As the industrialised world struggles to curb emissions, developing countries’ demand for resources continues to expand. There is high optimism that technological innovations could enable us to leapfrog conventional systems, paving the way for progress that demands fewer resources. Renewable energy sources, for instance, could efficiently meet many energy demands. Similarly, telecommunications and personal banking have gained tremendous momentum thanks to mobile networks. Such sustainable solutions present lucrative opportunities. Yet, western investors often view them as high-risk.
Enter the financing innovation provided by debt investors. From green bonds to blended finance, the past 10 years have seen a strong surge of new fixed income instruments that can facilitate access to capital for emerging markets-based projects. But how do these financial solutions function in practice? And how can investors ensure their contributions have the intended impact? Answering these questions requires a deep understanding from investors actively involved on the ground, coupled with a keen ability to navigate multi-stakeholder negotiations.
In an engaging and interactive forum, NordSIP invited a selected group of Copenhagen-based investors to join four emerging market debt experts, from two different firms: Sylvia Giezeman, CFA and Sinisa Vukic, Portfolio Managers Impact Investing at Cardano, Sathish Dhanapal, Head of Climate Advisory Specialists at responsAbillity and Sameer Tirkar, Head of Climate Infrastructure Investments, for the Asia-Pacific (APAC) region at responsAbillity.
The objective was to delve into best practices concerning emerging market (EM) transitions investing within the realm of private debt and blended finance. From selecting the projects to pursuing them and monitoring their progress, the audience was invited to find out how investors can resolve some of their toughest challenges. Through the examination of short case studies and an open exchange of ideas, our aim is to foster mutual learning and enhance outcomes, ultimately benefiting not only the end investors but also the broader business community.
Concerns and the Appeal of Emerging Markets
While the appeal of EMs to impact investors was undeniable, the event saw a few participants express their reticence to entering this market on account of several factors. Among others, Nordic institutional investors have a strong bias towards Europe and the USA, because they tend to be seen as stable economies, enjoying moderate growth and political stability, and hosting innovative companies.
Some have also noted that there appears to be a disconnect between investment value and economic growth in EMs, where the latter does not always translate into the former. These countries are home to economic structures that do not foster value creation for capital owners in listed equity markets, which is a showstopper.
However, EMs play a crucial role in preventing climate change. Economically, their underdeveloped state offers unique investment opportunities not found in more advanced markets. Demographically, the large population in these developing economies presents abundant opportunities for impact investors. Additionally, the climate impact of investments in EMs is significantly greater than in developed countries where easy wins are already funded.
“Bridging the Sanitation Gap”
Taking a thematic approach, Cardano’s Giezeman sought to discuss the merits of investing in sanitation and opened by asking how many in the audience had at least one toilet. While sanitation is taken for granted in the developed world there are still 3.2 billion people, mainly in emerging and frontier markets, that do not have access to safe sanitation, she warned.
This headline figure underlies profound health and economic challenges. Every year, 830 thousand people die of diarrhoea and cholera. The problem is most acutely felt by women and children, who are responsible for taking care of people who are ill in the household and for fetching water, respectively. On average, every day 1,000 children under the age of five die due to poor hygiene. In India, for example, 48% population in India have no access to safely managed sanitation. 17% of people living in rural areas still relieve themselves in the open.
The problem is not just personal, but also societal. Unhealthy populations create negative externalities to their economies. When the lack of access to safe sanitation is detrimental to people’s health it also affects their productivity, as people become incapacitated and need to seek care. At the same time, the women are responsible for taking care of sick family members, reducing to possibility to earn a living and provide for their families.
However, there is a significant funding gap to address this issue. Only 7% of impact capital targeting the Sustainable Development Goals (SDGs) is allocated to clean water and sanitation (SDG6). US$114 billion per year is needed to achieve SDG6. With close to 20 years of experience in impact investing, and partnerships with Development Finance Institutions (DFIs) such as the Dutch FMO and institutional investors, Giezeman argues that Cardano is well-positioned to address these concerns.
