has made EVs and renewable energy systems more competitive leading to greater adoption. Going forward, sodium-ion batteries could be a potential alternative to lithium- ion batteries.
• The game-changer technologies in the fight against climate change are green hydrogen, waste to energy, carbon capture and storage, battery storage, nuclear fission/ SMR, clean metal mining and others. For such climate interventions to be meaningful and reach scale, access to finance will play a key role.
• From a financier perspective, the approach to climate finance projects is similar to traditional development finance projects, albeit that climate finance carries a higher magnitude of technology risk. This is an area where traditional banks are not proficient and lack expertise. This gap can be addressed by insurance companies that possess capabilities to assess such risk and provide efficacy insurance to mitigate this risk. The insurance industry typically relies on partnerships with technical experts and can be expected to price this risk better.
• Such efficacy insurance ensures that the insured product (climate technology or infrastructure) meets predefined performance standards or delivers expected outcomes and can be used in climate sectors (renewable energy or water treatment or waste to energy et al). This can help in de-risking unproven technologies (where performance becomes a key risk for financiers) and provide confidence to investors and financiers.
• Appropriate usage of insurance can mitigate risks and contribute to the further evolution of climate finance as a potentially stable asset class with low default.

Huge Opportunity for Private Debt

• Private debt can potentially play a crucial role in supplementing other sources of finance (which often fall short of the required scale for development finance and climate finance). This is feasible if risks in both development finance and climate finance projects are mitigated appropriately for financiers.
• Private debt can provide flexible and tailored financing solutions by way of customized financing structures (including mezzanine loans, green bonds, and sustainability-linked loans) that align with the specific needs of development and climate finance projects (with long development timelines, unique risks & cash flow profiles)
• Private debt can enable development finance and climate finance in emerging markets, where traditional financing is limited. It can also help foster innovation by financing cutting-edge technologies which are crucial for addressing climate change.

Conclusion

• In conclusion, both development finance and climate finance are closely intertwined and are growing and evolving as distinct asset classes. The financing gaps in development finance and Climate finance are huge and Private debt can play a pivotal role in complementing existing funding sources.
• To achieve this (and more specifically for Climate finance), the existing project finance tools (used in the relatively mature development finance asset class) need to be sharpened to address the peculiar challenges posed by climate finance projects (mainly related to technology risk). Efficacy insurance can play a huge role in mitigating such technology risks. In essence, suitable risk mitigation & structuring can help climate finance's evolution into a more stable asset class and enhance its appeal to a broader investor set.
• Private debt capital can be a game changer (in both development finance and climate finance) by providing structured and flexible risk-adjusted capital & potentially unlocking new markets and fostering innovation in areas where it's needed the most. And as Abraham Lincoln once said, "The best way to predict your future is to create it".