Financing Low Carbon Infrastructure in India

Transcription

1 4 Financing Low Carbon Infrastructure in India Dhruba Purkayastha, Manisha Gulati, and Sunder Subramanian Introduction Growth on a low carbon economy trajectory has the potential to yield multiple benefits for India. These include, enhanced energy security from efficient energy usage (both supply and demand sides) and renewable energy projects; human health benefits from non-polluting transport; and environmental benefits through improved forestry and natural resource management, waste reduction programmes, and reduced emissions of local pollutants from energy facilities. As such, reducing carbon intensity of growth is an imperative. A shift to low carbon infrastructure (LCI) 1 growth would necessarily have to be progressive and will need a mix of enabling factors spanning the right policy environment, tec nology and process innovation, human and institutional capacity, markets and regulatory frameworks, and more importantly, access to dedicated finance directed towards low carbon growth initiatives. But how much financing will be required? Various estimates are available at the global level (see Table 4.1) but as far as India is concerned, no readymade estimates are available. Such an estimation requires a great deal of information about physical impacts of LCI; the mitigation and adaptation needs of the country; the expected economic growth, population growth, demand for infrastructure, use of clean technologies, and finally, the funding requirements of such needs. Nevertheless, it would suffice to say that the funding requirement is huge and could easily run into billions of dollars. A study by McKinsey & Company 2 corroborates this. According to this study, a projected increase in emissions to billion MT of carbon dioxide equivalent in India could be lowered by 30 per cent to 50 per cent by 2030 by investing in energyefficient technologies in road transport, power, buildings, and appliances. The report suggests that incremental capital of about billion euro ($874 billion to $1.1 trillion) would be needed between 2010 and 2030, even after accounting for steep declines in the cost of emerging technologies such as solar power. The estimates are staggering and there is no clear understanding of how these financing requirements will be met. Against this backdrop, this chapter examines the options for financing LCI in India. The main questions addressed here are: What is the role of the public and private financial sectors in supporting the implementation of a low carbon development strategy? How can international and domestic financing mechanisms facilitate new public and private sector investment to facilitate low carbon growth, build carbon market access, accelerate technological innovation, and support adaptation to the impacts of climate change? How can the country generate new and additional funds to finance such infrastructure development? What should be the role of commercial banks and financial institutions in facilitating such infrastructure development? 1 Low Carbon Infrastructure is a broad-based term encompassing all possible measures to reduce carbon footprint in basic infrastructure services such as green/energy-efficient transport, renewable power, reduced carbon emissions in coal-based power, etc. 2 McKinsey & Company (2009).

2 62 India Infrastructure Report 2010 Table 4.1 Estimated Costs of Addressing Climate Change at the Global Level Study Adaptation costs Mitigation costs Total costs OECD Environmental Outlook to 2030 IPCC Fourth Assessment Report: Climate Change per cent of global GDP in 2030 and 2.5 per cent of global GDP in per cent of global GDP in 2030 and about 1.3 per cent of global GDP in 2050 UNDP Human Development $ 86 billion by per cent of global GDP Report between 2007 and 2030 UNFCCC Dialogue on long-term Indicatively at least approx. $ billion approx. $ billion from cooperative action to address climate $ billion private and public sources in the change by enhancing implementation year 2030 to return global GHG of the Convention, 2007 emissions to the level of 2004 Stern Review: The Economics of 1 per cent of global GDP by 2050 Climate Change, 2006 Copenhagen Accord, 2009 $ 30 billion during and $ 100 billion a year till 2020 Source: Authors own. How should public finance directed for low carbon be intermediated/distributed? Barriers to Financing Low Carbon Infrastructure Before exploring financing options for LCI, it is necessary to get a sense of the current barriers to financing such infrastructure. The barriers for financing would differ from project to project but can generally be classified under the following three categories: Divergence between social and private costs The first and perhaps the most important barrier to the financing of LCI projects is the existence of externalities. Negative externalities arise when an entity s actions impose costs on others for which the entity does not pay. Similarly, positive externalities arise when the entity s actions generate benefits for others for which the entity has to incur costs. Externalities can be internalized if those who benefit or bear costs are made to pay in the latter case or are compensated in the former. The social benefits from avoided carbon-inflicted damages are much larger than the private benefits to carbon emitters and are often much greater than the social costs of the investment required to cut emissions. Put more simply, the investments in low carbon infrastructure usually do not generate adequate returns on investment given the potential for generating revenue from LCI. The theoretical solution would be to price the damage done and force the polluters to pay for it, thus internalizing the externality. However, this solution cannot be adopted without public intervention. The absence of such intervention leads to a huge divergence between the social and private costs, and therefore provides little incentive for investments in LCI. In addition there are inadequate incentives for research, development, and commercialization of lower carbon technologies 3 (LCT). There are of course other discontinuities that sit alongside, but are often not included, in the traditional economic analysis. For example, traditional power infrastructure is often supported by extensive implicit subsidies, which is not available to smaller scale distributed forms of renewable power. Credit market failure Many of the barriers to LCI and related technology development or transfer are the same as the barriers to growth and investment, that is, a poor investment climate, due to a variety of factors political, regulatory, administrative complexity, etc. Financial intermediation for LCI through banks or through markets for financial instruments is hindered by: lack of familiarity in the lending community with LCT and consequently, LCI leading to the inability to assess risk appropriately; 3 LCT refers to the development of low carbon technology such as specific solar technology or bio-fuels which could then be applied for LCI.