Building Toilets in Emerging Markets
Leveraging Cardano’s experience with financial inclusion and microfinance and partnering with low-income households in emerging markets, Giezeman presents a case study that seeks to address this particular issue. The solution she presents focuses on providing loans to microfinance institutions earmarked for the construction of sanitation facilities by micro entrepreneurs and households, in the form of toilets. The combination of investing in emerging markets and providing non-income generating loans to low-income households, is perceived as high risk by institutional investors. Cardano’s solution therefore requires a blended finance approach.
The typical client of this loans is a woman, aged between 36-45, with a family of 5. She has an established relationship with the microcredit institutions and is considered a reliable client and therefore a good credit. She has an existing flow of income through her micro or small business, like selling milk from a couple of heads of cattle, or sowing. A water, sanitation, and hygiene (WASH) loan is usually provided only after successfully going through 3 or 4 loan cycles. The new sanitation facilities will benefit the extended family. The loan is not directly income-generating, but it does so indirectly, by improving health outcomes in the family unit and beyond. Cardano has ran a couple of pilot WASH projects in the past years. The results of the projects were tremendous in terms of impact, WASH goals, achieved while they provided market-based return to investors. Research suggests that US$1 investment in sanitation services leads to a US$5 increase in productivity.
What about the risks underling the provision of sanitation services through this type of financing structure? Giezeman acknowledges that providing a loan to build a sanitation system is only part of the solution. Constructors need to be aware on how to build a safe sanitation system and communities need to be informed about the benefits of having and using a sanitation system. If an investor merely provides a loan to a microfinance institution, the negative impact on peoples’ health can be bigger than the positive. This opposite of what impact investors try to achieve.
The Importance of Outcome-Based Incentives and Monitoring
But in the first instance, how can an investment manager such as Cardano ensure that the funds lent to the microfinance institutions are at all allocated to the sanitation facilities as expected?
Giezeman argued that one of the best solutions to the principal-agent problem remains the creation of outcome-based incentives to ensure that investments deliver on their promise. To ensure that the microfinance institutions use the investment for the desired purposes, every loan agreement has a use-of-proceeds clause to demand that the funds are used for water, sanitation, and hygiene (WASH) projects. Cardano also builds another outcome-based incentive into the investment agreement according to which, the microcredit institutions become eligible for an interest rate discount when they meet certain impact targets. The fulfilment of this outcome-based incentive is monitored and verified by an independent third party that inspects the projects on site.
Discussing the competitiveness of impact investment returns, Cardano emphasized that target investments returns are a balancing act in the microcredit world. While asset managers have a fiduciary responsibility to provide their institutional investors with a competitive return, any additional basis point is borne by the microcredit financial institutions, which in turn will likely pass it onwards to the low-income households. The risk is that this transmission process leaves the end borrower facing unsustainable credit terms, which is antithetical to the mission of such a project.
In 20 years of investing in emerging markets Cardano’s losses have been extremely low and the negative returns have yet to be experienced in this strategy. Given this empirically low risk, double digit returns would be unwarranted despite the perceived risk investors often attribute to emerging markets.
Scale, Specialisation and CO2 Emission Mitigation
In the second part of this session, responsAbillity discusses a top-down approach, to prioritise blended finance investment opportunities globally, partnering with DFIs such as Denmark’s IFU, Sweden’s SIDA, the Netherland’s FMO, Germany’s KFW, US Aid and the the WB’s IFC. Public sector partners are eager to mobilise private sector capital for impact strategies, requiring concessional security to address critical funding gaps hindering Sustainable Development Goals (SDGs) by 2030. Blended finance is crucial for mobilising private capital in emerging markets where traditional funding falls short, mitigating risks, enhancing returns, and accelerating SDG progress while opening new markets and investor opportunities with social and environmental impact.
The three key factors that drive responsAbility’s investment decisions are risk, return and scale. While a focus on scalability and risk management might suggest a preference for a diversified global fund, experience shows that each region has its own financing needs and is best addressed in a dedicated manner. For example, while Africa’s main need is electrification, Asia is much more populous and thus most vulnerable to climate change. The risk profiles are also largely different. Instead of trying to combine different regions and confuse investors, responsAbility tailors its investment strategies to the specific needs and conditions of each region, ensuring more effective and targeted impact.
