N 19 September 2012 Assessing the financial efficiency of the Green Climate Fund: leverage ratios - from theory to practice The Green Climate Fund s first Board meeting was held between August 23 rd and 25 th 2012. It is now time to specify how this organisation responsible for financing climate initiatives in developing countries will operate in practise. The current budgetary environment specifically requires the Green Fund to raise private funding in order to boost the efficiency of the public funds received from developed countries. This leverage effect of public finance will need to be accurately defined, and be accompanied by other key indicators, in order to avoid the development of practices that are contrary to the Green Fund s original purpose. Background: assessing the financial efficiency of public funding through leverage At the 2010 Cancun Conference, the international climate negotiations officially recognised the need for developed countries to provide financial support for the implementation of climate policies in developing countries. This funding, which should be in addition to the existing development aid, is set to increase to an amount able to contribute to mobilise US$ 100 billion per year by 2020. The use of the expression contribute to mobilise signifies that the expected funding may come from private sources in addition to public funds. This nuance is significant within the current highly constrained budgetary environment in developed countries. It thus allows nations to attempt to increase the efficiency of the use of public finance and thus, allocating fewer public funds to achieve the desired initiatives. In this case, we refer to maximising the leverage effect 1 of public funding, which usually consists in selecting appropriate financial instruments to attract more private funding. The tools for increasing leverage available to government authorities The aim of the Green Fund will be to maximise its impact in developing countries through a finite publicly-funded budget provided by developed countries. The Fund therefore finds itself in the situation of public actors seen in Figure 1, who aim to limit their share of funding (Pu) while ensuring that the action (Ac) is funded. Their interventions may therefore be in the form of direct funding and/or of incentives to foster private sector participation. Obviously, the overall funding package should not occur without public involvement; otherwise, the leverage would be reduced to zero given that the private sector has an incentive to act without public intervention. This condition is known as a causal link, or as the 1 In this brief, the term leverage refers to the injection of private funds in response to public initiatives. It does not correspond to leverage in the financial sense, which refers to the debt-to-equity ratio. By Romain Morel, romain.morel@cdcclimat.com and Anaïs Delbosc, anais.delbosc@cdcclimat.com
additionality of public funding. Additionality and causal links must therefore be demonstrated whenever leverage is calculated. Figure 1 Leverage effect and direct or indirect incentives Several economic instruments may be used to create leverage: Grants, loans and capital investments, in order to fund the action directly; Source: CDC Climat Research. The provision of guarantees, including cases where an institution borrows on the markets; regulatory constraints (including limits on carbon emissions); and tax constraints, in order to encourage the private sector to invest, and so make an indirect contribution to funding the initiative. The involvement of a public institution in an initiative may also play a role in reducing perceived risk for a private investor. Defining the leverage ratio in practice The leverage ratio is an indicator for assessing the financial efficiency of public funding: the higher the leverage ratio, the greater the impact of one dollar of public funding will be. However, there may be a lack of consensus and clarity on how a leverage ratio is defined and calculated. A better understanding of both processes allows for the comparison of various instruments more accurately, and to determine which ones to prioritise at the international level in order to expand investments with a climate component. From a government authority s perspective, the financial efficiency of the instruments used is inversely proportionate to their share (Pu) of the initiative s funding. We can therefore define leverage ratio as the ratio between the total amount financed (Ac) and the total amount of public funding (Pu). We often show this as :1, which we read as to 1. However, this definition of the leverage ratio is not the only one that exists. In fact, Brown et al. (2011) have reviewed the definitions adopted by various institutions. These definitions are summarised in Table 1. There is also a debate surrounding the perimeter taken into consideration in calculating the leverage ratio. Should we take the overall investment into account, or only the climate-related marginal cost? The answer may depend on the type of investment. In some cases, only a cost overrun may be considered to be climate-related, or viewed as additional. This is the case for a housing construction policy, for example, where one can, in fact, assign the climate-related and additional aspect to the cost overrun due to better insulation. Practices for factoring in just the cost overun vary, depending on the financial institution. 2