3 Financing Low Carbon Infrastructure in India 63 high transaction costs relative to conventional project financing. This is due to lack of maturity of various clean technologies with higher initial capital outlay and long payback periods, increasing the risks leading to higher interest rates being charged; absence of long-term funds and hence financing instruments; tendency of the lenders to frequently consider asking for recourse, that is, looking at the borrower s assets along with the project s ability to finance itself due to the risks associated with LCT; and inadequacy/unsuitability of bank regulations and investment policies for LCI, since such regulations and policies are often geared for larger conventional projects. Intergenerational barriers In simple terms, this barrier deals with the classic question of why should the existing generation bear the cost of investing in clean technologies, while the benefits would arguably accrue to future generations? The question can, of course, be asked differently by asking why the cost of pollution caused by the existing generation be borne by the future generations. Towards an LCI Financing Framework Given the context outlined in the section above, we now take a look at the broad contours of an LCT/LCI financing framework. The LCT/LCI financing needs can be divided into two broad phases, with Phase I dealing with LCT development and Phase II dealing with the roll-out of commercialized clean technologies. Phase I can be further split into three sub-phases (see Figure 4.1). Phase I: This phase covers the stages from technology innovation and development to scale-up, when the technology can be deployed commercially, but has not yet achieved the volumes and cost reductions necessary for it to be fully competitive with conventional technologies. This phase ends with the achievement of full commercialization. Phase II: This phase refers to the post commercialization stage when the technology is being rolled out at a commercial level to produce goods and services. At this stage, attention would also have to be paid to the needs of businesses that produce, distribute, and sell such goods and services. The financing strategy for each phase would have to be geared to the financing needs of that phase. Therefore, in suggesting the financing options for these phases, we first identify the gaps in financing in respective stages, and then suggest an appropriate strategy to address this gap: mechanisms for enabling directed funding and options for meeting the incremental finance requirement. Of course, this does not take into account the significant allocation of R&D spending which takes place in a corporate context rather than on a project basis in the case of the power sector, examples would include GE, Suzlon, Funding Options Financing Needs Innovation R&D & Demonstration Grants & subsidies Scale-up Pre-commercialization Commercialization Grants & subsidies Phase I Convertible loans Technology Innovation Fund Debt Guarantees Venture Capital Phase II Roll-Out Developer s equity Debt Risk management Private Equity Green Infrastructure Financing Institution Figure 4.1 LCI/LCT Finance Continuum Financing Needs and Some Possible Options Source: Adapted from UNEP SEFI s Sustainable Energy Finance Continuum. Market mechanisms

4 64 India Infrastructure Report 2010 Siemens, the global energy companies, and existing power companies. Also, capital will flow in the face of significant barriers when there is great potential for marketplace change (through new price signals) or great potential for technological innovation. In the markets that we most commonly refer to when making this type of argument, for example, telecom and pharma, venture capital has often flowed quickly as a result of new technology and regulatory opportunities. Enabling Directed Funding of LCI Phase I: Innovation to scale-up This phase can be divided into two broad parts (i) research, design, and development, and (ii) pre-commercialization and commercialization. In the first part, a general lack of funds for basic innovation and development and a funding gap when technologies move beyond the research stage, (popularly referred to as the valley of death ) inhibits progress from getting to and through the demonstration stage. Some technologies or projects may be too far along to get funding from traditional sources that fund research; at the same time, they are unable to attract investors, because they are perceived as being too early in the stage of technology development. This is because there is scarcity of risk capital focused towards this stage for three reasons: Technologies are subject to extensive timing uncertainty in this stage, thereby increasing strategic and financial risk. In demonstration and deployment, LCTs are more financially vulnerable than their conventional alternatives to variations in weather, changes in political support, and operational failure due to system complexity. Business risks are also significant because of capital intensity, high costs of production and consequently, low market demand. This increases the physical, political, and operational risks associated with them. This results in lack of availability of funds to help the LCT achieve full commercialization. The typical financing needs for different stages of technology innovation and development (see Figure 4.1) include seed capital, contingent grants, debt financing, and debt guarantees. While capital grants are self-explanatory, contingent grants are grants that are loaned without interest or repayment requirements until the technology and intellectual property (IP) have been successfully exploited. Such grants can serve to cover some of the costs during the highest