Ways to reduce climate finance risk

In recent climate finance reports, almost every think tank, development finance and multilateral bank has emphasized the need to “de-risk climate finance” or “mobilize public finance”, or “use the mixed financing”.

But they often leave out critical points such as “how”, “by whom” and “next steps for the national or global level”. In this article, we aim to outline some possible next steps beyond using these seemingly mythical and empowering terminologies of climate finance.

Current investment globally, according to the 2021 Global Climate Finance Landscape, is approximately $632 billion, which falls short of the desired levels of required climate investments, conservatively estimated at between 4.4 and 5 trillion dollars a year. This climate investment should be funded by private and public finance, both equity and debt.

Since equity is by definition risk capital, risk reduction would generally apply to debt financing, i.e. loans and bonds. And since financial theory establishes risk-based pricing, it becomes important to reduce financial risks to make the total capital invested cheaper and thus increase capital flows to climate investments.

For example, a quick look at global solar investments compared to national-level solar energy potential shows an inverse correlation, i.e. most solar investments are made in low-income countries. high while countries with high solar potential have low solar investments.

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

While the cost of producing cleaner electricity from wind and solar power continues to drop, the costs of cleaner electricity remain high compared to fossil fuels. And the wide variation in costs between countries, ranging from a few cents to a few dollars, does not help. This is partly due to the current outdated transmission and distribution infrastructure.

A simplistic approach to the cost of financing

Generally, finance is rated at risk, with equities and senior debt being the two ends of the risk continuum. The main components of the price of risk, which tend to add up, are — a base rate, which reflects inflation as the time value of money, and a “risk premium”. It is this risk premium that makes all the difference in pricing.

How do we arrive at the risk premium? All risks such as sovereign/country risk, political risk, commercial or project risk are added in percentage or basis points (100 basis points equals 1%). Additionally, there is currency risk associated with investing in developing countries, which is managed by hedging which again adds to the price. The equation ends with something like this – Base Rate + ∑ Risk Premiums (Country, Policy, Company/Project, Forex, etc.).

Additionally, as risk premiums rise, financial regulators around the world advise protecting against black swan losses (known as windfall losses) by maintaining a capital cushion against such windfall losses, meaning that the investor/lender must keep dormant capital. and the cost of maintaining that capital also adds up.

So how do you go about reducing financial risk? It is essentially about “managing risk”. Classical risk management tells us that risks must either be transferred, insured/mitigated or ultimately borne. Equity investors realize risk-adjusted returns to bear the appropriate level of risk.

But climate risk-adjusted returns become perverse for climate finance flows and debt risk reduction is still essential as equity alone would not suffice. Risk management principles tell us that risks should be unbundled and allocated to the entities best placed to manage them.

Types of risks

Sovereign Risk – Sovereign risk is effectively a risk where a government is unable to repay principal or interest, and therefore defaults.

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

Business/Project Risk – Business/Project Risks generally refer to the risks associated with businesses not being able to repay principal or interest due to uncertainty associated with the business/project. to the project.

Risk mitigation can be done by providing mechanisms to provide collateral for different risks instead of viewing it as a collective risk and providing risk mitigation from outside high risk countries. Sovereign risk can have a substantial impact on the final price of the investment.

One of the ways to overcome this could be the socialization of sovereign risk by creating a global risk institution, i.e. outside of all countries – a system used by multilateral development banks to lend to countries low income at lower rates. Pooling different currencies could help manage exchange rate risks.

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

In conclusion, climate investment risks are country-specific and arise due to various factors such as credit, market, politics, currency, etc.

A domain-centric approach could be helpful through global intergovernmental risk mitigation mechanisms. This would ensure that funding is directed to solving the global climate problem and is not limited to countries.

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

Published on

April 08, 2022

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