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McKinsey Report Hits The G(reen) Spot

by Sean Kidney and the Climate Bonds Team

Working on climate change involves reading a lot of reports. A lot. My general view nowadays is “Enough already! Can you we just do now and stop theorizing?”

But sometimes you come across a report and you find yourself sitting up in your seat and shouting “Yes Yes Yes” like that scene with Meg Ryan in the movie When Harry met Sally.

It usually means the report is saying what you’d like to say, but much better; and so it is with the McKinsey Center for Business and Environment’s new report on Financing change: How to mobilize private sector financing for sustainable infrastructure.

The report:

  • Draws the link between country climate change plans submitted to the UN Climate Change Conference and infrastructure needs. Tick.
  • Then explains that global demand for new infrastructure to 2030 could amount to $90 trillion – as compared to the value of the world’s existing infrastructure at $50 trillion. Wow!
  • Infrastructure spending has to scale up from $3 trillion a year now to $6 trillion a year.
  • More than 60% of this funding gap is for infrastructure in emerging markets, like China, Brazil, India and Mexico.
  • Explains that public sector capital will not be enough and we need to mobilize private capital. Yep.
  • That means attention has to be given to “enabling environments” that ensure capital will flow from institutional investors like insurance and pension funds.

They posit five major barriers:
  • Lack of transparent and “bankable” pipelines: Even in the G-20, only half the countries publish infrastructure pipelines.
At Climate Bonds we think this is by far the most urgent issue, because a clear pipeline will drive home to governments the extent to which they need private capital and make them more receptive to proposals for that “enabling environment”.

  • High development and transaction costs.
That’s a tough one; but it’s interesting to see how in India the government has been tackling this with fast-track approvals, cutting red tape and the like. A long way to go, but hopeful.

  • Lack of viable funding models: Up to 70 percent of water provided by utilities in sub-Saharan Africa is leaked, unmetered, or stolen; therefore not enough revenue is generated to maintain or expand the system.
We’d add urban rail transport as another example, where too many governments insist on trying to recover the cost of investment from operating revenues. Doesn’t work. But what does work is Hong Kong’s system of massive property development on top of subway stations that allows the capital cost of the subway to be paid for with property profits. Go MTR!
  • Inadequate risk-adjusted returns: Investors may be willing to take on sustainable infrastructure but want higher returns to compensate them for the perceived risks.
This has always been the issue with infra development; and governments in many many countries have successfully found ways to structure investments with long-term contracts, regulatory support, and even revenue guarantees (often used for motorways) to attract the right kind of capital.

  • Unfavorable and uncertain regulations and policies: Basel III and Solvency II regulations could have the effect of reducing investment in infrastructure at the global level; uncertain tax policies can do the same at the national level. The fact that sustainable-infrastructure projects typically have higher up-front capital costs makes them even more sensitive to the cost and availability of capital.
That’s the key challenge of the green investment path we need to take: capital costs are much higher (20-30%) than the dirty brown path we usually take. But against that are health benefits (like less toxic air in Beijing, Delhi, Mexico City and Sao Paulo); lower operating costs with clean energy and rail maintenance (vs roads); and 100 year assets that, once capital costs are paid off in 20-30 years, keep working for a lifetime afterwards. Oh, and we help fix climate change; mustn’t forget that.

McKinsey’s prescriptions:

  • Scale up investment in sustainable project preparation and pipeline development. Governments and development banks should focus investment on project-preparation facilities and technical assistance to increase the “bankability” of project pipelines (meaning those that have an attractive economic profile). This is the highest-risk phase of the project life cycle; it is critical to get right; and it is subject to significant rent-seeking conduct. Given a chronic shortage in many developing countries of the right developer equity/expertise, this is an arena in which the right financing facilities could have disproportionate returns.
Agree 100%

  • Use development capital to finance sustainability premiums. Encourage development banks and bilateral-aid organizations to provide financing for the incremental up-front capital spending required to make traditional infrastructure projects sustainable, in economic, social, and environmental terms. Attract private-sector financing by demonstrating that risk-adjusted returns can be competitive with those of traditional infrastructure, even if the policy settings and prices do not fully reflect the total benefits of greater sustainability.
  • Improve the capital markets for sustainable infrastructure by encouraging the use of guarantees. Increase development-bank guarantee programs for sustainable infrastructure by expanding access to guarantees.
In fact, policy risk is usually cited as the number one risk for investors. Selective guarantees that address policy risks hold the potential to be fiscally efficient compared to the blunderbuss full guarantees too often used in the past.
  • Encourage the use of sustainability criteria in procurement. Governments should strengthen sustainability criteria in both public-procurement processes and public-private partnerships.
  • Increase syndication of loans that finance sustainable infrastructure projects. Encourage development banks to expand loan syndication and create a larger secondary market for sustainable infrastructure-related securities.
This would increase institutional investor familiarity with the asset class, reduce transaction costs, and allow the recycling of development capital.
  • Adapt financial instruments to channel investment to sustainable infrastructure and enhance liquidity. “Yieldcos” or “green bonds” have characteristics similar to traditional investment instruments, but with an emphasis on sustainability. Increasing use of these instruments could unlock investment from previously restricted investors, lower transaction costs, and reduce barriers to entry.

Green bonds? Nice idea.

I like their concluding remarks as well:

If capital markets were perfect or could respond instantaneously, then it is possible that some of the actions proposed in this report would be redundant.

However, in the real world, there is ample evidence of pervasive imperfections in the capital markets, partly due to policy and regulatory rules (for example, which result in risk mispricing or excess capital weighting for specific asset classes) and partly due to institutional conduct and agency factors.

Given their limited direct exposure to infrastructure risk, institutional investors are naturally cautious about increasing their exposure to this asset class. That is why a muscular set of nudges and risk-sharing instruments are required: they can shift perceptions and get capital to flow.

And finally

There are many challenges to changing the design, construction, financing, and operation of infrastructure.

There are no simple solutions. What there should be is a sense of urgency.

In the next 15 years the world is set to build more infrastructure than the value of all the infrastructure that exists today. That will dramatically remake the global landscape and profoundly shape the trajectory of efforts to deal with climate change for decades.

We can secure a better future, but only if we act quickly—and wisely

Thank you Aaron, Mike, Melissa and the legendary Jeremy Oppenheimer for a fantastic report highlighting practical solutions to scale green infrastructure investment!

----------------------

Financing change: How to mobilize private sector financing for sustainable infrastructure, by Aaron Bielenberg, Mike Kerlin, Jeremy Oppenheim, Melissa Roberts, McKinsey Center for Business and Environment, January 2016.

To find out about Climate Bonds Initiative work in this area read about our Green Infrastructure Investment Coalition, being developed with the Principles for Responsible Investment, the International Cooperative Insurers Federation and the UNEP Inquiry.

Also check out our public sector guide for scaling green bonds markets, which looks at how governments can leverage the green bond market to meet, their green infrastructure investment needs.

——— The Climate Bonds Team includes Sean Kidney, Tess Olsen-Rong, Beate Sonerud, and Justine Leigh-Bell.   The Climate Bonds Initiative is an "investor-focused" not-for-profit promoting long-term debt models to fund a rapid, global transition to a low-carbon economy. 



was posted on AltEnergyStocks.com.


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