risk development stages, and in some cases they increase investor confidence, which helps to leverage highly needed risk capital. These grants can be particularly effective during high risk demonstration phases when the technology start-up has little or no access to capital. The advantage of contingent grants over conventional grants is that they steer the technology developer and entrepreneur towards private and commercial financing. To a smaller extent, debt financing, in the form of soft and convertible loans, can help bring technologies through to revenue generation and commercialization. However, local commercial financial institutions (CFIs) that is, banks, non-banking financial companies (NBFCs), and micro-finance institutions are reluctant to invest at this stage due to the high risks involved. The high-risk nature of new technology makes typical credit instruments such as loans difficult to access, particularly when the technology incubator has a weak history of investment, collateral or revenue flows for debt-servicing. Therefore, availability of debt guarantee mechanisms is useful as it can offset some of the risk of the CFIs. Strategy to Enable Directed Financing in Phase I Innovation Funds and Venture Capital Given the risks associated with funding LCT in Phase I and the longer timeframe over which these risks are experienced, there is limited willingness by the private sector in India to invest at this stage. Therefore support for development and commercialization of LCTs needs to be significantly augmented by targeted public sector financing interventions, directly by the Government of India (GoI), through its agencies or indirectly through universities or research institutes. It may also be useful to acknowledge the importance of demand-side regulatory drivers here. While investors always seem to focus on explicit incentives, for example, feed-in-tariffs and subsidized funding, history often shows that a limited, but stable set of policy initiatives is often as important. In a similar vein, policy uncertainty including politically unsustainable tax incentives can often be value destructive. Also note that where risk is a barrier to securing long dated financing, risk management tools, including innovative FX and credit insurance schemes, can also be quite powerful and less expensive/intrusive. Public sector funding would reduce the risks of investing in LCTs and demonstrate their commercial viability so as to create scaled-up, commercially viable business activity. This in turn would stimulate and mobilize private finance and investment to scale-up their deployment over time. It is therefore important that the GoI creates a Technology Innovation Fund (TIF), which would address a variety of financing needs required for technology

5 Financing Low Carbon Infrastructure in India 65 innovation and diffusion through targeted interventions such as technology incubation, field trials, capacity building, and seed capital (see Table 4.2). Setting up the TIF is also in line with the announcements made by the GoI in its budget for FY , wherein it has proposed deployment of a National Clean Energy Fund (NCEF) for funding research and innovative projects in clean energy technologies. It is not yet clear whether the NCEF will take up equity in clean energy projects or undertake debt financing of such projects or it would only support early stage low carbon innovation. However, this fund is limited to the area of clean energy and would not support LCT in other areas/sectors. A TIF focused entirely on LCT would better serve the need of the hour and would also serve to overcome the usual criticism levied at the GoI for introducing overlapping funding schemes, making the public sector funding landscape difficult to navigate for companies constrained by limited time resources besides creating bureaucratic hurdles. Initially, the TIF in India may have to be capitalized by the GoI. It could also seek or leverage contributions from international financial institutions (IFIs) such as multilateral and bilateral development banks and international financial institutions which are seeking to cost-effectively deploy funds in the area of technology innovation and development in India. Subsequently, when sufficient momentum has built up and some progress has been made, the fund can play an important role in leveraging private financing sources such as venture capital (VC) into the LCT area by securitizing debt and equity investments at a sufficient level to draw in a matching level of venture capital investment. It could invite contributions from corporate leaders interested in investing in the development of LCTs. In fact, private sector investors may accept lower returns while co-investing alongside the GoI, multilateral and bilateral development banks and IFIs. Else, technology incubators and innovators could leverage support from the fund for obtaining assistance from commercial financing vehicles such as Venture Capital (VC) at the later stages in the technology development cycle. Several examples of such innovation funds exist across the world. The UK Carbon Trust (see Box 4.1), the China Environment Fund, the Canadian Technology Early Action Measures (TEAM) fund, the Massachusetts Sustainable Energy Economic Development Fund, and Massachusetts Pre-Development Financing Initiative are along the lines of the proposed fund. Initiatives similar to the UK Carbon Trust have been deployed in Australia in the form of a Low Emission Technology Fund that provides finance for large-scale demonstration of industryled low emission technology projects, to reduce the costs of developing such technologies. Many companies that have been funded by these sources have subsequently