How de-risking renewable investments can bridge the $1.2 trillion gap in developing countries

This article is brought to you thanks to the collaboration of The European Sting with the World Economic Forum.

Author: Gareth Francis, Senior Writer, Forum Agenda

• We need to invest $1.7 trillion every year in developing countries — in 2022, we hit $544 billion.
• Private capital will be instrumental in closing this $1.2 trillion gap, so de-risking of that credit by multilateral development banks is key.
• Here are just some of the key tools being used today and how they can be further improved to hit that $1.7 trillion target and close the gap.

The adoption of renewable energy (RE) technology in developing countries is significantly less than desired. We need to invest $1.7 trillion every year in developing countries — in 2022, we hit $544 billion. To close that $1.2 trillion gap, de-risking private capital is key.

This deficit is one of the key constraints stifling the adoption of the RE sector in developing countries. There are several risks preventing capital flows to the RE sector in developing countries. Among them, credit risk is key.

In the last two decades, international institutions and financial intermediaries innovated and deployed credit risk-mitigation instruments. However, these instruments are not currently being used to their maximum potential. The high cost of these instruments, cumbersome process, inflexibility, lack of awareness and slow decision-making by multilateral institutions and governments is limiting the use of existing credit risk-mitigating instruments — and slowing the energy transition.

The Asian Development Bank’s partial credit guarantee

In the early days of solar energy in India, the Asian Development Bank (ADB) provided a partial credit guarantee (PCG) for addressing credit risk in utility-scale solar lending in India. The idea was to provide broader comfort to lenders in a new space. However, the PCG programme has not been successful yet; only two RE issuers have used this instrument to raise funds. Delayed deployment of the facility, changed perceptions in the interim, high perceived cost of availing the guarantee, cumbersome process to understand the mechanism, inflexibility and limited awareness have prevented wider uptake. Addressing these barriers, primarily increasing the flexibility of offers, reducing the complexity of transactions and subsidizing guarantee fees, can greatly increase its adoption, which can attract massive amounts of private capital.

The International Finance Corporation’s partial credit guarantee

The PCG guarantees offered by the International Finance Corporation (IFC) are growing over time, primarily supporting local currency financing. These guarantees have improved tenors but their impact on cost of capital is less clear. Likewise, risk-sharing facilities (RSFs), another instrument of IFC aiming to address credit risk, have shown mixed results.

Guarantee instruments are fringe activity to the IFC’s primary activity: direct investment. They are one-offs given the IFC’s focus on project finance, plus the incentives for the provision of these guarantees are misaligned, given IFC’s focus on large deals. In addition, the IFC’s risk-averse approach also handcuffs its use of guarantee instruments.

To increase the use of these guarantees, the IFC needs to institutionalize innovation in offering and reduce complexity in transactions. It should focus on guarantee (instead of treating it as a fringe activity), increase the size of guarantee funds and add more human capacity to scale up the instruments that crowd in large-scale private sector investment.

The credit guarantee mechanism

The credit guarantee mechanism (CGM) was developed to address credit risks in lending to the rooftop solar sector in India in the medium and small size enterprise (MSME) segment, in the context of India’s ambitious target of 40GW of rooftop solar capacity by 2022. The instrument has a leverage of approximately nine — meaning $1 of commitment to the CGM catalyzes $9 in private sector lending.

Given the World Bank’s interest in supporting the rooftop sector in India, and its ongoing support to the State Bank of India (SBI), the implementation of CGM was passed over to these institutions in 2018. Quick decision-making in international institutions and prioritizing the MSME in India’s green transition can make this catalytic financial instrument run. The same instrument can also be deployed in other developing countries, where the credit risks in the MSME segment is the same in most of the countries.

Off-grid solutions to de-risk green investments

First-loss guarantee (FLG), an instrument in which a third party compensates the lender if the borrower defaults, is another catalytic instrument in the initial stages of a sector like renewables, given the general discomfort of financiers, evolving to PCGs as the sector matures. These guarantees have been provided for various businesses by various agencies over time. Take, for example, the US International Development Finance Corporation (DFC)’s $10 million guarantee to catalyze $20 million in loans by Trine or MIGA’s $5.9 million guarantee to the $100 million fund by BBox.

Another novel solution in the off-grid solar financing space is the Green 4 Access platform in Africa. Three years after conceptualization, Green 4 Access is still in fundraise mode. In this context, a key resource in Africa is the Africa Guarantee Fund (AGF), focused on mobilizing private resources for SME resources in Africa, which has enabled $1.6 billion in financing for SMEs in Africa. Using learnings from the AGF, solutions such as Green 4 Access can be further scaled and replicated elsewhere. To this end, learnings from Bangladesh’s successful solar home system (SHS) programme, facilitated by the Infrastructure Development Company Limited (IDCOL), could be instructive.

IDCOL was set up as an intermediary financial institution to provide grants and low interest loans to partner organizations. IDCOL was able to do so due to grants and credit support provided by various multilateral institutions. In this process, IDCOL was able to address the credit risk of the eventual customers.

However, the MSME segment faces similar issues to traditional guarantee providers: small size, lack of flexibility of guarantee to meet sector specific needs and slow decision-making processes of the institutions providing guarantees.

To scale up these instruments, multilateral development banks, bilateral financial institutions and donor agencies must make credit guarantee a core product offering and increase awareness of its product offerings. The guarantor’s balance sheet must be replenished through grants and concessional capital to scale up the use of these instruments. Credit guarantors must be flexible to accommodate the varying needs of developing nations and agile to meet the urgent needs of these countries.

Views are personal and do not represent that of the authors’ employers.