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The complex network of financial intermediaries

by Climate Finance and Markets on .

Javier Pereira

The prominence of financial intermediaries in climate finance is due to their perceived capacity to use public money to lower investment barriers for the private sector and facilitate access to finance. Before moving into a more detailed analysis of the different instruments that can be used to achieve this, it is important to examine why this is possible.

There are two key factors that determine investment decisions: profit potential and the level of risk. Risk is a complex concept that encompasses all those elements that are difficult to control and could prevent the success of the investment by incurring losses or lower revenues. Some of the main types of risks include: political risks (e.g. unstable governments, policy and regulatory changes), currency risks (e.g. fluctuations in currency values) and technology risks (e.g. untried technologies and solutions).

For an investment to happen, the profit potential usually has to compensate the risk. An informed investor is only likely to engage in a high-risk investment (e.g. a green start-up company) if the profit potential is also high. Another investor, however, may prefer to invest in lower risk assets (e.g. equity in a large company) even though the profits are likely to be slim. Risk also plays a crucial role in the availability of credit for private actors in developing countries.

Private sector investments are especially sensitive to these two factors in the sense that for a given risk level, private investors will usually require greater profit potential than a public one or, in other words, at a given profit potential the risk tolerance of private investors is lower. For instance, an insurance company is unlikely to roll-out a micro-insurance scheme for small farmers in a developing country as a consequence of the high upfront costs of creating the necessary infrastructure and the fact that profits can only be expected in the medium/long-term. This behaviour is motivated not only by different risk and profit appetite, but also by the ability of public investors to take into account positive social and environmental outcomes (externalities) that are difficult to measure in economic terms.

In order to leverage private climate finance, developed countries use development finance institutions (DFIs) and,1 to a lesser extent, other institutions that are backed and/ or funded by governments such as export credit agencies (ECAs). DFI’s are extremely powerful investors. DFIs that are members of the European Development Finance Institutions (EDFI) group have an aggregated portfolio of €21.7 billion.2 According to the datasets used in this research (see Methodology section), the International Finance Corporation (IFC) has a portfolio of over €9.4 billion in low income and lower-middle income countries and the European Investment Bank has investments of €36.8 billion outside the European Union.

2011 figures show that climate finance only represents a small part of these investments, €461 million in the case of the IFC and €3.3bn in the case of the European Investment Bank (EIB). Nonetheless, climate finance is growing at a fast pace: 70% of the combined climate related projects of the IFC and the EIB we looked at have been approved since 2009.

This section starts by looking at the main investment instrument donors use to engage with FIs. The term ‘public investor’ is used here to refer to any institution providing finance for the private sector that is supported by a government (mainly DFIs, but also ECAs). For greater clarity the different instruments have been divided into three main groups: equity, debt and risk-related finance.

Equity

Equity investments are all those investments that involve the ownership of shares in a company. There are two main types of equity investment instruments available to DFIs- direct equity investments and investment funds. The first option entails making a direct equity investment in the financial intermediary, for instance a local bank. Sometimes this investment is made by two or more DFIs at the same time and it may be open to private capital. In its most simple form, a direct equity investment provides additional capital that the financial intermediary can use to expand operations. In some instances, the direct equity investment grants the public investor access to the intermediary’s management, where it can work to make the company grow usually with a view to selling its stake at a profit at a later stage.

Private finance can be leveraged at two different stages. When the investment is open to other investors, private capital may flow in as a result of lower risks, greater profitability and the confidence induced by the DFI’s investments. When the public investor engages in the management of the company, private capital may also be leveraged at a later stage as a result of the company’s greater value.

Direct equity investments are not very common in the portfolios of large DFIs in developing countries. For instance, they represent less than 1% of the EIB’s portfolio assessed by Eurodad. No examples have been found of direct equity investments with a clear climate remit being channelled through financial intermediaries.

The second instrument DFIs can use is the investment fund, a collective investment instrument which acts as a financial intermediary and makes direct equity investments in other companies or banks. Investment funds make investment choices according to specific criteria or following a strategy and are a very common investment instrument because they diversify risk and share it among a larger number of shareholders. When DFIs use investment funds to channel climate finance, they can either set up their own funds or participate in existing ones.

Investment funds represent approximately 20% of the IFC’s portfolio in low and lower-middle income countries. In the case of Norfund, Norway’s DFI, the figure reaches 26% of the total portfolio. In contrast, the EIB only uses investment funds for around 13% of its total investments outside Europe, but the EIB reporting is not very clear and the figure could be higher. Among investment funds, private equity funds seem to be the preferred type of instrument. Private equity funds usually purchase equity of the company and engage in its management with views to increasing its value. In the case of the IFC, private equity funds account for €1.3 billion of the examined portfolio (13%). The EIB channels through private equity funds approximately 6% of its portfolio outside the EU (€2.1 billion).

In general, funds leverage money in the same way as direct equity investments: by attracting private capital when the fund is created and, in the case of private equity funds, by increasing the value of the companies that the funds invest in. In addition, when the fund is open to private investors, the public investor can take a subordinated equity stake in order to incentivise private investment. In practice, this means that private investors will be repaid first. This model is generally used for riskier projects.

DFIs also have other equity instruments such as mezzanine loans and quasi-equity investments. These are complex instruments between equity and debt, which require advanced financial markets and are best suited to large companies and financial intermediaries. This report does not examine these instruments because of their complexity and because many of their key features are shared by some of the instruments examined in these pages.

