Blended Solutions can Fill US$1 Trillion Climate Finance Gap – NZAOA

Scalability critical to flow of private finance to less developed countries to support energy transition, following lack of progress at COP26.

Blended finance can fill the gap left by rich countries’ failure to deliver on their US$100 billion climate finance pledge at COP26, but only if public and private investors collaborate to create scalable opportunities.

Much more private capital can flow to climate adaption and mitigation projects in emerging markets via blended finance solutions, according to a new position paper from the UN-convened Net-Zero Asset Owner Alliance (NZAOA). Progress is dependent, however, on overcoming stubborn obstacles to the sharing risks, returns and data among different types of investors.

The International Energy Agency has estimated that investment needs to increase from US$150 billion to US$1 trillion per annum over the next decade to enable low-carbon energy transition in developing nations.

At COP26, governments of developed countries made little progress on their longstanding commitment to provide US$100 billion a year to developing and emerging nations to support adaption to and mitigation of climate change, meaning it may now only be achieved by 2023.

Financial institutions representing 40% of the world’s financial assets (US$130 trillion) signed up to the Glasgow Financial Alliance for Net Zero at COP26, committing themselves to 2030 targets en route to carbon neutrality by 2050. But it is not clear how this translates into climate finance support.

The NZAOA paper, ‘Scaling Blended Finance’, says blended finance solutions can help to meet the shortfall, providing a major source of energy transition funding. It emphasises the need for multilateral development banks (MDBs) and development finance institutions (DFIs) to make better use pf blended finance mechanisms to mobilise and scale green private capital investment. The NZAOA has 61 members, which control US$10 trillion AUM.

In October, the Investor Leadership Network (ILN), representing 14 global institutional investors with over US$9 trillion in assets under management, called for the creation of a rolling pool of funds offering first or second loss guarantees to blended finance vehicles funding emerging markets projects, in order to enable the private sector to cover hard-to-insure risks relating to regulatory changes, taxation, and reputational risk.

Perceived and actual risk

Blended finance covers a range of instruments, but typically involves different types of investors providing finance and related inputs to support sustainable development projects, accepting different levels of risk and return. Typically, philanthropic or public donor sources provide catalytic ‘first-loss’ funding to attract private investors, with MDBs and IDBs also providing expertise, structuring advice and debt finance.

Historically, appetite for private sector investment in emerging markets – via blended finance or otherwise – has been limited by elevated risk perception, restricted market access and lack of transparency. But the NZAOA says blended finance can offset these concerns by increased provision of a first-loss tranche; expanding market access through the preferred creditor status of MDBs and DFIs; and increased collaboration on data disclosure “to close the gap between perceived and actual risk”.

According to Nadia Nikolova, Lead Portfolio Manager for Development Finance at Allianz Global Investors, blended finance solutions need to offer greater scale to private sector investors, as well as improvements in transparency and risk/return profiles.

“The median size of blended finance funds is still too small. It’s not an established asset class. We need scalable fund structures to attract large private sector financial institutions,” said Nikolova, co-author of the report.

Blended finance specialist Convergence’s ‘State of Blended Finance 2020 Report’ found that the median size of blended finance vehicles between 2017-2019 was only around US$65 million, whereas blended finance debt vehicles need to be at least US$750 million, and blended finance equity vehicles at least US$250 million to attract sophisticated and large investors.

“Many financial institutions have a minimum investment size of US$100 million and a maximum participation rate in a fund of 20%. But there are hardly any blended finance vehicles of US$500 million,” added Nikolova.

Building capacity and appetite

The NZAOA report offers a range of reforms and innovations aimed at increasing the size and appeal of blended finance solutions. Critical factors include enhancing the universe of investable projects and building capacity among all actors and stakeholders.

MDBs and DFIs should be permitted “to take on much higher risks”, the report says, to create creditworthy real-economy companies and projects that can then attract further equity or debt financing from private investors. MDBs and DFIs can also help asset managers to develop the expertise needed to identify and build solutions and projects which will pass through the strict due diligence processes of large institutional investors.

The report also suggests asset owners need to improve their own understanding and expertise to obtain approval for participation in blended finance opportunities.

“Greater knowledge and experience is needed to give asset owners comfort that blended finance structures are an appropriate means to diversify investment portfolios into other regions, enhancing the asset mix of portfolios in line with fiduciary duty,” the report said.

Nikolova said all participants in the blended finance market should reassess their approach to increase scale. Providers of donor and philanthropic capital need to take a broader view of the projects they will support by offering first-loss funding agnostic to theme within impact, sector or country. In addition, development banks should improve data-sharing on past projects to help new private investors understand their risks, and asset managers need to innovate to develop larger funding vehicles.

Other actions highlighted in the report include making private sector investment in funds eligible for official development assistance, pooling donor funds and standardising investment, revising the incentives model of DFIs, and generating data points to be made available and accessible.

On the data sharing front, Nikolova welcomed developments such as wider access to information from the Global Emerging Markets (GEMs) Risk Database Consortium, established by the World Bank’s International Finance Corporation and the European Investment Bank, as well as the increased openness of certain regional development banks to sharing data on the investment performance and characteristics of prior projects. But the report says more information is required to help private investors assess risk.

“While the GEMs Risk Database Consortium recently published the GEMs report with details on default rates of MDBs’ and DFIs’ portfolios, recovery rates, which are key to understanding historical losses, were not included,” it said.

The NZAOA previously asked asset managers to collaborate on new blended finance vehicles to fund climate-positive projects in emerging markets in February. NZAOA members have pledged to decarbonise investment portfolios to net zero by 2050 based on 1.5°C low/no overshoot scenarios as defined by the IPCC Working Group I contribution to the Sixth Assessment Report.

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