Direct funding Indirect funding (guarantee) Table 1 Review of leverage ratio methodologies and definitions Indicator Illustration using a $600 m initiative Benefits & Limitations Ratio based on joint public and private funding divided by the total of public funding awarded Ratio based on the joint private (and public) funding divided by the public funding awarded by a given institution Ratio based on foreign direct private investment flows divided by the amount of net public guarantees backing those flows The definition is correct for the leverage shown below. Example: Institution A is funding an initiative in an amount of $100 m. Other public institutions are contributing up to $200 m. Private companies are involved, up to an amount of $300 m. Leverage: 2:1 (100+200+300)/(100+200) Primarily used by the World Environment Fund and the World Bank s Clean Technology Fund Example: see above Leverage: 6:1 if we take all the joint funding into account (100+200+300)/(100) Leverage: 4:1 if we only take private joint funding into account (100+300)/(100) Primarily used by the Multilateral Investment Guarantee Agency (World Bank) Example: A public guarantee covers $200 m of the initiative described above Leverage: 3:1 (600)/(200) This definition allows the establishing of the leverage ratio for the overall public funding amount. It allows the avoidance of double-counting where a given initiative is concerned. The alternative method, which consists in taking the overall joint funding into account (leverage of 6:1 in the example in the left column), does not allow for the identification of public funds ability to attract private funding. The alternative method, which consists in taking only private joint funding into account (leverage of 4:1 in the example in the left column), is tantamount to taking the view that, out of all the public funding involved in the initiative, only the public funding provided by a given institution has enabled private funding. In this respect, the method can result in double-counting. The scope to be examined is sometimes hard to define. Where public funding is concerned, should the focus be on the capital contributed for the guarantee, the amount guaranteed, or the amount actually paid when the guarantee is triggered? Indirect funding (regulatory incentive) Ratio based on the capital investment required divided by the net present value of the carbon credits (primary market) generated by the initiative Used for carbon financing by the World Bank Example: The initiative generates 6 million credits per year for five years. The credit price is assumed to be fixed at $10.00 Using a discount rate of 8%, the net present value of the credits sold is $240 m. Leverage: 2.5:1 (600)/(240) There is no real public spending in this definition. We therefore assess the role played by public involvement in an initiative s financial outcome. This method does not, therefore, actually allow the assessment of the public funding leverage.. Conversely, it may be used as a tool to assess the financial additionality of the carbon constraint. Source: adapted from Brown et al. (2011). The choice of how to define a leverage ratio depends on what one is trying to assess. For instance, the World Bank s Clean Technology Fund (CTF) calculates its leverage by working out the ratio between the overall amount of the initiatives funded and its own contribution. The aim, therefore, is not just to assess its effectiveness in attracting private investments: the CTF implicitly considers that any joint funding has been raised thanks to its involvement, and so posts a significant leverage ratio (9.6:1). For comparative purposes, calculations based on the definition presented above and on the Brown et al. (2011) data, indicate rather an average leverage ratio of between 1.3:1 and 3.3:1 (depending on the assumptions made regarding the public/private origin of the funding assigned to multilateral development banks). These figures are in agreement with those used by the UN s high-level Advisory Group on Climate Change Financing (UN-AGF), as shown in Figure 2. 3
Examples of leverage ratios by instrument The UN-AGF Report used this concept of leverage ratio in 2010, in order to illustrate the kinds of funding available to combat climate change (Figure 2). The diversity of the methodologies used, as well as the lack of transparency for some data, makes an accurate comparison hard. The aim, therefore, is rather to compare orders of magnitude. 2 Figure 2 Overview of the UN-AGF s various estimated leverage ratios Note: MDB = Multilateral Development Bank; RE = renewable energies. Source: UN-AGF Final Report and Workstream 7 Report (2010). Just breaking: launch of the Green Climate Fund, and issues for the Fund over the coming months The Green Climate Fund s objectives The Board of the Green Climate Fund held its first meeting between August 23 rd and 25 th 2012. This organisation is the UNFCCC s financial development arm, and is referred to as an operating entity of the financial mechanism of the Convention in the Cancun Agreements (Par. 102, 2010). The Fund is should receive contributions from developed countries to be used to finance public or private climate actions exclusively in developing countries. In this regard, it is expected to play a key role in the commitment made by developed countries to mobilise US$100 billion new and additional per year by 2020 3. The Green Fund is expected to bring about improvements in three specific areas compared with existing institutions: Balanced governance between developed and developing countries; An improvement in the monitoring of international funding; An improvement in public funding leverage effect. On the one hand, the Green Fund will need to ensure that it has adequate resources. The aim is to work on upstream sources of funding. To do so, the Fund will depend on the level and method of public contributions. To date, only Germany ($50 m), South Korea, and Denmark ( 18 m) have committed to make a financial contribution to the Fund s launch. 2 The definitions used by the UN-AGF vary according to the financial instruments involved. A critical review of the UN-AGF methodologies has been conducted by Brown et al. (2011). 3 The only specific information on this issue concerns the funding of adaptation to climate change, as it has been decided that a significant share of new multilateral funding for adaptation should flow through the Green Climate Fund (Cancun Agreements, Paragraph 100, 2010). 4