received further private and public financing or have commercially replicated their technology in the marketplace. Although early international experiences indicate that VC has not been a very successful route for raising finances for Phase I and several VC firms have in fact had bitter experiences with their investments in this phase, such a situation has arisen mainly because these firms did not have strong business plans, technologies were embryonic, and markets were completely dependent on regulation. More recently, however, the experience with VC funding has been relatively positive and successful examples of VC investment in LCI in developing countries can be found in both Phases I and II. One example (while specifically tailored to unserved or under-served low-income communities) is that of E+Co, which has offices in eight international locations and has seed-financed over 200 clean energy companies located in developing countries in Table 4.2 Role of the Suggested TIF in India: Types of Interventions and Gaps Addressed Intervention by Technology Innovation Fund Grants and subsidies for applied research and development of prioritized technologies Funding to evaluate technology performance Business incubation and enterprise creation assistance Early stage funding for low carbon ventures Deployment of existing energy-efficiency technologies Source: Authors own. Gaps addressed Inadequate funding support for relevant applied research for technologies where private funding is minimal due to classic innovation barriers Uncertainty and scepticism about in-situ costs and performance, and lack of end-user awareness Lack of seed funding and business skills within research/technology start-ups the cultural gap between research and private sectors Co-investments, loans, or risk guarantees to help viable businesses in early stages attract private sector funding Encourage uptake of cost-competitive LCTs

6 66 India Infrastructure Report 2010 Box 4.1 The UK Carbon Trust The Carbon Trust was set up in 2001 by the UK government as an independent company to accelerate UK s move to a low carbon economy. The Trust uses a range of targeted interventions to develop commercially viable low carbon technologies, including: Technology acceleration projects in wave and tidal-stream power, micro-combined heat and power, advanced metering, low carbon buildings, biomass and offshore wind, which address specific shared technical and market barriers faced by industry participants. For example, the Marine Energy Challenge, focused on wave and tidal-stream power, was completed in 2006 and achieved a significant technology cost reduction, developing a route to cost-competitiveness for wave and tidal-stream energy devices. Business incubation services providing targeted advice on intellectual property protection, intellectual property licensing, fundraising and business planning to low carbon start-ups. Enterprise development where the Carbon Trust has built six new businesses, including Partnerships for Renewables which secured over 100m of private sector funding from 10m public sector investment, accelerating the deployment of wind farms on UK public sector land. Early stage venture capital support for low carbon companies (which face a funding gap). Deployment of existing energy-efficiency technologies through advice and resources to help businesses and the public sector identify and cut carbon emissions, working with over 50 per cent of the FTSE 100 companies, conducting over 3,500 site surveys annually and providing over 18m in interest-free loans annually. The fund has also helped shape up the policy landscape for low carbon growth in the UK by providing policy and market insights and by demonstrating the viability and business case of low carbon technology opportunities. To date, the Carbon Trust has made 11 investments totalling over 9m, which have leveraged 91m of private investment into low carbon companies. Source: The Carbon Trust. the past ten years, in part through an investment fund mandate from the IFC. It makes debt and equity clean energy investments ranging between $ 25,000 to $ 1,000,000. Besides capital, it also provides tools and business knowhow to make clean energy businesses successful. India can aim to target much of such funding by improving the overall environment for investment in the country. It may be useful to highlight that there has been positive activity in VC funding targeted towards LCI in India in recent years in Phase I as well as Phase II (see Table 4.3). But such financing has its share of drawbacks. For example, VC can be costly for the technology developer, because the investors receive both equity shares in the start up as well as a role in the management and technical developments of the company. While private VC financing is desirable it may be useful to think of a combined Public-Private Model which could then work well for both the financial risk-taker and the innovator. Foreign Direct Investment Capital flows from foreign sources can meet part of the huge investment requirement for the transition to LCI. Therefore, besides the creation of a technology innovation fund, there is a need to consciously tap greater Foreign Direct Investment (FDI) in Phase I as a means of strengthening the technological prowess for low carbon development. FDI, with its potential benefits of technology and knowledge transfer, can contribute not just in monetary terms but also fulfil many technology related needs of the country. In fact, by setting environmental requirements (such as a comprehensive suite of policies intended to encourage energy efficiency or by altering price signals to large/inefficient users and technologies), India can use its