Cornell University Johnson Graduate School of Management June 1, 2012
The International Finance Corporation (IFC) faces significant barriers when promoting climate change projects in developing countries.
Ajay Narayanan, the head of the Sustainability and Climate Business Unit in the Global Markets department at the International Finance Corporation (IFC), was clear from the outset that his lecture would not provide a tidy solution to the issue of mitigating emissions of green house gases (GHG) and promoting energy efficiency projects in developing markets. Instead, he acknowledged that the primary challenge was to frame and understand the problem of climate change in emerging markets. Only then, he posited, can we come close to identifying and supporting businesses and projects which address such issues.
In his role with the IFC, Mr. Narayanan is responsible for identifying new private-sector businesses in developing markets in which the IFC can invest both directly or via financial intermediaries (FI’s) to addresses climate change. While the IFC is a source of debt and equity financing for a wide range of projects in developing nations, its climate change business is a growing segment which will be a significant part of the overall business by 2015. This growth is driven by the current low spending on climate change mitigation (approximately $9B) relative to the huge need for such projects (approximately $100B).
The IFC seeks to enable market conditions necessary for climate change companies and projects to be successful. Efforts to do so typically come in two forms: advisory work to provide audits, sector studies and insights on building codes; and through direct action to provide financing to the company or to support an FI’s financing of the project. In doing this, the IFC lobbies for projects addressing climate change while also creating new market niches for FI’s, transforming the project financing market and turning the spotlight to smaller customers and companies. The end goal, following the IFC’s exit, is for the FI’s to continue financing such projects and companies as part of their normal operations.
Despite its efforts, Mr. Narayanan explained that the IFC runs into two significant barriers when pushing for FI’s to invest in climate change projects. Firstly, transaction costs exist for this extra work which often carries a lower return than other investments. Secondly, risk perceptions about the commercial viability of these projects are pervasive and often lead to inaction when making investment decisions.
Mr. Narayanan demonstrated this second barrier when describing the types of products the IFC develops with FI’s. Typically they are successful in partnering on trade finance projects or long-term credit lines, as these products are more straightforward and typically less leveraged. The downside to them is that they tend to be less impactful or catalytic. The more impactful products, including senior and subordinated risk-sharing facilities, are more complicated products that carry significant leverage and are therefore less frequently accepted by FI’s. This unwillingness of FI’s to take on risk is where the IFC steps in to take a larger share of the leverage.
By being patient and persistent, another key theme to Mr. Narayanan’s lecture, the IFC hopes to keep lobbying for such projects so that FI’s become more tolerant of taking risk to finance such projects. Ideally, as these projects develop the role of the IFC will diminish and the FI’s share of leverage will grow, replacing the role of the IFC. An example of this is the IFC’s role in the Chinese Utility-Based Energy Efficiency Program (CHUEE), where in phase 1 the FI held only 25% of the subordinated debt, while in phase 2 the FI moved to a 50% stake in the subordinated debt. Although this is just one example of the IFC’s strategy of filling the FI’s risk appetite gap, Mr. Narayanan believes that because “banks act like lemmings,” such financing partnerships will over time become more widely accepted and commonplace, allowing the IFC to focus on new areas or projects.
Due to his role in business development, Mr. Narayanan excitedly anticipates a number of these new projects. Examples include advocating sustainable value chains by partnering with local FI’s to upgrade facilities; developing off-grid energy infrastructure in developing markets; promoting organic food and waste management cycles for new urban areas; and what Mr. Narayanan described as the “holy grail,” partnering with energy service companies to mitigate climate change at the source. For each of these areas the IFC aims to partner with local FI’s to gain traction and eventually leading to more sustainable and scalable financing, as was the case in the CHUEE example.
Following these explanations and examples, Mr. Narayanan once again explained that the takeaways to these issues lead to further questions rather than solutions. What is the objective of the IFC’s efforts: are they looking to maximize return in a hot space or maximize impact while remaining profitable? Should the IFC finance the projects that are out there now, should it support an arguably unviable CSR model, or should it finance anything that provides a marginal gain in mitigating GHG emissions?
It seems to me that what is first required is a change in the mindset and culture of FI’s regarding the scope and riskiness and of investments. Only when these firms integrate the need for climate change financing in their culture and operations will we begin to approach a tipping point. While I believe the IFC’s “patient and persistent” strategy will help move this in the right direction, a change in direction and values at the highest levels of leadership within the FI is necessary to continue the progress. Furthermore, encouraging recent news of a proposal by BRIC nation leaders to create a shared development bank is likely to fuel the growth of such project financing, and I’m sure Mr. Narayanan is excited to gain a new partner in these efforts to lobby for change.
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