Australia and the Netherlands have already contributed US$800,000 in total, in order to enable the Fund s Secretariat to start work since the beginning of 2012. Downstream, the Fund s role will be to decide on the financial instruments that can be used, and on their proportion relative to all actions (Durban Decisions, 3/CP 17, Appendix, Par. 54, 2011) as well as on the way the funding will be allocated, and on its geographical distribution. Improved monitoring of the funding ought to make monitoring the leverage achieved by the Green Climate Fund easier. This information should thus enable the Fund to refine its strategy in order to improve its role as a catalyst for private funding. The Green Climate Fund may also rely on the work performed by a Standing Committee, which is responsible for issuing recommendations aimed at improving funding mechanisms, as well as monitoring of these mechanisms (Durban Decisions, 2/CP. 17, Par. 120-125, 2011). The roles played by the available expertise and by the Standing Committee Although the instruments that the Green Fund will use have not yet been determined, it is likely that the Fund will rely on the experience of other financial institutions, such as development banks, or some international funds. In this case, information regarding these institutions global leverage, as well as further details on the leverage for each financial instrument could prove to be relevant. As shown in Table 2, the necessary data for these calculations, together with the information that they provide, can make this task complicated, unless it is performed in close collaboration with involved institutions. Leverage ratio Scale By financial instrument At the institution s level Table 2 Data required in order to calculate various leverage ratios Historical Timeframe Over a given period Useful for comparing tools. The work can be performed with a view to assisting a decision, as the UN-AGF has done. An empirical study usually requires access to financial institutions non-public, or even strategic, data. A theoretical range can nonetheless be obtained by working specifically on prudential ratios. Theoretically the simplest ratio to calculate. In the most basic cases, the data can be found in the balance sheet. This kind of leverage calculation usually assumes that capital that is not returned is reinvested capital. The number obtained shows an average for all the institution s commitments. Recent efforts made by an institution could be, however, less visible. More complicated to calculate than a historical leverage ratio, as the balance sheet comparisons only shows net changes, which are equivalent to the total amount of new funding, less the amount of funding that has reached maturity. However, the chosen review period must be long enough not to be unduly influenced by annual funding fluctuations. Access to detailed data may be required especially in the case of complex financial or governance structures. Notes: Leverage ratio can be calculated both for a given financial instrument, and more generally for an institution. Likewise, the time horizon may vary. In fact, we can calculate historical leverage by considering all past funding, or limit the review to a given period. Source: CDC Climat Research. The Standing Committee could play a major role in ensuring access to data and facilitating the development of common definitions. 5
Analysis: The limitations of using leverage ratios as an indicator for the Green Fund Defining the appropriate leverage ratio correctly is essential The funding provided by the Green Climate Fund is expected be a part of developed countries commitment to provide US$100 billion per year by 2020. In this respect, the Green Climate Fund s leverage should be examined very closely. Although it is not desirable for that leverage to be too low, it appears necessary to make sure that efforts to raise it are not detrimental to the quality of the funding provided. In this respect, the scope of the leverage ratio definition chosen by the Green Fund must enable overall public contributions to be isolated regardless of whether they are from the Green Fund from the amount of the actions funded. A clear and shared definition is therefore essential. A need for additional indicators to assess funding performance Studying funding performance through the use of the leverage ratio indicator in isolation does may not be sufficient. Indeed, a desire to improve this indicator in absolute terms may lead to actions that are in contradiction with the Green Fund s values. First, excessive leverage may be a sign that the role played by the public institution in the initiative is minimal, or even negligible. A private investment will in most cases only take place if it is profitable and the perceived risk is acceptable. A causal link between public incentive and private investment only exists if the public measures have enabled the private investor to switch from an unacceptable risk-return ratio to an acceptable one. The higher the leverage, the more significant the doubts concerning the additionality of public funding. Obviously, every case is different, and it is possible that