Climate Finance Gets a Little Less Risky

Standard and Poor’s in conjunction with Parhelion Underwriting have released a new risk index which will make finding the money to finance the climate change clean energy transition easier. The new index hasn’t said anything new, but rather done something more important: it has spelled out the widely acknowledged risks of climate change related investment, created a universal language with which to refer to those risks, and standardized the threat those risks pose to investors by ranking them.

Kirsty Hamilton a Chatham House fellow in energy, environment and development said that the index creates “investment grade policy” to help catalyze the market for climate related finance. She explained, “one of the problems that we have, is how do you compress the distance between political discourse that has all these currents moving around and market reality which is what do you need-- what is the role of government-- to help money move into the places that science of climate change indicates.”

Any market in its gestation, like the financial market for climate related finance is, is inherently risky because the inter and intra-market relationships haven’t existed before, investors don’t know what to expect. Climate finance involves everything from renewable energy to adaptation and mitigation activities (the official language for strategy to adjust to climate change: it involves everything from clean energy finance to vast physical and social infrastructural adjustments needed to shield communities from natural disasters). The finance is needed in both the developed and developing world.

A study released by the UK government’s Green Investment Bank Commission on the prospects for renewable energy finance reads, “The competition for capital, whether between companies or between countries in Europe, mean that low carbon investments… are unlikely under current market conditions to attract the capital needed within the time desired.” In the UK alone utility companies will face a debt financing shortfall of £24.3 billion.

“Why this is a useful exercise,” stressed Julian Richardson, CEO of Parhelion Underwriting, “is that it gives a common risk language because people are very bad at talking about risk. They often argue with ill defined risks and they find a word and put the word ‘risk’ at the end of it and think they’ve defined a risk but that’s not the case. And if someone else uses that expression do they mean it in the same way?”

By establishing “clarity and commonality” in the risk language and prioritizing the risk in a system, there is a way in which climate related finance is made less scary for investors. Risks that are enumerated can begin to be placed into offsetting structures (leveraged) and finance can begin to flow. The total estimate of finance needed varies by a lot already, not least because of the uncertainty in the risk involved but also because much of it is needed in developing countries which are risky markets to begin with. The UN estimates that anywhere from $90- $200 billion is needed per year for the next decade at least.

And market conditions haven’t improved much-- and not just because of a lack of an international climate accord. The Market is still limping along because of the financial crisis and investors in general, have not recovered their appetite for high risk investments.

The index lists 28 types of risk for investing in climate finance, covering 4 categories: policy risks, capacity risks, transactional risks, and project risks. Policy risks are governmental changes to climate change adaptation and mitigation policies at the national level, capacity risks relate to enabling infrastructure (less physical infrastructure than trained local personnel), transactional risks are challenges or barriers to doing business that are faced by every investor whether they be public or private sector (examples of which are the number of public officials that have to be paid off, the amount of paperwork needed for locality permits to build), and project risks are risks unique to individual projects (challenging geography, transport, etc).

The risks are then placed on a scale where the likelihood of the risk is ranked against the potential severity.

The risks that top the list are not anything anyone was unaware of:

The most probable and most severe risk to investment is longevity. The time horizon for any investment in renewable energy technology is often longer than most investors are willing to undertake even for a higher return. The second most probable and most severe is transaction cost risk which relates directly to the third most probable and severe is the risk-return balance (imbalance)-- in the developing world this is the amount of money needed to get a deal through like buying permits and paying off officials as well as the cost of the financing the capital (interest rate) measured against the return to the investor (incentives provided by profits and earning carbon market allowances). Investors prefer that cost to return margin to be high.

There are a number of tools available--bonds, securities, asset backed finance, hybrid (multilateral and sovereign) guarantees combined, insurance, taxation-- that require innovative iterations to get the money moving. With a common language of risk, that innovation can begin to take place.

The one area the risk index fails is how historic finance market shortfalls will be resolved particularly with respect to financing adaptation and mitigation fiance in developing countries: the riskiest countries for investment have never received the amount of financing they need even in terms of development aid. Two decades of ‘financial innovation’ and risk appetite on behalf of investors for risky developing country investments never solved this problem.

The index places “illegitimate risk” -- the risk of an overthrown government or sudden public seizure of privately owned assets-- as the most severe but least probable type of risk because according to Richardson these are easily seen and thus easily avoided.

Simon Petley, Director at EnviroMarket, explained that in the traditional market high risk frontier markets (lesser developed countries, volitile political environments) receive investments through financing structures that are backed by export flows-- the trouble with which is that from many of those countries the exports are commodity based and thus the market prices can be unstable.

Petley said, “the challenge is those structures aren’t always competitive and it could be quite an expensive way to finance projects.” It appears climate related finance in developing country markets may still be too risky for investors, despite the common risk language the index provides.

But Michael Wilkins, Managing Director and Global Head of Carbon Markets at Standard and Poor’s is optimistic that all financing challenges can be solved, “Climate finance is at an early stage of evolution and if you look back fifteen years ago at where infrastructure finance was… Time has moved on and we’re now seeing a lot more project bonds in the capital markets and it’s standing up on its own two feet.”