Given its profile, Asia is the natural target for climate change mitigation investments. It is the largest emitter of greenhouse gases, accounting for more than 50% of global CO2 emissions. The figures cited by responsAbility make it clear that 85% of the Asia-Pacific (APAC) energy mix is still coming out of fossil fuels. This makes the transition urgent. Close to 60% of growth in global power demand for the next two decades will be in APAC. This makes the transition even more challenging. Asian countries are among the most vulnerable to climate change. Their populations are exposed to so much air pollution from fossil fuel-based energy generation and transport that in 2017 alone, 1,240,000 people died due to air pollution in India[1]. This makes the transition imperative. responsAbility’s strategic focus on emerging markets aligns with the pressing global imperative of mitigating climate change. The cost of reducing CO2 emissions is significantly lower in emerging markets, offering greater impact per investment dollar.
Through this top-down approach, responsAbility has identified three sectors targeting climate impact investment opportunities. Renewable Energy is one of these sectors. Distributed solar and wind energy generation as well as storage allows investors to produce renewable energy and sell it back to national grids via medium- and long-term US Dollar-denominated contracts. Population growth and increased urbanisation create opportunities in mobility and climate-efficient transportation. The development of the large industrial base necessary for economic development is also responsible for large CO2 emissions, which in turn gives rise to a range of opportunities to increase energy efficiency.
Measuring and Benchmarking Impact
As for every investor, risk and return should be at the core of any impact investor’s agenda. Dhanapal argues that therefore, measurements are key. All agree that measurements are particularly challenging in emerging markets due to data scarcity, reporting heterogeneity and the difficulty to benchmark financial and sustainability performance.
Based on a decade’s worth of impact assessments in green energy and emission reductions, responsAbility has developed a six-step climate impact framework to address these concerns and assess the emissions impact of its investments. The assessment process begins with an ex-ante estimation of emission reductions, followed by an ex-post monitoring of emission reductions. The asset manager then collects, analyses and validates this climate impact information. This is followed by responsAbility reporting and tracking the project’s climate impact through its in-house carbon tool (CO2rA). Once all these steps have been taken, EU Taxonomy requirements relevant to carbon and energy savings are integrated in the climate impact framework. Finally, responsAbility conducts an external portfolio review of the fund’s actual carbon impact at the end of a fund’s life.
Benchmarking Carbon Emissions Against the Grid
In two investment case studies of renewable energy and energy efficiency projects, responsAbility discusses the role of this impact assessment framework. The focus is on the Grid Emission Factor (GEF), which provides an estimate of the amount of carbon emissions per unit of electricity generated by an electricity system. This allows to measure the investment ability to deliver direct and indirect CO2 emissions savings.
The GEF allows to convert present energy consumption into emissions and then compare those with the savings generated by its projects. These include rooftop solar photovoltaic energy plants and more efficient wastewater recycling facilities for industrial off-takers. The GEF is also a moving average of the rest of the market, so it is an efficient and dynamic approach to benchmarking. While CO2 emissions assessment is at the core of responsAbility’s framework, this approach can be applied to other KPIs, such as volume of water recycled, job creation, and more.
A crucial dialogue with governments
While there is currently room for a significant increase in private investments in EM impact projects, be it through debt or equity, the need for governments to get involved seems to be a widely shared view. All parties along the impact investment chain should engage with their governments, but these interactions are not without underlying challenges. The water necessary for wastewater management for instance is effectively a public good that should be better managed by the relevant national or local authorities in many cases. What investors can do remains limited if the governments refuse or are unable to cooperated.
New energy-related investments also require concomitant investments in electric infrastructure, in places where the starting position is often already one of scarce capacity. These are often the realm of governments or government-owned entities.
Finally, governments need to be more transparent about their sustainable development commitments. Investors should encourage governments to fully realise their international development commitments to emerging countries and ensure that climate change aid is additional, rather than simply rebranded development aid.
[1] GIZ GmbH and Deloitte Touche Tohmatsu India LLP, “Status quo analysis of various segments of electric mobility and low carbon passenger road transport in India”