Risky Business Environments May Hold Back Climate Goals

Many promises were made at the Paris climate conference. But a January report from McKinsey & Company, “Financing Change: How to Mobilize Private Sector Financing for Sustainable Infrastructure,” shows countries without business-enabling environments may see their clean energy goals stall or be delayed. This could potentially compromise many national efforts.

Nations with enabling environments are straightforward places for businesses to construct infrastructure. Contracts are enforced reliably. War, corruption and crime do not pose risks to entrepreneurs. Red tape is easily manageable. Institutions operate effectively. Sound policies and incentives are in place. Procurement processes and supply chains are workable.

It’s important to underscore that developers often think the financial risk of investing in sustainable infrastructure internationally is greater than it really is. In Africa and the Middle East, default rates are very low, but some investors may not be aware of this.

Many nations face moderate to severe problems with creating enabling environments for business operations. To make risks manageable and ensure safety for entrepreneurs, a concerted international effort to stabilize some countries may be essential.

According to the report, international decision makers consider sustainable infrastructure to be low-carbon, climate-resilient, and socially inclusive. Their discussions incorporate social responsibility as a triple-bottom-line consideration for nations to follow.

The authors estimated international infrastructure spending would need to double from between $2.5 trillion and $3 trillion per year to $6 trillion per year on average over the next 15 years. This is a massive amount of growth. Private finance’s role is expected to increase to meet these goals.

A large amount of this new demand for infrastructure during this 15-year period would be located in middle-income countries. Over half of it would be in the power sector.

Where will the financing come from?

Between 2005 and 2014, over 60 percent of infrastructure financing that was generated by public-private partnerships or the private sector and flowed to middle-income countries from other nations came from other middle-income countries. The remaining 40 percent came from high-income countries. Over 50 percent of the overall infrastructure financing for these countries was generated domestically.

Low-income countries, collectively, are in a very different situation. They only receive 8 percent of their financing for similar projects domestically and are highly dependent on external support. High-income countries contribute 39 percent of this funding and middle-income countries contribute 53 percent of it.

Looking at these contrasting figures, one can see that ramping up the transfer of financing from high-income countries to middle-income countries is particularly crucial to achieve climate goals.

What actions can resolve this international investment imbalance?

Aaron Bielenberg, expert associate principal at McKinsey & Company, said he recommends setting up “one-stop shops for project developers and investors” on a national level.

“There’s a lot of really great work that’s being done by development agencies,” Bielenberg said. “It’s challenging to really understand how the various initiatives are interacting with each other.”

Transparent and open policies are highly valuable, Bielenberg said. He recommends having one point of contact for businesses that are seeking to enter a given national market. Having a clear approval process for projects is also positive. Clear timelines also simplify access. “In some countries, the process for approvals is coordinated.”

A map showing the relative corruption of individual countries is available from Transparency International.

Well-designed incentives can also help clean energy infrastructure grow. “There’s a wide variety of possible incentive structures,” Bielenberg said. These can include feed-in tariffs and other structured programs. As solar and wind power increase in competitiveness, these programs become less essential.  

“When countries are putting in place clear rules to direct foreign investment, that has an impact,” Bielenberg said. “It’s driven very much by the goals and agenda of the government that is in place.”

The report recommends using development capital to finance premiums, funding project design and planning via grants, creating guidelines for high-performing projects, publishing RFPs, changing international regulations for infrastructure investment, removing fossil fuel subsidies, and developing carbon pricing that has distortion corrections.

Six approaches can facilitate sustainable infrastructure investment, according to the report.

1. Investment can be scaled up for the development of project preparation and pipelines. Technical assistance can help improve the financing prospects for these pipelines.
2. Stakeholders can leverage development capital for sustainability premium financing. Development banks and bilateral-aid organizations could support this effort. Investors tend to be concerned about risk-adjusted returns in this market. It is important to show them that these would be competitive.
3. Guarantees can improve capital markets. This is another risk-reduction strategy.
4. Sustainability criteria can be used for procurement in government decisions and public-private partnerships.
5. Loans can be syndicated for these projects. Loan syndication, in combination with a larger secondary market for these securities, can allow development capital to be recycled. It might also reduce transaction costs. It can also allow investors to develop comfort with this asset class.
6. Financial instruments can channel investment in this direction, enhancing their liquidity. Yieldcos and green bonds are two tools that could be used to expand this opportunity.

Scaling up private institutional investment could increase private investment by $1 trillion to $1.5 trillion per year above the current level of $300 billion to $400 billion per year.

What are some of the hurdles that programs need to surmount?

Often, middle-to-low-income countries have difficulty providing risk-mitigation guarantees or creating the baseline funding for projects.

If infrastructure projects are not seen as bankable since their risk-adjusted returns are too low to attract private-sector support, this has a chilling effect on financing. Private investors tend to seek returns of 10 to 15 percent.

Some regulations about capital supply, reserves, asset and liability valuation, and limits to domestic and foreign investment can also create barriers.

World Bank statistics cited by the McKinsey & Company report show that only 4 percent of the 500 largest cities are viewed as creditworthy by international investors. This adversely impacts urban investment for climate resilience. It can be quite difficult for these cities to become creditworthy. Many properties are not registered for tax purposes. Sometimes, their spending exceeds their revenue. 

Conflict poses an ongoing hazard in some parts of the world. “Conflict creates a whole series of barriers that are both logistical – ability to travel – and also financial,” Bielenberg said. “Generally speaking, countries that are at risk of conflict provide a higher risk profile for private investment.”

Over time, throughout projects’ life cycles, their financing needs vary. Before projects begin generating revenue, it can be difficult for them to obtain financing other than through developer equity, which may not be available. Developer equity also has some risks associated with it.

A study cited by McKinsey said that Latin America, Southeast Asia, and North America are the regions in the world with the highest default rates – 14.8 percent, 10.0 percent, and 9.9 percent. The Middle East, Africa and Europe have the lowest default rates – 1.6 percent, 2.2 percent, and 5.2 percent.

This report was based on an in-depth literature review, interviews with over 50 experts, and a financing-flow analysis.

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