Debt

The debt instrument DFIs use to provide finance through financial intermediaries is the credit line. It is basically a loan extended to financial intermediaries with the purpose of providing finance to sub-projects, thereby facilitating access to capital. DFIs use credit lines because they do not usually have a strong presence in developing countries and without branches it is difficult to reach SMEs and companies in specific regions. In addition, there are important language, currency and economic barriers that make direct loans from DFIs only suitable for financing large companies. For instance, the average size of a loan operation for the IFC is USD 21.7 million (€15.6 million) Out of a total of 189 loans analysed in their portfolio, only 2 were for an amount under USD 1 million (€0.72 million).

Credits lines represent 25% of the EIB’s portfolio (€9.2 billion). Of these credit lines only twelve projects with an aggregated value of €560 million are related to climate. Figures for other DFIs are difficult to estimate because information is not adequately disaggregated. Despite this, examples such as the Global Climate Partnership Fund (GCPF), set up in December 2009 and managed by KFW (grant component €22.5 million) indicate that it is likely to see growth in this area.3

Risk-related finance

Risk is a decisive factor when it comes to investment decisions. Using tools that address the risk exposure of investors can therefore be an effective way of triggering additional investments and leveraging money. It is possible to identify three main types of risk-related instruments.

When the intermediary is a financial institution that acts as a lender, for instance a bank, we generally talk of loan guarantees. A loan guarantee is a commitment by a public institution to repay the loan provided by the financial intermediary -the lender- to a third party –the borrower- if the latter cannot meet the payments. Effectively, this instrument transfers risks from the private lender to the loan guarantor. It is commonly used to encourage loans that a private lender would not usually provide due to their risk profile. DFIs do not use loan guarantees to support financial intermediaries very often. This instrument only represents 2% of the joint portfolio of EDFI (€380 million). The figure is 1% in the case of the IFC (€70 million) and under 1% for the EIB (€80 million).4

A second option is export credit guarantees. They are intended to support foreign investment by underwriting loans for projects, mainly large ones, conducted in foreign countries by providing insurance against non-payment (default). Guarantees are mainly provided by export credit agencies in donor countries whose remit is to help donor economies by promoting the investments of domestic companies in other countries. Financial intermediaries can be targeted directly or be used to target SMEs that are not large enough to directly apply to the export credit agency. According to the Berne Union, USD 1.36 trillion (€0.98 trillion) in export credit guarantees were issued in 2010.5 The amount going through financial intermediaries is not very clear and only some ECAs disclose a breakdown of their operations by sector, but the information available suggest that the figure could be somewhere in the range of 10%-20%. For instance, the financial sector represents 43% of the portfolio the World Bank’s Multilateral Investment Guarantee Agency (MIGA) and 89% of the guarantees approved in 2011.6 Figures are lower in the case of bilateral ECAs. The financial sector accounted for 13% of Korea’s Eximbank total invested amount in 2010 and 18% of CDC’s portfolio exposure in 2010.7

A third option public investors can use to reduce risk are public insurance schemes that work as financial intermediaries. Most relevant initiatives focus on sectors that are particularly vulnerable to climate change such as agriculture and are based on the parametric insurance model. Parametric insurance offers a payout, which is determined upfront and is conditional on an exogenous variable reaching a pre-set threshold, for instance rain not reaching the yearly average. In some cases, such as the IFC’s Global Index Insurance Facility (GIIF), the insurance can be linked to loans, for instance for high-yield seeds. In this case the insurance also reduces the risks for the lender and increases the farmer’s access to loans. Parametric insurance simplifies risk evaluation and administrative costs, making it easier to deploy in developing countries and, in cases such as the GIIF, can also help to leverage additional finance.

Parametric insurance is relatively new. Pilot projects only started in the early 2000s. In the last few years they have expanded, but total funding remains low. The GIIF, for instance, has a total funding of just under €27 million.8 In total, there are about 20 parametric insurance programmes of this type in developing countries.9

 


 1 Development finance institutions (DFIs) are financial institutions backed by states, which are mandated to provide long-term financing to the private sector, with specific value-added development objectives, but on a sustainable commercial basis. They focus on developing countries and countries with transition economies. DFIs include both multilateral and bilateral institutions such as the IFC, EIB, Norfund, CDC, etc.

2 http://www.edfi.be/

3 IEG (2006) World Bank lending for lines of credit: an IEG evaluation. World Bank, Washington DC

4 The EIB’s figure could be slightly higher as information is lacking on the exact nature of some projects.

5 Data obtained from the Berne Union. See: http://www.berneunion.org.uk/bu-total-data. html

6 IEG (2011) MIGA’s Financial Sector. Guarantees in a Strategic Context. Independent Evaluation group, Washington DC

7 See Korea Eximbank’s online database availabe at: http://www.koreaexim.go.kr/en/ fdi/stat_01.jsp; and CDC (2011) CDC Group plc Annual Report and Accounts 2010. CDC group

8 IFC Factsheet. Global Index Insurance Facility (GIIF). Protecting livelihoods in Africa. Available online at: http://www.ifc.org/ifcext/ gfm.nsf/AttachmentsByTitle/Insurance- GIIF-Factsheet2011/$FILE/Insurance-GIIF- Factsheet2011.pdf

9 Cummins, J.D. & Mahul, O. (2009) Catastrophe Risk Financing in Developing Countries. Principles for Public Intervention. World Bank, Washington DC

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