Finding the Right Blend

Investors call for blended finance to play a larger role in supporting climate adaption and mitigation in emerging markets.

A new report last week sent a sobering message to the great and the good getting set to converge on Glasgow for COP26.

There will be much noise and excitement in the city on the Clyde about what changes and impact can be made as we strive towards net zero, largely focused on the actions of the G20 economies, representing 85% of global GDP.

But those conversations can’t remain fixated on what is and should be being done in the developed world, warned the Investor Leadership Network (ILN), a body composed of 14 global institutional investors with over US$9 trillion in assets under management, supported by the Rockefeller Foundation.

Combatting climate change and achieving the Sustainable Development Goals (SDGs) requires vast investment in sustainable projects in developing countries. But at present the ILN says the world is falling short.

Even a longstanding G20 pledge to provide US$100 billion per annum in climate finance won’t provide all the necessary financial fire power.

Public-sector resources in emerging market (EM) nations are constrained and, according to the United Nations, an investment funding gap of well over US$500 billion per annum for climate change solutions in such economies is projected for the next ten years.

Private investors, particularly large institutional investors, have the financial resources – many times larger than those of the public sector – as well as the expertise to allow them to increase sustainable investments in emerging and frontier economies. However, the report states that they have not done so to the extent required.

Removing investment barriers

It identifies barriers including the availability of investable projects, institutional constraints, high-risk premiums, and macro-economic and foreign exchange related factors, all leading to an “unfavourable risk-return nexus”.

The report says the private sector is eager to significantly increase its sustainable investments but is often constrained by avoidable obstacles. Private investors lack access to crucial public sector information, for example, and feel insufficiently insured against the risks of investing in developing economies.

“We need to unlock private investment in EM markets,” says ILN chief executive Amy Hepburn. “The obstacles aren’t rocket science. Many of them are very obvious. There is much more white space around the solutions. There hasn’t been enough focus on finding them.”

The organisation’s new blueprint – Investing in Emerging and Frontier Economies: How Blended Finance can make the most of public funding – proposes a set of measures that the blended finance community can take to reduce risk and barriers to investment, create new cross-sector partnerships and increase sustainable investments in emerging and frontier economies.

It identified seven specific actions that the public sector can take over the short, medium, and long term to increase private investors’ ability to participate in blended finance partnerships.

The proposals include the ‘Big Idea’ of creating a rolling pool of funds offering first or second loss guarantees so the private sector can cover currently hard-to-insure risks such as those relating to regulatory changes, taxation, and reputational risk.

In addition, there is a need to create a separate facility to help with one of the biggest obstacles, namely foreign exchange risk, and to create a detailed shared database of projects that multilateral development banks are screening so that private investors can express an interest early on.

Information asymmetry

The ILN also calls for the private sector to be given full access to the Global Emerging Markets Risk Database or similar information to help assess risks and proposes expanding the ILN Fellowship Program to help emerging-market government officials understand institutional investors’ needs and network with potential investors.

“The information asymmetry is important. There is not a universal database for investors to say look these are the projects we can get involved in. There is a constant refrain from investors trying to find projects with the right ticket size. If they are going to spend months on a deal it must be worth it,” Hepburn says.

“Some EMs have better visibility and data than others but so many of the solutions rely on access to data. It is difficult to price risk projects without data and as an investor your fiduciary responsibility is paramount. They don’t need every risk scrubbed from an investment, but we need the right risks to be addressed and mitigated.”

Hepburn says relationships between public and private sector are also fundamental to the deals that rely on blended finance. “Understanding the environments and communities we are investing in seems small but from an investor’s perspective it is important,” she explains.

Private procurement

From her ‘on-the-ground’ perspective, Lisa Pinsley, Director, Head of Africa, Energy Infrastructure, at Actis in South Africa, suggests there are challenges with supply as much as demand for EM investments. “I don’t think there is a lack of private investment in renewables in Africa but there is a lack of opportunities for that capital. That’s because of the way the industry is structured,” she says.

“In Africa most of the utilities are still vertically integrated and so the best solar and wind are far from demand centres, but it is only really the utilities which can invest in the grid infrastructure. We can’t put our capital in to build the grid out to where the resources are strongest. That means we can’t build that wind or solar plant 300 kilometres from the capital. Intermittency for the smaller grids is also still an issue.”

Pinsley adds that utilities procuring private power for government-run programmes, a predominant mechanism in India and Brazil, is travelling at a slower pace in Africa. “They need to allow private capital into grid infrastructure and for the governments to run more procurement programmes,” she says.

“We also need to continue to have baseload power solutions until storage is more widely deployed and cost effective. It is not on a large enough scale yet for a lot of the African markets to be able to afford it and install it to support the intermittency of renewables on the grid. Utilities are conservative about adding significant renewables before they have tested out how their grid can handle it.”

Making a difference

Actis focuses on markets which have a history of private involvement in the power sector, have good contractual structures, low currency risks, suppliers willing to work in the country and the ability to do multiple follow-on deals.

“We have 10 to 15 markets in Africa such as South Africa, Egypt and Senegal that we actively follow, because the others either don’t allow private sector investment or are too small economically so wouldn’t be able to accept multiple investments,” she states.

“We do the same in Latin America such as Chile and Brazil. In Asia we look at India and are looking to expand our focus to the rest of the continent as well as Central and Eastern Europe. As long as the regulatory structure and the macro-economic structure is ok, renewables makes sense everywhere. In Africa we are looking also at mini grids which we see as a great area of development.”

Pinsley says there is a role for blended finance in EMs as a complement to existing channels. “You shouldn’t use blended finance to get to a lower solar rate in a bid, because they are already low. But if you are trying to install a new storage system in a medium-sized economy in Africa, blended finance would be a great way to do it.”

Tony Coveney, Head of Infrastructure Asset Management at ThomasLloyd, agrees: “When you have institutions which are prepared to step in and finance development and construction and effectively take the first loss, then blended finance is the way to leverage up our knowledge and experience to make a real difference.”

He says that if we are serious about achieving a net-zero world then continuing to have a focus on European renewables investment is like shifting the deckchairs on the Titanic. Investors might be more comfortable making investments in familiar markets “on their own doorstep”, he says, but the investment and commercial case in EMs is increasingly clear.

“We can build and operate renewable plants in these markets cheaper than coal. There is significant demand and capacity in our target markets of Asia. Institutional investors get this when you point out the investment potential there,” says Coveney, “The challenge is, how can we get that story out to enough people to get enough capital to make a difference.”

The profile of EM climate-related investment needs is increased by high-level inter-governmental summits such as COP26, but the ILN’s Hepburn says this needs to be supported by structural change to capitalise on investor demand.

“We are making all these grand commitments but now we need to create a system which can realise them,” she says. “This is a moment in time and a new way of doing business.”

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