Climate change is expected to increase risks to businesses, infrastructure, assets and economies. Understanding how to involve the private sector in responding to these risks – or encouraging them to take advantage of the new business opportunities that may arise from changing climate conditions – is crucial to catalyze greater investment in activities that increase countries, businesses, and communities’ resilience.
This working paper provides emerging insights from the experience of seven Development Finance Institutions (DFIs) in driving private sector investment in climate resilience, and from a workshop on strategies and business models that could help to scale up current efforts. It examines a subset of projects developed by five multilateral, one bilateral and one national development bank over 2011-2014, in both developed and developing countries. In particular, it looks at the tools and approaches designed by these DFIs to address pre-investment and investment stage barriers holding back private investment in measures that would enhance the resilience of infrastructure, water-intensive industries and agriculture. These are the sectors where DFIs have focused their private sector-oriented interventions. It aims to provide governments, their agencies and DFIs with an overview of the strategies employed so far and to identify opportunities to further scale up private investment in climate resilience.
KEY LESSONS LEARNED
The projects assessed show that DFIs have employed a variety of approaches to tackle pre-investment and investment stage barriers preventing private action in climate resilience. Grants or concessional loans from donors often supported multilateral DFIs to develop pilot projects, provide technical assistance or give access to finance at longer and more affordable terms, thereby encouraging private investment in climate-resilient projects that are capital intensive, have long payback periods, or carry first-mover risks.
The study highlighted the following lessons.
- A combination of policies, regulations, and longer-term debt from DFIs can trigger private investments in climate resilience. In high-income Western European countries, compliance with national or European regulations and pressure to meet changing market demand played a role in driving capital-intensive investments in water and wastewater infrastructures. The renewal of these ageing infrastructures provided an opportunity for water companies to integrate climate resilience in such assets. The European Investment Bank enabled private investment by providing access to longer-term debt finance, presently in short supply in EU countries. Longer-term finance better matches investors’ financing needs given the high upfront investment and long, uncertain returns of such infrastructure projects.
- Technical assistance measures helped to stimulate demand for private investment by addressing knowledge gaps. They supported water-dependent businesses to identify opportunities for climate-resilient investments, and engaged local banks in the financing of water-efficient technologies. Inability to recognize and evaluate the materiality of climate change risks and a lack of knowledge on how to manage them represent key barriers to private investors in responding to climate change. This is particularly true for small and medium-sized enterprises (SMEs) in middle-income and developing countries. To overcome such constraints, and show the business case for investment, some DFIs (the International Finance Corporation [IFC] and the European Bank for Reconstruction and Development [EBRD]), engaged in consultations, carried out studies or business-tailored audits or provided other advisory services. In upper-middle-income countries, these activities helped to identify and evaluate climate change risks to water-dependent business operations, and options for addressing them. In developing countries, they are helping DFIs to engage agribusinesses in better managing the climate change risks in their supply chains. In more than half of the projects in both groups of countries, filling knowledge gaps was the first step to stimulating demand for investments and designing suitable financing and climate resilience strategies. In Turkey, a market study helped to engage local commercial banks in providing finance for businesses to take up water-efficient technologies. In low-income developing countries, technical assistance and advisory services – carried out also thanks to donors’ support – are helping to create the preconditions for private investment to happen.
- Technical assistance, provision of finance for on-lending, and credit enhancement measures are encouraging local financial institutions and non-bank entities to address the debt funding gaps preventing micro-, SMEs’ from investing in climate-resilience. In developing countries some MDBs are building alliances with members of agricultural value chains (IFC, the Inter-American Development Bank [IDB] and the Asian Development Bank [ADB]), or engaging local financial institutions (IFC, IDB and EBRD) in on-lending to micro-, small-, and medium-sized enterprises. The development of such intermediated and targeted financing structures not only aims to strengthen the ability of these businesses to cope with the projected impacts of climate change, but also to develop the deal-flow and financiers’ expertise in understanding, promoting and financing technologies and practices that can improve climate resilience. DFIs have also devised credit enhancement measures to address financiers’ credit default risk perceptions and facilitate access to finance at terms better aligned with borrowers’ investment needs.
