Wednesday, 31 July 2013

What is ‘inclusive green growth’, and how should it be financed in low income countries?

By Stephen Spratt

Last year, colleagues from the Initiative for Policy Dialogue (IPD) at Columbia University and I were asked to assess what institutional investors (pensions funds and the like) could do to boost ‘inclusive green growth’ in low-income countries (LICs). We were also asked to consider what donors could do to support this. Our answers to these questions have now been published.

To get a handle on this, we had first to unpack the phrase, ‘inclusive green growth’. First up, we have two dimensions – ‘inclusive’ and ‘green’ – both of which mean different things to different people. ‘Inclusive’ can mean that the poor benefit to some extent from the process of growth – this is its ‘weak’ form. It can also mean that the poor benefit more than other groups, so that inequalities decline – this is ‘strong inclusivity’. A similar approach can be applied to ‘green’: proponents of ‘weak green’ growth, for example, would assume that many forms of ‘natural capital’ can be replaced, while supporters of ‘strong green’ growth would be less sanguine, and more likely to apply the precautionary principle to the exploitation of environmental resources. Already we can see that ‘inclusive green growth’ in its ‘weak’ or ‘strong’ form would imply very different things.

The next step was to consider what impact institutional investors could have on these versions of inclusive green growth. We identified investment in the energy sector as crucial, particularly how private investment might be used to increase the supply of renewable energy, to increase energy efficiency (green), and to expand affordable access and eliminate energy poverty (inclusive).

The purpose of these institutions is not to mitigate climate change, however, but rather to build and manage a portfolio of investments that produce the best risk-adjusted returns for their members. The question, therefore, is how compatible this goal is with investing in energy efficiency or renewable energy generation in LICs, and doing so in such a way that energy poverty is reduced?

On this question, the first point to make is that renewable energy remains more expensive than fossil-fuel generation in most instances. Potential returns are thus lower than comparable, alternative investments. Given this, most countries have used a variety of subsidies (feed-in tariffs, for example) to boost returns and attract private investors. While LICs are no different, the question of who should pick up this bill is different? Our conclusion was that donors should make a major contribution.

LICs bear no responsibility for climate change, and it is therefore unfair for them to be penalised for implementing measures needed to address it. As well as this ethical point, there is also a pragmatic argument: the credibility of financial support for renewables is key to attracting private investors; our interviews in the City of London made it clear that donor involvement could be essential in boosting this credibility. By providing financial support for mechanisms like feed-in-tariffs, therefore, donors would be both boosting returns and reducing risks: a double benefit.

The second point relates to inclusivity. Generally, the ‘stronger’ the level of inclusivity that is desired the lower the potential profitability of the project. This does not always hold, but doing things like ensuring access to remote rural areas, and making tariffs affordable for the poor, are unlikely to boost the returns available for investors. This is why definitions matter: the ‘stronger’ we want inclusive green growth to be, the more financial support is likely to be needed to make these investments attractive to private investors. A key finding is that this issue needs to be recognised and explicitly addressed if inclusiveness is to be realised, particularly in its strong form.

Not everything comes with a price tag though. We also found that donors can do much to mitigate the different forms of risk that act as obstacles to institutional investors.
  • Reduce early stage project risk: many developing countries have real advantages with respect to renewable energy resources. Institutional investors, however, are not going to invest in projects until they are fully ‘investment ready’. Sourcing and developing projects so that they reach this stage is a precondition for investment, and an important role for donors.
  • Reduce regulatory risk: renewable energy projects in particular are heavily dependent on the maintenance of a supportive policy framework. Donors can do a number of things in this regard. First, they can boost the credibility of policy instruments by directly contributing as described above. Second, by co-investing they may provide some ‘insurance’ for private investors, who believe that policy is less likely to be changed in these circumstances. As well as partnering on individual deals, there is potential value in donors establishing – and investing in – dedicated investment vehicles that focus on low-income countries.
  • Reduce information asymmetries and logistical barriers: for energy efficiency, interventions are needed less to improve project economics, than to overcome informational and structural barriers. Projects tend to be small in scale but large in number, raising transaction costs. There are also costs to identifying viable projects, and structures need to allow diversified access to the sector. Here donors have an important role to play in helping develop these structures. They may also play a role as co-investors and guarantors.
As described in the report, there are many examples of best practice that can be drawn upon. While it is possible to imagine how most of the key obstacles to institutional investment could be addressed, we also identified a major underlying issue. Achieving a shift to a trajectory of inclusive green growth in LICs requires very large investments. The assumption has been that only institutional investors can provide resources at the scale required. As well as the level of finance, the attraction of institutional investors is that they may also provide long-term finance with reasonable return expectations. An important finding is that some investors have excessive expectations in developing countries, which do not seem to have been adjusted downwards in the light of the global financial crisis and the low yields available in developed countries.

Projects that can attract long-term financing at 5-8% in Europe or the US, might need to yield 25-30% in low-income countries to attract the same private investors. This could only be achieved by charging very high tariff rates, or by increasing public subsidies to high levels. Neither is particularly attractive in a low-income country setting.

Achieving growth that is both green and inclusive is inherently difficult. Doing so using private investment which requires very high returns may be impossible. Unless investors can be persuaded to adopt more reasonable expectations, alternative sources of finance may be needed if the goal of generating genuinely inclusive green growth in low-income countries is to be achieved.

Stephen Spratt is a Fellow in the IDS Globalisation Team working on development finance, financial sector reform and regulation, socially responsible investment, the emerging climate change financing architecture and the intersection between these issues.
Previous Globalisation and Development blog posts on investment, energy and the green transformation:


Hubert Schmitz said...

I have just read your very interesting blog. I am surprised that Western institutional investors have such high yield expectations for less developed countries. The figures you mention suggest that these expectations are four times higher than for Western Europe or North America. Three questions come to mind:
First, do these expectations reflect ignorance, arrogance or actual experience?
Second, do we know whether BRICS investors have lower expectations for comparable projects?
Third, do their expectations differ significantly between less developed countries?

Stephen Spratt said...


Glad you found the blog interesting. What became clear in the research is that Western institutional investors look at renewable energy projects in Africa in a completely different way to the same project in, say, Europe. If they undertake projects in LICs, these are financed from different parts of the portfolio – more specifically, the high-risk/high-return, private equity-style ‘buckets’. Investments in this part of the portfolio, as the name suggests, are expected to yield high returns.

In part this is ignorance, as we found more realistic return expectations in asset managers that focus on emerging markets. In part it is ‘experience’ in the sense that they tend to expect high returns for investing in developing countries, and would argue that renewable energy carries additional risks (e.g. the possibility of policy support being removed). In this regards, there is a general view that developing countries are inherently risky places to invest, and there is some arrogance here – little account seems to have been taken of the very high risks of investing in developed countries, as evidenced by the losses suffered in the crisis of 2007/8.

This is not all unreasonable, however. Clearly there are risks of investing in renewable energy projects that are dependent on policy support – FITs, for example. The question then becomes how credible this support is. We address these questions in depth in the report linked to the blog.

We focused on Western investors, so don’t know much about any differences from BRICs investors. My guess is that this would be more reasonable on average, but there would be considerable variety between different types of investor. Be very interesting to explore this question though.

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