highly leveraged initiatives may have required public involvement. Nonetheless, without an appropriate and effective process to prove additionality, seeking an increase in leverage ratio may lead to the approval of projects that do not necessarily require public intervention. Second, seeking to raise leverage may run counter to other of the Green Fund s goals, such as achieving a sound environmental outcome, or introducing financial tools that are suited to their recipients. It may also encourage the preference of loans over other type of financing. Although leverage is beneficial for the finances of the countries providing the funding, it is not necessarily beneficial for the recipient countries. As shown by the French Court of Auditors (2012), pursuing a maximum leverage goal for public development aid may encourage loans to emerging countries to be preferred over aid for less developed countries. In fact, the Court of Auditors report states that in 2008 the leverage on the French Development Agency s loans was twice as high for emerging countries (7.3) than for countries in Sub-Saharan Africa (3.6). This is primarily explained by the fact that loans to emerging countries are rarely on concessional terms. Seeking to maximise leverage may also run counter to other goals, such as a regional breakdown of aid. In fact, although some countries set minimum aid targets for each region, they often find it hard to achieve them (Court of Auditors, 2012). This situation may also arise for the Green Climate Fund. Indeed, its Board must ensure an appropriate geographical balance. A minimum allocation can therefore be decided for the least advanced countries, small, insular developing countries, and African countries (Durban Decisions, 3/CP. 17, Appendix, Par. 52, 2011). Likewise, the environmental benefits could be reduced by seeking a high level of leverage through favouring some kinds of initiatives over others. Leverage is therefore a useful but incomplete financial indicator. A broader analytical matrix is required in order to judge overall funding performance. The aim is to take extremely varied criteria into account, such as the appropriateness of the financing method, the relevance of the initiatives that are financed, and the environmental benefits, etc. Ex-post assessments 6
are also desirable, especially in order to judge the performance of the measures that were financed, and the impact of the choice of financing method. Other indicators that have been introduced alongside leverage in order to assess both the financial and overall performance of a financing package may enable some of the latter s undesirable effects to be mitigated. To find out more Documents on the leverage effect : - Brown, J., Buchner, B., Wagner, G. et Sierra, K. (2011). Improving the effectiveness of climate finance: a survey of leveraging methodologies http://climatepolicyinitiative.org/wp-content/uploads/2011/11/effectiveness-of-climate-finance-methodology.pdf - Clapp, C., Ellis, J., Benn, J. et Corfee-Morlot, J. (2012). Tracking climate finance: what and how? http://www.oecd.org/env/climatechange/50293494.pdf - French Court of Auditors (2012). La politique française d aide au développement http://www.ccomptes.fr/content/download/44455/770878/version/1/file/rapport_public_politique_francaise_aide_publiq ue_au_developpement.pdf - UN-AGF (2010). Report of the secretary-general s high level advisory group on climate change financing http://www.un.org/wcm/webdav/site/climatechange/shared/documents/agf_reports/agf%20report.pdf - UN-AGF Workstream 7 (2010). Public intervention to stimulate private investment in adaptation and mitigation http://www.un.org/wcm/webdav/site/climatechange/shared/documents/agf_reports/work_stream_7%20_public_priv ate.pdf International Decisions : - Cancun agreements (2010). http://unfccc.int/resource/docs/2010/cop16/eng/07a01.pdf - Durban decisions on the Green Climate Fund (2011) http://unfccc.int/resource/docs/2011/cop17/eng/09a01.pdf Managing editor : Benoît Leguet To receive regular updates on our publications, send your contact information to research@cdcclimat.com Press contact : Maria Scolan - +33 1 58 50 32 48 maria.scolan@cdcclimat.com Disclaimer This publication is fully-funded by Caisse des Dépôts, a public institution. CDC Climat does not contribute to the financing of this research. Caisse des Dépôts is not liable under any circumstances for the content of this publication. This publication is not a financial analysis as defined by current regulations. The dissemination of this document does not amount to (i) the provision of investment or financial advice of any kind, (ii) or of an investment or financial service, (iii) or to an investment or financial proposal of any kind. There are specific risks linked to the markets and assets treated in this document. Persons to whom this document is directed are advised to request appropriate advice (including financial, legal, and/or tax advice) before making any decision to invest in said markets. The research presented in this publication was carried out by CDC Climat Research on an independent basis. Organisational measures implemented at CDC Climat have strengthened the operational and financial independence of the research department. The opinions expressed in this publication are therefore those of the employees of CDC Climat Research alone, and are independent of CDC Climat s other departments, and its subsidiaries. The findings of this research are in no way binding upon, nor do they reflect, the decisions taken by CDC Climat s operational investment and broking services teams, or by its subsidiaries. CDC Climat is not a provider of investment or financial services. 7