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Module 02
Climate Finance
Lesson 2
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1.2 Introduction
In this lesson, you will learn how public finance and risk mitigation instruments can
remove barriers to climate finance investment. Specifically, you will better understand
the various risks acting as barriers to private sector climate finance investments; the
different types of risk categories in low-carbon projects; risk mitigation instruments
used as tools to reduce risk, and case studies of risk mitigation in practice.
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Some key questions that will be addressed during this lesson include: What are the risks
in low-carbon investment projects? How are risk mitigation instruments being used?
What are the current gaps and trends in risk mitigation instruments? What are examples
of utilizing risk mitigation instruments and how have they supported climate finance
investment?
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In order to better understand risks to climate finance investment, the Climate Policy
Initiative has grouped risks into four categories according to their different sources and
character. The following slides will introduce each category of risk is more detail.
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The first risk category includes political, policy, and social risks associated with actions
by governments and citizens. Political risks are due to illegitimate actions of public
authorities discriminating against investors. Policy risks involve legitimate actions of
local authorities exercising their power to rule. Social risks are due to actions of private
individuals or groups. These risks also include misappropriation of public and private
resources. Click on each Example button to read more.
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These risks are enhanced by the very nature of low-carbon projects. For example
reliance on public financial and institutional support; having investment horizons longer
than policy cycles; and sometimes cause environmental impacts that lead to social
resistance.
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The second risk category includes technical and physical risks. They are technologyspecific or related to the ongoing availability of natural resources. Four examples
include; construction and operation risks, physical output risks, environmental impact
risks and decommissioning risks. Take a moment to read about these examples in detail.
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In low-carbon projects, these risks are enhanced by the fact that many technologies
employed are not yet proven green technologies. This means that such projects lack
accurate technology performance data; and suffer from uncertainty over measurements
of the natural resources availability.
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The third risk category includes market and commercial risks. Six examples include
currency risks, market risks, financing risks, counterparty and credit risks, and liquidity
and exit risks. Take a moment to read about these examples in detail.
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In low-carbon projects, these risks are enhanced by the fact that they incur high upfront
costs; long investment horizon and payback periods; financiers' unfamiliarity with green
investments; and complexity of infrastructure investments.
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The last category of risks include outcome risks which are risks perceived by the public
sector and are linked to the ability of publicly-supported green projects to meet
objectives within expected costs. Outcome risks include emission reduction risks, coimpact risks and budget impact risks. Take a moment to read about these examples in
detail.
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In low-carbon projects, outcome risks are typically enhanced by the amount of public
support required for such projects to be successful and the budget constraints such
projects face.
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In light of the low-carbon projects risks we just covered, risk mitigation instruments are
tools to promote climate finance investment. The Climate Policy Initiative has identified
six categories of instruments that directly addresses specific risks or multiple risks at
once. Click on the private and public sector buttons to learn which sector uses which
instruments. Advance the slide to start learning about each instrument.
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Bilateral contracts are risk mitigation instruments addressing project risks not related to
credit. They are usually provided by private entities to cover technical risks related to
the operation phases of projects, or to cover output price risks. For more advanced
technologies, like offshore wind farm projects, bilateral contracts can be highly specific
with complex drafting, implying high transaction costs. Click on each example on the
right to learn more.
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Credit Enhancement Instruments are usually developed by specialized public and private
entities to cover commercial and market risks by guaranteeing (partially or in full) the
liabilities of a project towards its lenders. Credit Enhancement Instruments improve the
quality of loans and bonds issued by the projects by mitigating the borrower's credit risk
and enhancing coverage of debt service obligations. Click on each example on the right
to learn more. You may also click on a mapping of the World Bank's Risk Mitigation
Instruments, mostly focused on guarantees.
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Revenue Support Policies are the public sector's main tool for promoting low-carbon
projects by reducing output price risks and offering resources that reduce financing risks,
for example tax credit or equity. One drawback is that, as technology deployment
increases, revenue support policies become heavier for public budgets, creating
incentives for governments to renegotiate them. For investors, this creates the
perception of policy risks. Click on each example on the right to learn more.
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Direct Concessional Investments are risk mitigation instruments from public entities
(such as governments' budgets, bilateral and multilateral development banks),
dedicated private-equity facilities, and international climate funds. They help mitigate
financing risks by providing loans or equity funding that enhances the financial viability
of low-carbon projects. Click on each example on the right to learn more.
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In developing countries, public and private entities provide several risk mitigation
instruments yet this does not cover all kinds of risks. For example, instruments only
appear to address political risk, not policy risk. Also, financing risks have been mostly
addressed with concessional resources, which do not improve the liquidity of
investments or attract private finance. And most low-carbon projects supported by
public spending weigh heavily on already tight public budgets, furthering the perception
of outcome risks. This means that new and innovative risk mitigation instruments are
needed.
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Currently, two types of new risk mitigation instruments have emerged: Policy Risk
Insurance and First-Loss Protection.
Policy risk insurance provides coverage against retroactive policy risk, when national
governments shift policies in ways that hurt the financial stability of projects. First-loss
protection protects investors from a pre-defined amount of financial loss, enhancing the
credit worthiness and improving the financial profile of an investment. Click on each
new instrument to learn more.
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Policy Risk
Policy risk insurances can indirectly address policy risk. Partial Risk Guarantees can also
address policy risk, but only when it is clearly identified in the contract and when a
counter-guarantee by the host government is available. Another form of policy risk
insurance, such as feed-in-tariff insurance, reduces the impact of policy risk by providing
coverage for changes to national policies that would harm the financial stability of
existing projects.
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1.23 Summary
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