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5 April 2023, Financial Express

Enabling climate finance creatively

The focus on climate finance must take into account the high cost of debt, foreign exchange risk and weak public energy utilities in the developing economies. A creative and workable solution to all these issues is to establish a Global Climate Finance Agency, managed by a reputed multilateral agency with some of the capital support promised by the developed countries.

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Climate finance is not a macroeconomic problem. There is no dearth of funds available in developed countries, but the requirements for finance are growing exponentially in developing countries. According to IEA’s World energy Outlook 2021 report, there is an estimated annual investment requirement of $4-$5 trillion to reduce emissions in developing countries which is significantly small relative to the global annual savings of $20 trillion and global GDP of $80 trillion. To encourage sustainable development, capital must flow from the global north to the global south, prioritising low and middle-income countries.

The transfer of savings is imperative, and can be achieved successfully by addressing the following key issues:

First is the high cost of debt. clean technologies inherently have higher upfront costs, but significantly lower operating costs as compared to conventional technologies. This means the key recurring cost is mainly cost of the capital, which has a direct bearing on the price of clean energy or energy services. Apart from this, clean technology projects have long payback period, necessitating funding through patient, long-term funding solutions.

Second is the need for cost-reflective hedging to eliminate foreign exchange risk. Nearly 90% of cross-border debt to projects in developing countries from developed countries is in hard currency, while the revenues generated from these projects are in local currencies. The market for currency hedging swaps in developing countries is not deep enough, especially for average maturity of over three years. For a tenure greater than the average maturity of 10 years, the hedging solution itself is non-existent, leaving projects exposed to currency risk depreciation in the medium to long term. This unhedged forex risk adds to the fragility of projects. Ultimately, it translates to high overall cost of capital because of expensive hedging, even if the cost of the foreign currency loan is low, thereby neutralising all savings. For example, the annual cost of rupee-dollar hedging is around 6%, which is significantly higher than the long-term annual rupee depreciation rate of 3.5%.

Third, it is necessary to consider the weak financial position of public utilities.: The off takers for most of clean technology projects are public utilities. These include state distribution companies, state transport corporations and municipalities. The financial health of most of these entities is weak. The nature of clean technologies is such that their future price could be much more attractive than it is today, because technology becomes cheaper as its scale increases. New contracts therefore look far more competitive than the ones entered into in the previous five years, resulting in commitments being reneged as they were expensive. This has increased the risk of financing clean technology projects with public utilities as off-takers, and it is reflected in the cost of funding.

In addition to promoting capital flows, emerging technologies, storage and new business models also need to be encouraged. Power generation, being the largest source of emission, has brought global attention to renewable energy, and also to the issue of storing it. Financing support is also necessary to mainstream other nascent sectors such as electric mobility, green hydrogen and carbon capture and storage. Hence to meet climate goals, an entire ecosystem of clean technologies needs to be created and promoted.

One way to resolve the multidimensional aspects of financing clean energy is through the creation of a Global Climate Finance Agency (GCFA) which can provide hedging capacity and support the creation of currency risk market. The GCFA can be managed by a reputed existing multilateral agency and capitalized by some part of the promised financial support from developed countries. Apart from this sovereign support, additional funds can be sourced from grants provided by foundations. These foundations in turn will receive Certified Emission Reductions (CER) credits, which they can use either as green credentials or for trading.

This agency will be responsible for the following key functions:

The main purpose of the platform will be to provide a cost-effective hedging mechanism for private sector projects that are green. Like an insurance cover, the GCFA will create a gross currency book by pooling together capital from multilateral banks, climate investors and philanthropies from developed countries for green projects. Developers of green projects can avail of foreign capital from this pool at a rate marginally above the annual currency depreciation. Any volatility in the hedging cost can be absorbed by GCFA with its transparent and long-term pricing of risk related to currency depreciations. This will result in green project developers getting better off-sets for their exposure. The GCFA will also act as a market maker by creating new risk markets at a global scale and crowd in commercial actors such as investors, borrowers, donors, corporates and remitters to bring additional hedging capacity and diversity in it to further lower the hedging costs.

Second is the creation of a First Loss Facility. Government utilities with weaker financial positioning are major buyers for clean technology projects in developing countries. In the absence of a payment security mechanism, the risk perception of a project increases, resulting in higher energy and energy services costs. A First Loss Facility for clean technology projects will reduce such related risks and accelerate adoption and funds flow in these segments.

Finally, venture capital for emerging technologies/ business models is needed. Today, there is a large dependence on some countries for imported capital equipment for the solar and battery sector. This restricts the creation of a local ecosystem for new technologies. For adoption of hydrogen, battery storage and electric mobility, emerging countries needs to reduce import dependence before scaling up these technologies. It is also necessary for business models to evolve to reflect the nature of emerging technologies. Venture capital for emerging technologies/ business models will ensure that energy transition is more democratic.

The GCFA will not only increase mobilisation of capital but also bring in risk transparency and market discipline especially in developing countries. The larger size and transparent pricing of currency risks by GCFA is will likely to attract more institutional investors as this futuristic energy source expands.

Manish Chourasia is Managing Director, Tata Cleantech Capital and Working Group Lead for Gateway House’s independent G20 Task Force on Energy Transitions and Climate Finance.

A version of this article appeared in Financial Express.

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