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Often over the past few years, I’ve come across fellow colleagues working as investment officers who view concessional climate finance as a pure co-financing instrument that can quickly and effectively cover a funding gap in any given project. They fail to understand that if structured in such a simple way, the full potential of concessionality to drive private investment in under-invested sectors will not be met.
Concessional Finance can be instrumental in, for instance, crowding-in commercial investors, addressing information asymmetries, market and institutional failures and affordability constraints that hinder positive market dynamics. In short, it is a tool to effectively address barriers and mitigate risks to unlock deployment of valuable financial resources that contribute to a paradigm shift to low-emission and climate resilient development.
Concessional financial instruments are broadly defined as those extended to a counterpart on terms substantially more generous than market-based financial instruments. The Green Climate Fund (GCF), a valuable global source of concessional finance, is committed to support the potential of private sector for clean energy, energy efficiency and climate resilience in its target countries. For Africa, this means that a high number of investment opportunities are hanging in the trees waiting to be picked.
It is widely known that private investors will only take a decision to invest if they are able to secure a return large enough to cover their initial investment plus operational costs, and a profit that is commensurate with the risk associated with the investment itself. In most cases, the key issue is not lack of liquidity per se. Rather, it is the benefit to be gained from setting up a conducive enabling environment and an investment framework that allows for proper risk allocation among all relevant parties to a project.
Concessional climate finance must therefore be structured in a way that effectively addresses existing barriers and mitigate risks with the objective of supporting a sustained and long-lasting market transformation. In order to be successful, the level of minimum concessionality must be determined on a case-by-case basis so as to avoid market distortions while ensuring that subsidies can be phased out over time. Other key principles to be considered include additionality, commercial sustainability and investors crowding-in and markets’ reinforcement.
This approach is particularly valuable in the forest sector. For example, in the context of a private sector-led commercially-based sustainable plantation business, a concessional loan can greatly contribute to removing pressure on the cash-generating capacity of the business, if it is tailor-made to propose a tenor and grace period longer than market-terms, a sculpted repayment profile that allows for back-loading of principal repayments, and deferred interest payments during the grace period. These elements take into account the fact that trees require considerable time to grow, both in size and in value. It’s not that these businesses are not profitable in the long-run, it’s just that their ability to generate cash in the short- to medium-term is highly constrained due to the nature of their business model and underlying assets that need time to mature.
For these businesses, cash-flows from financing activities during the first years of operation cannot be covered by revenues and this put investors off and deviates the much-needed capital to fight deforestation and forest degradation into more traditional sectors of an economy. This is especially a concern for greenfield commercial plantations.
Guarantees can also play an instrumental role in countries where markets are under-developed and payment default risk will be severe enough to keep commercial debt providers at bay; therefore, if concessional finance is used to mitigate this and other risks, commercial investors will be incentivized to get involved and to participate in this market transformation.
Opportunities are out there and private investors are lining up to seize them. It is up to the donor community, the GCF, and other sources of blended finance to contribute their share.