Many environmentally beneficial technologies require significant up-front investment. This investment will be typically offset, over time, by the environmental benefits, out-of-pocket cost savings, or financial revenues associated with the new technology. There are, however, many circumstances where users are unable to purchase equipment that is financially viable to them or beneficial to the society, simply because they do not have access to the private or government investment funds necessary to install the equipment. To the extent that private entities are not willing to provide funds to implement investments that are financially viable and in addition reduce GHG emissions, they constitute failures of capital and financial markets that must be overcome to reach the level of economic potential. In contrast to private financiers, who are primarily concerned about the risk-adjusted financial return, governments are expected to evaluate desirability of investments in a wider context of the well-being of the whole society, including harms and benefits that some entities impose on others. To the extent that governments are not willing to finance investments that are socially desirable thanks to climate and other environmental benefits, they constitute policy failures that prevents achievement of socioeconomic potential. All these market and policy failures are aggravated in developing countries and low income transition economies, where they interact with poverty and capital constraints.
Notwithstanding the significant potential as a supplier of investment capital for climate-friendly technology transfer, commercial banks thus far have not developed large portfolios of environmental loans (Delphi Int. Ltd. and Ecologic GMBH, 1997). Banks face high up-front cost of developing new, green financial products (e.g., energy-efficiency loans). To bear these costs is often perceived risky by the bankers, given uncertain and policy-dependent future market conditions. Relatively low capital requirements and the long-term cash-flow profile of many climate friendly investments, as well as high transaction costs of servicing large numbers of small and medium-sized projects, further reduce comparative attractiveness of this sector to the commercial banks (Berry, 1995). Technologies such as energy efficiency or public transport often have low collateral value compared to their traditional alternatives, making it difficult for the banks to use some financing instruments such as project finance.
Even if the size of the loan for manufacturing or distributing climate friendly technologies would justify the attention of bankers, the debt carrying capacity of such projects hinges upon the availability of financing for the end users, e.g., households to enable them to purchase those technologies. These down-stream projects most often require completely different financial products, which commercial banks are often not able to offer (e.g., micro-credits or grants to low income households with no assets).
Different energy producers and consumers have varying access to capital in financial markets, and at different rates of interest. In general, energy suppliers can obtain capital at lower interest rates than can energy consumers thus, an interest rate gap. Differences in these borrowing rates may reflect differences in the knowledge base of lenders about the likely performance of investments, as well as the financial risk of the potential borrower. At one extreme, electric and gas utilities are able to borrow money at low interest rates. At the other extreme, low-income households may have essentially no ability to borrow funds, resulting in an essentially infinite discount rate for valuing improvements in energy efficiency. The broader market for energy efficiency (including residential, commercial, and industrial consumers) faces interest rates available for efficiency purchases that are also much higher than the utility cost of capital (Hauseman, 1979; Ruderman et al., 1987; Ross, 1990).
Green Financial Institutions
In response to the difficulties faced by the emerging environmental business sector in accessing traditional financing institutions, such as banks (Asad, 1997), a number of innovative approaches and specialized financial institutions have developed. These include environmental project finance (Stewart, 1993; Shaughnessy, 1995; Davis, 1996), green investment funds, leasing (Carter, 1996), environmental and ethical banks, environmental funds (OECD, 1999b), and energy service companies (ESCOs). Not clearly defined property rights to GHG emitting assets create obstacles to ESCOs and other similar institutions, that invest in the assets of third parties and rely on a contracts with owners to recuperate the return (WB and IFC, 1996). The growth of new green financial institutions hinges upon the long-term market growth prospects for the environmental business sector, which in turn depends fundamentally on the consistent and clear commitment by governments to climate policies (Delphi Int. Ltd. and Ecologic GMBH, 1997). Specific incentives, such as tax allowances, have been shown to stimulate the market penetration by green investment funds in some developed countries (e.g., The Netherlands).
In the last years of the decade sustainable forestry has started to attract private finance. Some new green financial institutions have worked towards capturing values of standing forests through innovative financial mechanisms. Sustainable forestry has provided attractive returns relative to stock markets. Forestry investment funds have typically achieved annualized returns in excess of 14% over the last decade. This was in excess of the returns on the S&P 500 index for the equivalent period (Ecosecurities, 1999). Forestry investments had lower volatility than stock markets, and could provide solid long-term returns. However, to the extent that these involve wood plantation where logging is an important part, the climate benefits are negligible. Managing forests and harvesting their products and services efficiently significantly improves financial return to the standing forests versus logging. The marketable goods and services of forests include pharmaceuticals (Simpson et al., 1996), genetic resources (Rosenthal, 1997), and ecotourism (Panayotou, 1997). An important factor stimulating financial viability of sustainable forestry is the move of government, world business, and consumer demand towards confining wood procurement to environmentally sustainable sources.