purchasing power to transfer environmentally sound technologies into the country or it can encourage the diffusion of technologies, thus making them accessible to local industry. This is important because the transfer of technologies cannot be accomplished by way of trading of goods and services or through investment of financial resources. Many Indian companies either do not have the required R&D base or are not willing to spend their limited resources on modern technologies that can reduce the carbon footprint. Moreover, activities focused on improving the society at large and Corporate Social Responsibility (CSR) are not something which the indigenous companies focus on and that, too, in such a scale so as make a significant difference, although it cannot be denied that this is a thrust area for many indigenous companies. Therefore, FDI can only help improve the scenario in terms of environmental sustainability. Phase II: Roll out LCI projects generally operate with the same financing structures as applied to conventional infrastructure projects and businesses. At the same time ventures involved in low carbon goods and/or services also need

7 Financing Low Carbon Infrastructure in India 67 to be given due attention, while making clear distinctions between projects, products, and services. These are linked but have different investment propositions with differentiated risk/reward profiles. Funding strategies are not uniform (many projects will be funded 3:1 by debt while a start-up LCT company making an innovative project will often be funded through two or three rounds by venture capital). Examples of ventures could include energy service companies undertaking energy-efficiency (EE) improvement projects or ventures producing and selling solar power based applications such as solar lighting systems, solar water heating systems, or alternative fuel-based systems. Such ventures often need financing support at all stages commencing with start-up capital to raising funds for operation and expansion. The main forms of capital involved in Phase II (see Figure 4.1) include equity investment from the owners of the project, loans from banks, insurance to cover some of the risks, and possibly other forms of financing, depending on the specific project needs. The financing characteristics for different projects may vary from renewable energy projects to low carbon transport options such as hybrid or electric vehicles, but the fundamental capital needs generally remain the same. Guarantee programmes may also be crucial for certain types of projects to ensure access to affordable debt financing. Traditionally, financing for this stage has been provided by CFIs and international financial institutions (IFIs), with the latter having played a significant role through a variety of interventions (see Box 4.2). Most of these interventions involve provision of concessional or grants funding to a local CFI, which then provides structured adapted financing for LCI development. The role of CFIs in funding LCI has been limited. However, CFIs do fund LCI in forms other than project finance. For example, EE projects are often funded under loans for procurement of new machinery (which is more energy efficient). Several CFIs in the country have now started dedicated programmes or offerings by way of structured products to meet the specific needs of LCI. One example here is the lending programmes for EE developed by CFIs such as the State Bank of India, Canara Bank, the Bank of India, Union Bank, and the Bank of Baroda the Small Industries Development Bank of India s (SIDBI s) funding of such projects in the small and medium enterprises segment is another example. However, public sector CFIs are still the largest credit providers to LCI given the fact that they have traditionally served social and other non-economic objectives of the government. While at the role of CFIs, it is necessary to highlight the role of the Indian Renewable Energy Development Agency Limited (IREDA) in financing renewable energy Box 4.2 Role of International Financial Institutions in Financing LCI Projects International financial institutions can take many forms. These include assistance from multilateral and regional development banks, bilateral development institutions, and international financial agencies that provide support for country-level low carbon growth efforts, including the adoption of LCTs, through the combination of conventional lending, concessional funding, carbon finance, and guarantees, which in turn can leverage traditional commercial lending. The range of assistance provided by them covers the following: Credit lines to designated local financial institutions (DFI) or local CFI that in turn provide structured adapted financing to the projects Guarantees to mobilize domestic lending for LCI projects and companies by sharing with local CFIs the credit risk of project loans they make with their own resources Debt financing of projects by entities other than DFIs and CFIs Private equity funds investing risk capital in companies and projects Venture capital funds investing risk capital in technology innovations Carbon finance facilities that monetize the advanced sale of emissions reductions to finance project investment costs Grants to share project development costs Loan softening programmes to mobilize domestic sources of capital Technical assistance to build the capacity of all actors along the financing chain Examples of IFI assistance in India include the loans to the IREDA by the World Bank, ADB, and KfW Germany, USAID funding of EE through ICICI Bank which lends 50 per cent of project cost at 9 per cent interest rate and Yes Bank credit guarantee, and many more. Source: Authors own.

