Institutional Investors Can Help India Meet Its Climate Action Pledge
Earlier this month, India announced its pledge for action on climate change beyond 2020, ahead of the United Nations summit on climate change negotiations this December in Paris. India’s pledge, called an INDC (Intended Nationally Determined Contribution), has been much anticipated, since it is the last to be announced of the countries which are major contributors to climate change. It promises that renewable energy will be 40% of the country’s expected energy mix in 2030, along with a 35% reduction in greenhouse gas emissions by 2030 from 2005 levels.
India’s INDC is laudable and an important step forward that will be good for both the climate and for the nation’s economic growth and energy supply. However, it is also very ambitious, given that the amount of renewable energy needed will be a significant jump from India’s current supply of less than 5GW of solar power and less than 25GW of wind power.
Cost-effective financing will be critical to India achieving its INDC. The growth of renewable energy in India has been dampened by both a lack of financing, and financing at unattractive terms. In particular, the high cost, short tenor and variable interest rates of debt have made renewable energy in India approximately 30% more expensive than in the US or EU.
Achieving India’s INDC is going to require mobilising a lot more financing, at more attractive terms. There are several avenues the government could explore for a more cost-effective and realistic pathway to the INDC.
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One promising avenue is institutional investors in India,such as domestic insurance companies and pension funds.
Renewable energy in India has traditionally relied on domestic commercial banks for debt financing. However, the typical tenor of bank loans is around 10 years, whereas most renewable energy projects require longer term financing that matches their project life cycles of 20 to 25 years.
Compared to commercial banks, institutional investors not only invest over longer terms, but also accept lower returns in exchange for lower risks, providing a better match with the low risk, low return profiles of renewable energy projects.
Analysis by Climate Policy Initiative shows that domestic institutional investors may have the capacity to finance $15 billion of operational renewable projects up to 2019. This is a significant share of the $100 billion of investment in infrastructure needed to meet India’s previous target of 175GW of renewable energy by 2022.
However, one key barrier stands in the way: institutional investors are restricted to investing in projects above a certain credit rating threshold, which is AA or above in the case of India. Most renewable energy projects fall below this threshold.
Enabling institutional investment will require financial instruments that can raise the credit rating of renewable energy projects. Two promising instruments may be able to do this: infrastructure debt funds by non-banking financing companies, which are pooled investment vehicles designed to facilitate investment across infrastructure sectors, including renewable energy, and renewable energy project bonds with partial credit guarantees, which are a form of credit enhancement where the borrower’s debt obligations are guaranteed by a guarantor with a strong credit rating.
While both instruments currently face structural and regulatory barriers that have impeded their use as investment vehicles, the government can address these with appropriate policy changes.
Another potential source of more financing for renewable energy is foreign institutional investors. However, foreign investors face a key risk. Because currency exchange rates can be volatile, when a renewable energy project is financed by a foreign loan, it requires a currency hedge to protect against the risk of currency devaluation.
Market-based currency hedging in India is too expensive, making foreign financing just as expensive as domestic financing. Reducing the cost of foreign financing by reducing the currency hedging cost can mobilise foreign capital and spur investments in renewable energy.
One way to do this could be through currency hedging sponsored by the Indian government. Recent analysis by Climate Policy Initiative shows that government-sponsored currency hedging, if designed appropriately, could reduce hedging costs by nearly 50%, lowering the cost of renewable energy by nearly 20%.
As India embarks on its ambitious journey towards reaching its INDC, attracting institutional investors through improved policy, such as credit enhancement for renewable energy projects and smartly designed government-sponsored currency hedging for foreign investment, could prove key in providing the critical low-cost, long-term financing needed for renewable energy growth.
A version of this blog first appeared in the Huffington Post.