OPPORTUNITIES TO INCREASE PRIVATE INVESTMENT IN CLIMATE RESILIENCE
DFIs have made progress in designing approaches and business models to drive private investment in climate resilience. The number of private sector-oriented projects in DFIs portfolios has increased over the period analyzed (2011-2014), and the approaches used have evolved. However, several of the assessed DFIs are just beginning to develop their portfolios of private adaptation projects, and more remains to be done to integrate climate resilience in the financial system and unlock finance from a broader range of financiers and investors. DFIs, in fact, represent a limited share of overall investment flows.
The lessons learned from the DFI approaches assessed and discussions with investors, policymakers, and practitioners, suggest that identifying viable investment opportunities and developing project pipelines is the top priority for promoting private investment in climate resilience. There are four main opportunities to achieve this end:
- Governments should adjust regulatory frameworks to create stronger incentives for private investment. Well-designed frameworks can trigger private engagement in climate resilience. Non-existent or deficient frameworks can inhibit the incentives for investment by failing to put an adequate price on the risk of inaction and lowering the rate of return of possible climate-resilient investment opportunities.
To this end, DFIs could engage more often in policy consultations with governments – an approach we identified only in one EBRD project in Tajikistan – and could facilitate dialogue between governments and business.
- Governments, their agencies, and DFIs, sometimes in partnership with private actors, can equip businesses with the information and tools they need to integrate climate information into investment decision making processes by:
- Promoting or supporting investment in the development and dissemination of business-relevant data and providing business-friendly impact assessment tools;
- Supporting cost-sharing approaches to facilitate and incentivize climate change risk assessment and support projects structuring; this is particularly relevant for micro and SMEs in middle-income and developing counties which typically have limited financial and technical capacity to carry out such assessments and develop bankable projects.
- DFIs and other public agencies can enhance collaboration with the financial system and between actors of supply chains as a means to foster private investors’ engagement in climate resilience. Local banks, insurance companies, and agricultural supply chain actors can all play a role in this context. Local banks, in particular, are in a privileged position to engage businesses to scale up investment because they understand local barriers to investment. In particular, they can play a greater role in engaging with SMEs, which represent the majority of private sector enterprises and whose financial needs are typically too small to benefit from direct DFI support. Local banks’ access to climate risk screening tools and know-how could help them to shape finance for resilience building. Regulators and stakeholders can also play a role in enhancing banks’ awareness of the need to determine, assess and manage climate change-related risks in projects. Agricultural value chains are emerging as a vehicle to deliver climate resilience to a large number of micro- and small enterprises, and to lower financiers’ risks and transaction costs. Such collaborative models could be further explored.
- DFIs can help to create the evidence base needed to encourage private sector interest in climate resilience by piloting approaches in middle-income countries for use in lower-income countries. Most DFI activities we identified targeted private actors operating in upper-middle-income countries. In these countries, which have a stronger private sector than lower-income countries and, therefore, more bankable opportunities, technical assistance and advisory services are driving investment. The decision of the Pilot Program for Climate Resilience’s (PPCR) governing body in May of this year to open up the use of the Program’s private sector set-aside to all the countries of the Climate Investment Funds present a noteworthy opportunity to support the creation of the evidence base needed to encourage private sector investment. This decision aims to overcome the geographic restriction limiting the use of the set-aside funds in PPCR low-income countries, where the formal private sector is generally small in size, technical capacity is limited and investment environments are challenging. In these countries, in fact, the conversion of project concepts into approved projects and investment has been limited or slow so far. Given the relative novelty of the topic for the private sector, the PPCR decision can help to pilot and test private sector adaptation approaches in middle-income countries to generate the experience and track record needed to identify and develop scalable and replicable business models for lower-income countries.
- Finally, a sustainable scale up of investment in climate resilience will require efficient use of concessional resources from donors to reduce costs and risks. Our understanding about how to use public money effectively for climate action is increasing. However, open questions remain on how to best use limited public resources to drive private adaptation investments while avoiding the creation of unhelpful market distortions.
The evidence base on the optimal use of limited concessional public finance in private adaptation projects is limited and needs to be built.