8 68 India Infrastructure Report 2010 and EE projects. The GoI, realizing the barriers associated with financing these projects, under its strategy to develop a sustainable path of energy development created IREDA in IREDA s resources have come mostly from international assistance and domestic borrowings in the form of borrowings from other banks and issuance of long term bonds. IREDA has sanctioned loans of about Rs 10,355 crore since its inception. However, other areas of LCI have not been equally fortunate. Going forward, given the huge investment requirements to enable a strategic shift towards LCI, it is clear that these cannot be met only by local CFIs, which find several more profitable projects competing for their funds and IFIs who must provide similar assistance across several developing countries. Even IREDA with its limited mandate and funding sources would not be able to make the desired impact. Therefore, there is a need to broaden the sources of funds for financing LCI as well as the manner in which these funds are intermediated. On the equity side, there is a need to encourage new financing sources which can help LCI projects as well as business involved in the LCI space meet the equity requirements. Strategy to Enable Directed Financing in Phase II Debt finance A new Green Infrastructure Financial Institution Effective long-term availability of funds for facilitating the shift to LCI would necessitate large-scale, well constructed involvement of local CFIs. However, given the barriers to investment described earlier in this chapter, the extent of funding undertaken by CFIs would be limited. There is therefore a need to have a dedicated financial institution with specific focus on driving the transformation to LCI. It is suggested that the GoI restructure and empower IREDA as a Green Infrastructure Financial Institution (GIFI) towards this end. IREDA already has substantial sector-specific expertise in some areas of LCI and can easily fit into the shoes of a GIFI. However, IREDA would have to be significantly strengthened to be made capable of responding to, and in many areas anticipating, the needs and complexities of the low carbon transition and thereby designing new and effi cient financial instruments to meet these needs. The concept of a sector specific structured financial institution such as a GIFI is not new to India. IREDA itself is a case in point. Other similar institutions in the country include the National Bank for Agricultural and Rural Development, Power Finance Corporation, Rural Electrification Corporation, Industrial Development Bank of India, Small Industries Development Bank of India (SIDBI), and more recently India Infrastructure Finance Company Limited. These institutions were created with the objective of channelizing investment in the sectors under their mandate and most have done commendable work to this end. The proposed GIFI can be visualized to carry out the following functions: Facilitating, financing, and syndicating the delivery of low carbon investment programmes Acting as a supervisory body to ensure that government funds or grants are effectively utilized for LCI Providing guarantee facilities on behalf of the GoI through allocation of a Statutory Government Guarantee or GIFI Guarantee Scheme Filling the debt gap for LCI through provision of direct loans as well as syndicated loans (loans supplemented by loans from other CFIs) to LCI and provision of credit lines to identified partner CFIs Facilitating a transparent communication of government policy Promoting skills/capacity building on LCI by designing and running training programmes Acting as an intermediary of local cap and trade mechanisms as well as green/renewable energy certificates and making such instruments liquid. The creation of a GIFI would however require a large pool of technically qualified talent. The government would therefore have to undertake a huge capacity building exercise across relevant institutions in the country to create such a pool of talent. A start has already been made under the National Solar Mission which aims to train at least 100,000 specialized personnel across the skill spectrum for employment in the solar industry. But greater attention has to be paid to the creation of skills across the broad set of LCI. Role of Commercial Financial Institutions Even with the creation of a Green Investment Bank, CFIs would continue to play an important role as an intermediary between investors, and companies/organizations operating green projects. CFIs, both in the public and private domain, must consider developing financial product modifications to match the characteristics of different types of low carbon or green infrastructure projects. This would help expand the market for such loans and could increase uptake of financially viable, yet unimplemented projects. The task would perhaps be simpler if CFIs look at such products or servicing such needs as a way to expand and strengthen their position in a specific market or business line.

9 Financing Low Carbon Infrastructure in India 69 CFIs can also consider strengthening the environmental risk management system by better evaluating and addressing carbon risks in the financing and construction of infrastructure. Signing up to the Equator Principles (EP) or the UN s Principles for Responsible Investment are perhaps the easiest way to do that. There have been several arguments against Indian CFIs signing up to the EP. While a debate on this issue is beyond the scope of this chapter, the point remains that CFIs can take several steps to ensure that infrastructure projects funded by them are benign to the environment. The development of carbon principles jointly by Citi, JPMorgan Chase, and Morgan Stanley (see Box 4.3) could be a guiding force in this regard. The GoI has taken several steps to facilitate greater funding of specific LCI by CFIs especially banks. For instance, under the National Mission on Enhanced Energy Efficiency (NMEEE) it has created a Partial Risk Guarantee Fund, which will be a risk-sharing mechanism that will provide commercial banks with partial coverage of risk exposure against loans made for energy-efficiency projects. This will reduce the risk perception of the banks towards lending for new technologies and new business models associated with EE projects. While this is a welcome initiative, it would not be wrong to say that instead of creating separate financing machineries for different LCI, initiatives such as these can all be combined under one roof through the GIFI. In addition, the GoI should consider declaring defined LCI such as renewable energy, EE, and clean transportation projects as a priority sector. 