Individual and institutional investors send important signals to companies in the pricing of new capital raised by the companies and in on-going valuation of quoted companies. They can also exert direct influence by using their rights as shareholders and owners. The key concern for investors is the relationship between environmental performance and investment performance. Many investors remain unconvinced that the present value of their portfolios may be affected by the future consequences of climate change. They also are not convinced that environmental performance contributes to good financial performance.
There is some empirical evidence, however, that investors do value environmental performance of firms. Dasgupta et al. (1998) showed that capital markets in Argentina, Chile, Mexico, and the Philippines reacted positively (increasing the firms market value) to the announcement of rewards and explicit recognition of superior environmental performance. They found capital markets to react negatively (decreasing the firms value) to citizens complaints and to news of adverse environmental incidents (such as spills or violations of permits). Environmental regulators could harness market forces by introducing structured programmes to release firm-specific information about environmental performance, and empower communities and stakeholders through environmental education programmes. Lanoie et al. (1997) arrived at similar conclusions, drawing on evidence from American and Canadian studies.
The potential of the insurance sector lies in its ability to diversify its investment portfolio and to have its premium structure reflect environmental risks (Delphi Int. Ltd and Ecologic GMBH, 1997). The insurance industry may provide project finance and insurance for preventive infrastructure projects, thereby enhancing their access to finance. The insurance industry also provides strong financial incentives for loss prevention and mitigation to their clients and the public, e.g., by means of deductibles (UNEP, 1999). Some insurance companies have launched the Insurance Industry Initiative for the Environment, in association with UNEP.
Generation of revenues from the users of public infrastructure can be an important source of funds for financing GHG emissions reduction in the power and district heating sector and other types of GHG emission-intensive infrastructure. Covering the costs of operation, maintenance, depreciation calculated according to the international accounting standards, and eventually debt service for investments is essential for the sustainability of infrastructure systems and important for attracting multilateral development banks (MDBs) and private finance (UNIDO, 1996; EBRD, 1999). In low-income countries this needs to take full account of affordability constraints. However, concern about the social impacts too often makes the governments reluctant to adopt higher tariff levels, even though evidence suggests consumers in many countries could afford and would be willing to pay more for improved service (Lovei, 1995; Gentry, 1997; AFDB, 1999).
Government-created Disincentives to Private Investment
Government policies may themselves be a source of risk to private investments, creating detrimental framework conditions for all, not only environmental, investments through unstable fiscal policy and a macroeconomic environment. This leads to high interest rates, elevated inflationary expectations, and fluctuating exchange rates. The traditional response to these problems through fiscal consolidation and tight monetary policies usually induces low liquidity in the enterprise and banking sector (EBRD, 1999). This liquidity constraint may be sharpened by obstacles to trade and bank credit, barriers to entry, especially for SMEs and foreign firms, barriers to foreign direct investments (FDIs) and to long-term foreign capital investments, all of which could otherwise relieve capital shortages (EBRD, 1997b; EBRD, 1998; EBRD, 1999). Weak governance, typically manifested by the lack of the rule of law, soft budget constraints, absence of competition in government procurement, and corruption, may foster a perverse microeconomic incentive structure that rewards private sector entities not for being competitive and efficient in using resources, but rather for seeking rents through friendly and not transparent relations with politicians (Gady and Ickes, 1998).
Governments sometimes introduce distortions directly to financial markets, constraining the private lending to investments. Imprudent government borrowing can raise interest rates and crowd out bank loans from the real sector of the economy (OECD, 1998b). Also, excessive subsidies to environmental investments may crowd out private sector financing (Peszko and Zylicz, 1998). The risk of lending for investments may additionally be increased by inadequate protection of creditors. This occurs when an underdeveloped legal and institutional system does not make it easy for creditors to seize collateral or initiate a turnover of management in the event of default.
