Why risk coverage matters and what can be done to scale up green investment
Risk, whether real or perceived, matters. It is the biggest barrier preventing private capital from flowing into investments and, given the enhanced risk profile of low-carbon technologies, it is even more crucial for climate finance investments. Higher risks demand higher returns and higher financing costs, making low-carbon technologies even less competitive.
While not all risks need to be reallocated, whenever risk falls onto a party not suited or not willing to bear it, risk coverage instruments (such as guarantees) can be key to unlocking private resources without depleting public budgets.
CPI has observed this phenomenon time and time again in our case studies.
In Tunisia, for example, once households’ perceived credit default risk was addressed (through a guarantee issued by the state-owned utility), local commercial banks started to extend lending to households at below market interest rates for solar water heaters, greatly expanding the number of these renewable appliances in the country.
In a more recent example, the Danish Export Credit agency covered credit risks for Jädraås Onshore Windfarm – much like export agencies do for many other countries and technologies. This allowed pension fund PensionDanmark to lend €120 million to the project, an investment that brought it a return only slightly higher than triple A rated government bonds but which was less risky than a straight investment in a wind project.
Similarly, our early analysis of a large hydropower project in Uganda — a country with minimal private capital penetration in the energy sector — shows how the offer of the International Development Association’s (IDA) Partial Risk Guarantees prompted two commercial banks to invest $115 million in the project.
There are a wide range of instruments, like IDA’s Partial Risk Guarantee, available on the market. However, our analysis shows that these are largely underused and fail to reach the scale needed to limit emissions sufficiently to keep the world on track for a 2°C, or even a 4°C,temperature rise scenario. Their providers blame a lack of demand, and their potential users consider them too complex, onerous, and their coverage ineffective.
For example, CPI recently looked at the World Bank Group’s risk mitigation instruments. The World Bank Group has historically been a major provider of risk mitigation instruments through its member institutions – MIGA, IFC, IBRD, and IDA. Our study suggests that, in theory, the WBG provides coverage against most risk categories related to climate projects, and particularly those faced by private debt investors. Yet, despite its increasing commitment to addressing climate change – translating into an increased supply of risk mitigation instruments, few of them appear to have been used at a significant scale to support climate-related projects. Further, the majority of cases in which these instruments have been used have involved mature renewable energy technologies such as hydropower and geothermal.
During CPI’s work on Risk Gaps we found that policy risk, technology, and uncertainty of access to finance were the most common risks for which coverage was critically needed but rarely available in an effective way – preventing more investors from committing to green investments.
So what needs to be done?
Either governments and other public institutions must develop new innovative risk coverage instruments, or they must fix existing ones and the way they are delivered to the market.
Development finance institutions are already responding to this call by launching new instruments, and are setting out to comprehensively modernise their guarantee instruments in order to make them a real alternative to loans. For instance, the EIB and UNEP recently launched a one-stop risk mitigation platform for small scale renewables projects, the Renewable Energy Performance Platform, while the World Bank recently undertook a public consultation on modernising the operational policy of guarantees.
However, to be effective, these and other instruments will need to address investors’ specific needs and, critically, do so quickly. They will need to be transparent. And they will need to be directly aimed at climate investments but also have sufficient scope to have a transformative impact.
CPI will continue to study the role of risk in climate investments in upcoming case study analyses.