4 The inclusion in priority sectors will enhance credit availability at lower rates, lead to greater participation by CFIs in such projects, and eventually make available more funds for such projects. Box 4.3 Carbon Principles Formulated and Adopted by Citi, JP Morgan Chase, and Morgan Stanley Citi, JPMorgan Chase, and Morgan Stanley formed a consortium and consulted with power companies and environmental groups in the US to develop a process for understanding carbon risk around power sector investments needed to meet future economic growth and the needs of consumers for reliable and affordable energy. The outcome of this initiative has been the development of an Enhanced Diligence framework to help lenders better understand and evaluate the potential carbon risks associated with coal plant investments. The carbon principles and associated Enhanced Diligence represent an important step by these banks in contributing to the efforts to address growing greenhouse gas emissions. These principles are as follows: Energy effi ciency: An effective way to limit carbon dioxide emissions is to not produce them. The adopting financial institutions will encourage clients to invest in cost-effective demand reduction, taking into consideration the value of avoided carbon dioxide emissions. We will also encourage regulatory and legislative changes that increase efficiency in electricity consumption including the removal of barriers to investment in cost-effective demand reduction. The institutions will consider demand reduction caused by increased energy efficiency (or other means) as part of the Enhanced Diligence Process and assess its impact on proposed financings of certain new fossil fuel generation. Renewable and low carbon distributed energy technologies: Renewable energy and low carbon distributed energy technologies hold considerable promise for meeting the electricity needs of the US while also leveraging American technology and creating jobs. We will encourage clients to invest in cost-effective renewables and distributed technologies, taking into consideration the value of avoided carbon dioxide emissions. We will also encourage legislative and regulatory changes that remove barriers to, and promote such investments (including related investments in infrastructure and equipment needed to support the connection of renewable sources to the system). We will consider production increases from renewable and low carbon generation as part of the Enhanced Diligence process and assess their impact on proposed financings of certain new fossil fuel generation. Conventional and advanced generation: In addition to cost effective energy efficiency, renewables and low carbon distributed generation, investments in conventional or advanced generating facilities will be needed to supply reliable electric power to the US market. This may include power from natural gas, coal and nuclear technologies. Due to evolving climate policy, investing in carbon dioxide-emitting fossil fuel generation entails uncertain financial, regulatory and certain environmental liability risks. It is the purpose of the Enhanced Diligence process to assess and reflect these risks in the financing considerations for certain fossil fuel generation. We will encourage regulatory and legislative changes that facilitate carbon capture and storage to further reduce carbon dioxide emissions from the electric sector. Source: Morgan (2008). 4 At present the priority sector broadly comprises agriculture, small-scale industries and other activities/borrowers such as small business, retail trade, small transport operators, professional and self-employed persons, housing, education loans, microcredit, etc.

10 70 India Infrastructure Report 2010 The GoI can also draw inspiration from the Dutch Green Funds Scheme to develop innovative schemes that encourage the funding of green projects by local CFIs (see Box 4.4). While on the subject of the role of CFIs, it may be useful to highlight that besides direct financing of projects, CFIs can also play an enormous role in creating a retail market for products and services that in turn promote low carbon infrastructure growth. An example here would be renewable energy applications such as solar home lighting systems and solar water heaters. If consumer durable loans are available for such products on easy terms and conditions, it would help create a market akin to that for consumer goods and would incentivize people to integrate renewable energy applications into their home, thereby avoiding fossil fuel based generation. Similarly, cheaper home loans for home owners/buyers installing roof-top photo voltaic (PV) systems would encourage the uptake of such homes and provide an indirect incentive to real estate developers to integrate roof-top photo voltaic in buildings. An example of such an initiative can be found in the Standard Chartered Bank, which, as part of its efforts to expand financing for green development, has developed a green product innovations guide, a tool to help generate ideas for environment-oriented products and services in the countries where it operates. Under this guide, the Bank rolled out a Go Green campaign in Malaysia where it donated RM3 to the Malaysian Nature Society Tree Planting Programme for every customer who activated their online banking before a pre-specified date. This campaign was then replicated it in countries such as Pakistan, the UAE, and South Korea. One may argue that initiatives such as this one are more in the nature of fulfilling a bank s CSR and can hardly be qualified as active interventions. But initiatives such as these help create awareness which could be effective in raising funds through other methods such as green bonds. Box 4.4 Funding Green Projects through Commercial Financial Institutions The Dutch Experience The Netherlands has adopted a unique method of funding green projects. This method, called the Green Funds Scheme, was launched in 1995 by the Dutch government and comprises the Green Projects Scheme (which establishes the conditions governing the projects), the Green Institutions Scheme (which regulates the role played by the financial institutions) and finally the tax incentive for individual investors (which gets the flow of funds under way). Under the Green Funds Scheme, a tax incentive scheme has been provided to encourage individual investors to put money into green projects that benefit nature and the environment. Individuals who invest in a green fund or save money with financial institutions practising green banking receive a rate lower than the market interest rate but the tax incentive compensates for this. In their turn, the banks charge green projects a low interest rate. Generally in the Netherlands, an individual investor would normally pay 1.2 per cent capital gains tax on the amount invested. But green capital is exempt up to a maximum of Euro 53,421 per person (as in 2007). Green investors also