Ways to de-risk climate finance

In recent climate finance reports, almost all think tanks, development finance and multilateral banks have outlined the need for ‘De risking climate finance’ or ‘leveraging public finance’, or ‘using blended finance’.

But they often leave out critical points like ‘the how’, ‘by whom’, and ‘the next steps for the national or global level’. In this article, we aim to outline some possible next steps beyond usage of these seemingly mythical, climate finance enabling terminologies.

The current investment at a global level, as per the Global Landscape of Climate Finance 2021 is around $632 billion which falls short of the desired levels of climate investments required which is conservatively estimated at $4.4–$5 trillion annually. This climate investment would need to be met with private and public finance, both equity and debt.

Given that equity by definition is risky capital, typically de-risking would apply to debt financing, that is loans and bonds. And since finance theory lays down risk-based pricing, it becomes important to de-risk finance to make total capital invested cheaper and thus increase capital flows to climate investments.

For example, a cursory glance at global solar investments relative to country-level solar energy potential, shows an inverse correlation, i.e., most of the solar investments are made in high income countries while high solar potential countries have low solar investments.

A major share of climate investments for mitigation is in the clean energy sector and because operating costs are very low (since variable fuel costs are zero), cost competitiveness of clean energy becomes directly proportional to cost of money.

While cost of cleaner electricity generation through wind and solar continues to fall, cleaner electricity costs continue to remain high compared to fossil fuels. And the high cost variation among countries ranging for from a few cents to a few dollars does not help. This is in part due to the current outdated transmission and distribution infrastructure.

A simplistic approach to cost of finance

Typically, finance is risk priced with equity and senior debt being two ends of risk continuum. The major components of risk price, which tend to be additive are — a base rate, which reflects inflation as time value of money, and a ‘Risk Premium’. It is this risk premium which makes all the difference in the pricing.

How do we arrive at risk premium? All risks such as sovereign/country risk political risk, business or project risk are added in percentage or basis points (100 bps is 1 per cent). Further, there is a currency risk associated with investment in developing countries, which is managed by hedging which again adds to the price. The equation ends up something like this – Base Rate + ∑ Risk Premiums (country, political, business/project, foreign exchange etc.).

In addition, as the risk premiums go up, financial regulators across the world advise on protecting against black swan losses (called unexpected losses) by way of keeping a capital cushion against such unexpected losses which means that the investor/lender need to keep idle capital and the cost of keeping such capital also adds on.

So how does one go about de-risking finance? Essentially, it is about “Managing Risks’. Textbook risk management tells us that risks must be either transferred, insured/mitigated or finally borne. Equity investors make risk adjusted returns to bear the appropriate amount of risk.

But climate risk adjusted returns are turning perverse to climate finance flows and de-risking debt is still essential as equity alone would not suffice. Principles of risk management tell us that risks must be unbundled and assigned to entities that are best positioned to handle them.

Types of risks

Sovereign Risk – Sovereign risk is effectively a risk where a government is unable to repay the principal amount or interest, and thus default.

Political Risk – Political risks refers to the risk that the investor faces due to political changes or instability in a country.

Business/Project Risk – Business/Project risks typically refers to the risks associated with businesses not being able to repay the principal amount or interest due to uncertainty associated with the business/project.

Mitigation of risks can be done by providing mechanisms to provide guarantee for different risks instead of looking at it as a collective risk and providing risk mitigation from outside high-risk countries. Sovereign risk can have a substantial impact on the final pricing of the investment.

One of the ways to overcome this could be socialisation of sovereign risks by creating a global risk institution, that is outside all countries — a system used by multilateral development banks to lend to low-income countries at lower rates. Pooling different currencies could allow for managing FX risks.

Finally, development finance institutions can issue green /climate bonds to raise capital and then can redirect that capital towards suitable clean energy projects.

In conclusion, climate investment risks are country specific and arise due to various factors such as credit, market, political, currency, and amongst others.

A domain centric approach could help through global intergovernmental risk mitigation mechanisms. This would ensure that finance flows towards solving the global climate problem and does not limit itself to countries.

Purkayastha is the India Director at Climate Policy Initiative (CPI) and Director of the US-India Clean Energy Finance (USICEF) initiative, and Khanna is a Manager at CPI