The conclusion of the UN Intergovernmental Panel on Climate Change’s most recent report is stark: Climate action is far more urgent than previously believed and it must include a wide range of initiatives, from improved regulations to continued technological innovation.
However, without massive amounts of long-term “patient” capital — which only institutional investors can muster — it will be impossible to transform energy systems fast enough to mitigate the risk of ecological, economic and social disaster.
Technically, institutional investors — such as pension funds, sovereign wealth funds and insurance companies — hold sufficient financial firepower to address climate change and some are seeking to align their portfolios with the UN Sustainable Development Goals (SDGs).
In Organisation for Economic Co-operation and Development (OECD) countries alone, institutional investors control an estimated US$92 trillion in assets. Annual official development assistance by multilateral finance institutions (MFIs) and governments amounts to just 0.16 percent of that — about US$145 billion.
However, as commercial actors, institutional investors’ primary objective is to maximize financial returns. Even as some purge their portfolios of carbon-intensive companies, they generally consider investing in new clean-energy infrastructure projects to be too risky, particularly in emerging markets.
To finance the SDGs, including clean-energy infrastructure, MFIs have committed to mobilizing capital from private investors. This mobilization takes place largely through so-called blended finance, whereby MFIs and other public finance institutions use their own capital to crowd in private financing.
However, institutional investors have been largely absent from multilateral blended-finance initiatives, which have, in turn, failed to achieve a scale relevant to climate change.
So, what will it take to mobilize the needed capital from institutional investors?
A paper by researchers at Stanford and Maastricht universities suggests focusing on three recent developments in the global financial sector.
First, a growing number of institutional investors are reducing their dependence on financial intermediaries. Institutional investors have traditionally outsourced their investments to investment management firms, whose performance is generally assessed on a quarterly basis. Yet the investment horizon for infrastructure, including clean-energy infrastructure, is often more than 20 years.
From the perspective of blended finance, traditional financial intermediaries, with their short-term biases, constitute a bottleneck between institutional investors and MFIs. The elimination of such intermediaries could thus provide new opportunities for direct cooperation between institutional investors and MFIs,
Second, many institutional investors are establishing collaborative platforms to enable cost-sharing on deal sourcing, due diligence and other stages of the investment process. Each of these platforms represents a large amount of long-term capital, but, with few exceptions, they do not include MFIs.
Third, there are new types of local strategic investors who can be highly effective at mobilizing private capital, including from institutional backers. Over the past decade, at least 20 countries have established state-sponsored strategic investment funds to co-invest in infrastructure projects with private-sector partners.
The strategic investment funds that have successfully mobilized private capital are structured much like private investment organizations. They emphasize the independence and integrity of the investment decisionmaking process; and their boards and board committees have a high share of independent directors selected for their financial and business expertise.
Some funds, such as India’s National Investment and Infrastructure Fund, are owned mainly by private and institutional investors, with the government in a minority position.
Managed by finance professionals recruited from the private sector, these strategic funds invest primarily in equity and take an active role in structuring and arranging new deals. Because they are linked to local government and business networks, they are in a strong position to mitigate local risk.
MFIs, by contrast, tend to emphasize country representation on their boards, leaving these boards with less financial-sector expertise in the relevant sectors. At the management and staff level, the private-sector branches of MFIs frequently have expertise in a wide range of areas.
Despite this, MFI boards — unlike their private counterparts — generally do not establish a broad investment policy or delegate decisions on individual infrastructure projects to an independent investment committee; instead, they themselves make the decisions on capital allocation.
Simply put, to mobilize institutional capital effectively, MFIs will need to start functioning more like private investment organizations, even as they fulfill a policy-defined mandate. This is a tall order; the OECD has suggested that efficient private capital mobilization might require a culture change within MFIs.
However, if climate change is to be curbed and the SDGs achieved, it could be the only way for MFIs to mobilize institutional investor capital at any relevant scale.
Havard Halland is a visiting academic at the Stanford Global Projects Center at Stanford University. Justin Yifu Lin, former chief economist at the World Bank, is dean of the Institute for New Structural Economics and the Institute of South-South Cooperation and Development, and honorary dean at Peking University’s National School of Development.
Copyright: Project Syndicate
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