pay less income tax on their green capital. Their reduction is 1.3 per cent, so the total tax advantage is 2.5 per cent. This means they can accept a lower interest rate or dividend on their investment. The Green Projects Scheme designates projects that are eligible for green project status. There are a few technical and financial conditions, but the main requirement is that these are new projects providing a significant and immediate environmental benefit. Projects are divided into categories such as renewable energy, construction infrastructure, voluntary soil decontamination, organic farming, etc. The Green Institutions Scheme involves the creation of a green fund or a green bank in participating commercial banks and financial institutions. The banks issue bonds with a fixed value, term and interest rate, or shares in a green investment fund. Usually, the interest rate or dividend paid by the bank is lower than the market rate, which means that the bank can in turn invest the funds in green projects at a lower interest rate. The banks then use the capital in the green fund to offer soft green loans to finance green projects. The banks are obliged to put at least 70 per cent of that money into certified green projects. They may invest the remaining 30 per cent elsewhere to spread the risk and to compensate for financing barely profitable projects. The Dutch central bank and the tax authorities supervise the process. The implementation of this scheme has yielded many benefits. First, following the implementation of this scheme, the green capital available under the green institutions scheme rose to Euro 5 billion in Of this, roughly 85 per cent has actually been invested in green projects. In fact, now the CFIs ask developers to consider sustainable energy financing, rather than the other way round. Second, the scheme has also had an impact on the way in which people think about their responsibility for the environment. The scheme enjoys broad public support in the Netherlands and has encouraged the banking sector to offer a wide range of sustainable investment products, enhancing its contribution to corporate social responsibility. And together with other tax incentives and grants, the scheme has increased environmental investment among entrepreneurs. Source: SenterNovem,

11 Financing Low Carbon Infrastructure in India 71 Equity finance Given that equity represents the owner s contribution, there is no doubt that the equity finance needs would have to be mobilized. But for this moblization, LCI must be made attractive by way of risk mitigation measures and adequate institutional mechanisms to enable debt financing. The creation of TIF and GIFI will serve the precise purpose of providing the institutional mechanism that would make LCI attractive for equity investments. The main sources of finance that can be tapped for LCI are venture capitalists, private equity (PE) funds, pension funds (mostly international), and hedge funds who invest in companies or directly in projects or portfolios of assets. These funds blend public, private, and philanthropic sources of financing and engage in investments depending on the type of business, the stage of development of the technology, and degree of risk associated therein. The characteristics of some of these equity funds are provided in Table 4.3. It is heartening to note that LCI in India is rapidly emerging as a new asset class for many of these funds. Recent estimates indicate that capital raised by international PE and VC funds focused on India grew by 67 per cent between 2007 and 2008 with a quantum increase in investment going towards clean technology (see Table 4.4). Another exciting development is that there has been a dramatic growth in PE funds within the country (see Figure 4.2) and many of these have shown a clear intent of investing in LCI. Examples of domestic PE funds include Jacob Ballas Capital India, Chrys Capital, Actis, ICICI Ventures, IDFC Private Equity, IL&FS, and Baring India. Many of these such as IDFC Private Equity have consciously built a green infrastructure portfolio, with an estimated investment of over Rs 1,000 crore ($ 200 million) either invested in, or already committed, to such infrastructure. Similarly, VC firms are setting up exclusive carbon funds for clean infrastructure projects which have the potential to generate carbon credits. The IFCI Venture Capital Fund (see Box 4.5) is one such example. The GoI too has announced the creation of a Venture Capital Fund for Energy Efficiency (VCFEE) under the NMEEE, which would be implemented from 1 April It is expected that the VCFEE will ease a significant barrier from the viewpoint of risk capital availability to energy service companies and other companies who invest in the supply of energy efficient-goods and services. While VC and PE funds are becoming active investors in this space and have the potential to fill the equity gap, there is little scope to tap the domestic pension funds for financing LCI in the short to medium term. There are two main reasons for this. The first is the absence of a comprehensive old age income security system in the country. With the organized workforce accounting for only about 10 per cent of the total workforce, the coverage by government provident funds or private pension schemes is rather low. The second is that the regulations applicable to such funds have historically been based solely on investment Table 4.3 Characteristics of Different Types of Equity Funds Venture Capital Funds Private Equity Funds Pension Funds Sources of finance Sources with high-risk appetite Sources with medium-risk appetite Organized sector workforce, such as insurance companies, such as institutional investors and companies in the organized pension funds, mutual funds, high net worth individuals sector by way of their contribution high net worth individuals towards the benefit of employees, labour unions, and the government Investment areas New technology, start-up Companies and projects with more Public equity (via stock markets), companies mature technology including those corporate and government bonds, preparing to raise capital on public real estate, inflation-linked assets stock exchanges (pre-ipo stage), (such as commodities, inflation demonstrator companies, or under- linked bonds), specialized Private performing public companies Equity or Venture Capital funds Investment horizon 4 7 years 3 5 years cash yielding investments, that is those that generate a stream of cash year on year Return requirement Many multiples of original Higher return requirement Low-risk appetite, stable returns investment (50 500% IRR) (typically 25% IRR) at around the 15% level Source: UNEP Sustainable Energy Finance Initiative, Bloomberg New Energy Finance, and the Royal Institute of International Affairs (2010).