Over the last decade a series of multilateral agreements on climate change in Copenhagen (2009), Paris (2016), and Marrakesh (2016) has established a global consensus on the need to transition towards sustainable, low-carbon economies that might allow us to limit global warming to 2°C above pre-industrial levels. But developing countries, not least in Latin American and the Caribbean, face a double challenge: many are located in the equatorial regions which will bear the brunt of climatic changes, yet their level of development leaves them under-resourced and ill-equipped to adapt to climate pressures in advance.
Developed countries have agreed to mobilise US$100 billion per year by 2020 to assist with climate-change adaptation, but even alongside existing global climate investments worth nearly US$400 billion, this is only a fraction of what will be needed to achieve a low-carbon transition. Currently, 62 per cent of global climate investment comes from the private sector, whose involvement is vulnerable to policy changes, market signals, gaps in understanding of sustainable technology, and profit instability. As powerful financial actors attuned to national development goals, national development banks are ideally placed to help boost climate finance – public and private – despite the many challenges involved.
Early difficulties in an emerging field
One key challenge is information asymmetry between investors and recipients, with ambiguities over environmental information and project performance leading to overpricing of assets due to misunderstood risks. The situation is not helped by the novelty of climate finance, as there are currently few established and agreed upon guidelines, definitions, or regulations.
Relatedly, the technical complexity of many green investments requires in-house expertise or institutional capacity capable of properly evaluating potential projects, yet neither public nor private investors tend to have these specialist skills. Actual and potential investors understand financial markets and instruments but not the specifics of so-called “green technologies” or environmental goods.
The nature of the sector – and the regulations surrounding some public institutions – also mean that there is a proliferation of low-carbon projects involving micro, small, and medium-sized enterprises, which makes large-scale investment more convoluted than in traditional energy sectors. Bundling projects, for example, to create larger investment vehicles cannot eliminate the inherent complexities of patchwork performance assessment, due diligence, and capital sources.
Even where external funds are successfully secured, inexperience in terms of budgeting and implementation can prevent financing from trickling through to lower levels occupied with the nuts and bolts of launching low-carbon projects.
Facing up to the challenge of climate finance
National development banks can face up to these challenges, first, by exploiting their position as intermediaries between international and local financial institutions. Their positional advantage allows them to investigate the commercial, technological, regulatory, and political conditions associated with particular low-carbon projects, facilitating assessment of current and future risks and returns. By mitigating perceived and actual risks, the national development bank thus becomes a financial hub that can “crowd in” local and international capital.
Second, within their national arenas development banks can also help to reduce the uncertainty around low-carbon projects – and the associated mispricing of risk – by providing clear, transparent, and exhaustive guidelines on how evaluations of financial feasibility are carried out: from stakeholder analysis and financial modelling of cash flows to specifications of due diligence procedures and projected returns on equity. And given their public character, national development banks can liaise with state bodies to target specific skill and capacity deficiencies that hamper development of a pipeline of transformational projects that respond to key policy priorities.
Third, and externally, national development banks are well placed to forge relationships with increasingly important south-south climate-finance actors. The contribution of south-south relationships has been relatively minor to date, but the emergence of multilateral lenders such as the New Development Bank (or “BRICS Bank”) and the Asian Infrastructure Investment Bank, as well as substantial growth in bilateral links with China, suggests this will soon change.
Bringing wind energy to Mexico with Nacional Financiera (NAFIN)
The case of NAFIN’s involvement in stimulating wind energy in Mexico helps to illustrate how national development banks can begin to bring about a wider shift to low-carbon economies.
When the idea of developing wind energy in Mexico was first floated in 2010, there was no precedent for the involvement of a financial institution in construction of wind farms. Neither national development banks nor commercial banks had the technical expertise to take on such specialised projects, and financial institutions also baulked at the risk profile of the sector.
Recognising the need to move away from fossil fuels, the Mexican government intervened to reform the vertically integrated electricity market, which by 2015 had helped to make Mexico one of the top ten destinations in the world for clean-energy investment. NAFIN then combined its own funds with Inter-American Development Bank (IDB) credit lines to finance the first wind farm in Mexico.
An investment of US$550 million ultimately produced Eurus, the largest wind farm in Latin America. Located in Juchitán de Zaragoza, in the state of Oaxaca, its 167 wind turbines generate 250 megawatts of power, satisfying the needs of half a million people and reducing annual carbon dioxide emissions by 600,000 metric tons.
Building on this success, NAFIN’s Sustainable Projects Division has since financed 13 wind farms, one solar-power plant, and two hydroelectric plants across nine states in Mexico. These projects constitute an investment of more than US$4 billion and 1.7 gigawatts of installed capacity, amounting to a 700 per cent increase in NAFIN’s portfolio since 2010. The bank has also re-entered international markets for the first time in nearly 20 years by issuing its own Green Bonds in order to reinforce the viability and profitability of its wind and water projects.
Successive Mexican governments have provided commitments to the transition to low-carbon economies despite the importance of the oil sector to the national economy and public budget. There is recognition that this transition is beset with challenges, but that in Mexico as in the rest of the world the economic and social costs of a failure to act are far greater. National development banks like NAFIN can and must prove that they are up to the task.
- This blog post was originally published by LSE’s Latin America and Caribbean blog, and it draws on the author’s working paper How can national development banks address key challenges associated with raising climate finance to increase investment flows for projects in their countries?
- The post gives the views of its author, not the position of LSE Business Review or the London School of Economics.
- Featured image credit: Hans, CC0
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Emilio Garmendia Pérez Montero held the first NAFIN Visiting Fellowship hosted jointly by the Latin America and Caribbean Centre and the Grantham Institute of Climate Change and the Environment at the LSE.