Government-created Disincentives to Public Investments
Ill-designed taxation, as well as failures in budget planning and expenditure control may cause fiscal imbalances and high budget deficits, which contribute to high country sovereign risk, constrained access to foreign capital, and high cost of borrowing by the government. Increased nominal interest rates and related discount rates applied by the governments inhibit financing for most public environmental investments. Budget expenditure cuts usually involve ceilings for investment expenditures, while financing is made available for operation of existing technologies or infrastructure. This often leads to continuing operation of inefficient and polluting assets, even if their replacement through investment would bring a high rate of return.
A barrier to efficient use of government funds is poor management of public investment programmes and government budgets (OECD, 1998b). This is sometimes a result of an underdeveloped civil society, and absence of government accountability and transparency in budget preparation and implementation. Under these circumstances budgetary spending on environmental infrastructure and biodiversity tends to be neglected (OECD, 1999a; Partridge, 1996). An important opportunity to enhance government spending on climate friendly investments is through revising public sector expenditure choices (de Moor, 1997; Pieters, 1997). Many developing countries and the countries of the former Soviet Union could help both climate and economic development by phasing out ongoing subsidies to loss-making state owned, or even private enterprises.
Central and local governments have ample opportunities to create new mechanisms and new sources of finance for climate-related environmental investment (Tlaie and Biller, 1994; Pearce et al., 1997). Budgetary resources can be used more cost-effectively (Lovei, 1995) and more creatively (Clements et al., 1995) to leverage private capitalization of public environmental investments (World Bank, 1994; Partridge, 1996; UNIDO, 1996; Gentry, 1997; Peszko and Zylicz, 1998). Central governments can foster the use of economic instruments (tariffs, taxes, fees, etc.) to achieve environmental goals while generating budgetary revenues (Herber, 1997; Schlegelmilch, 1999). In the area of biodiversity pricing, instruments can result in a double dividend. They can prevent the tragedy of the commons by limiting otherwise open access to vulnerable natural reserves. Prices also generate revenue to pay for the sustainable use of biodiversity resources and for afforestation. Successful examples of these government initiatives could be found in Latin America (Umana, 1996; Lopez, 1997), OECD countries (OECD, 1996) and Central and Eastern Europe .
Official Development Assistance
There is a mixed experience with donor aid programmes (Killick, 1997). Choice of beneficiary countries, sectors, and types of projects by the donor governments has often been driven by the geopolitical interests of donors rather than environmental or global priorities in the recipient countries. Bilateral aid is often a tool to support friendly regimes or strengthen the spheres of influence (Alesina and Dollar, 1998). Tied aid still dominates bilateral programmes, whereby the contracts are available only to firms from the donor country (Michaelowa, 1996).
Because of restrained competition tied aid may increase the costs of purchasing capital or providing services anywhere from 10% to 50%, and host governments are usually required to co-finance these projects. Some host governments have found themselves locked in the expensive, capital intensive, and inappropriate technologies that additionally created dependency for maintenance and spare parts. Tied aid may distort the efficiency of technology choice, and crowd out good technologies and viable business models (Graham and Hanlon, 1997). Tied aid has also had an impact on GHG emission reduction projects in the context of the Activities Implemented Jointly (AIJ) pilot phase (Michaelowa et al., 1998).
Multilateral Development Banks
Sovereign guarantees required with most MDB lending involve host governments in making budgetary commitments that may be difficult to attain in many low income countries. Furthermore, strict adherence to sound banking principles (of not lower standards than in the highest-rated private banks) poses very high requirements for the internal financial viability of projects. It is not, clear, however that the MDBs can do otherwise. They can provide low cost lending only as a consequence of their high credit ratings. Maintenance of these high ratings requires very low exposure to default risk, which in turn depends on sovereign guarantees and sound financial parameters of a project.
Another problem with MDB loans is a longer time for and higher transaction costs of project preparation relative to the typical GHG emissions reduction project size. It usually takes 1.5-2 years and several hundred thousand US dollars to develop a project for financing. This can only be justified if the size of a project is minimum US$10-15 million. MDBs are trying to develop financial products that could reach small and medium-sized environmental projects (ADB, 1999). Trust funds and donor grants are used to lower project preparation costs. Smaller businesses are targeted trough intermediaries (local banks, leasing, ESCOs, or even NGOs) which on-lend MDB loans as a package of smaller financial products. Structural lending is used to finance multi-project programmes.
Most of the financing difficulties discussed above are most severe in developing countries, where they interact with poverty to severely constrain investment in GHG-efficient technology. Less developed capital and financial markets call for innovative financing to enable low-income households to afford GHG-mitigating technologies. This offers an important opportunity to integrate the broader objectives of development, equity, and sustainability (DES).
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