Innovative Green Financing Mechanisms: The Role of Financial Institutions in Enhancing Access to Green Finance
The World Economic Forum Report (2023) presents a significant impact of climate change and environmental risks on economies, societies, and markets. Important to note are the implications for financial stability that cannot be ignored.
Increased severity and frequency of extreme weather events such as floods, landslides, increasing temperatures, heat waves, droughts, pests and diseases can affect resource availability and business operations. This results into adverse business outcomes such as business interruptions and reduced returns. However, it also presents an opportunity for innovative financing to increase the economic and social resilience to climate impacts.
The World Meteorological Organization (2021) estimated global economic losses worth US$ 2.32 trillion between 2000 and 2019 as a result of climate change. As such, there is an undeniable impact on the creditworthiness of investors and therefore a strong link with the credit risk profile of financial institutions.
There is a disproportionately higher impact of climate change on developing countries due to their limited preparedness and less resilience mechanisms. Accordingly, the International Monetary Fund (2022) reckons that emerging and developing economies will need significant climate financing in the future to reduce their emissions and adapt to the physical effects of climate change. Uganda in her recently updated NDCs will need an estimated total cost of US$ 28.1 billion by 2030 to implement the proposed climate action plan. Financing is needed to support climate smart agriculture, clean energy, low carbon industries, climate resilient infrastructure among other priorities.
The urgency to scale up investments in mitigation and adaptation to climate impacts is now a critical issue worldwide. As facilitators of the economy, financial institutions have a central role in the transformation to low carbon and climate-resilient development given their unique position in facilitating the capital flows through their lending, investment and advisory roles, financing of innovative technologies with less stringent conditions and incentives to maximize the impact of such measures.
While credit from financial institutions dominates financing in majority of the businesses in Uganda, only a small portion, is explicitly classified as green. The lack of clarity as to what constitutes green finance interventions and products, such as green loans and green assets, presents an obstacle for investors, enterprises and financial institutions seeking to identify opportunities for green investing. This makes it difficult to efficiently allocate financial resources for green projects and assets.
Whereas green finance definitions are complex, efforts to understand green finance are now converging on the financing of activities that can address climate change risks through mitigation and adaptation and other environmental challenges through natural resource conservation, biodiversity conservation, and pollution prevention and control.
Financial institutions such as the World Bank (2020) provide a guide for developing a common taxonomy. The idea is to identify eligible activities that can be financed more easily and consistently and measure financial flows toward sustainable development priorities to reduce the risk of green washing.
While many financial institutions have already taken steps to reduce the direct impact on the environment stemming from their own activities and investments, the European Banking Federation (2017) notes that their main contribution lies in providing financial solutions for climate sensitive projects for all customer segments including SMEs, large companies, and start-ups.
The Uganda Green Growth Financing and Resource Mobilization Strategy (2021-2025) recognises the market-led initiatives by various financial institutions that have unlocked a range of innovative financing mechanisms to support climate-proofing against future disasters. These include green loans, asset and trade financing, green bonds, green equity investments, risk insurance or credit guarantees, grants, and other de-risking instruments categorized under corporate/investment banking, retail banking, asset management and insurance.
Financial institutions provide term loans for environmental purposes, low carbon technologies and climate adaptation strategies. These are intended to support renewable energy/ energy efficiency projects while innovations such as agricultural insurance are being considered in the field of climate smart agriculture. In addition to the term loans, asset financing allows project developers to access cleaner production technologies without having to purchase the equipment upfront while trade finance supports trade in climate/ environmentally friendly products.
By offering green equity, risks associated with green fields are addressed. Banks hold equity and provide leverage to attract co-investments that require an improvement in the capital structure of potentially bankable projects where the sponsors cannot raise additional equity for application or scale-up of climate smart investments.
Through the credit guarantees, financial institutions unlock local green investments that suffer constraints of lack of collateral, high credit risk, and high start-up costs. Some Financial Institutions provide grants for technical assistance through project preparation support during initial phases from concept development, project design and structuring.
Lately, several banks have started to issue green revolving credit facilities where the margins are linked to the sustainability performance of the borrower. This creates an additional economic incentive for the borrower to improve sustainability.
Financial institutions are also exploring the use of digital technology as a lever for green finance in lending and investments, given their potential to raise awareness and grow businesses through artificial intelligence. A noteworthy example is the launch of the ‘Agri-Connect’ Platform by the Uganda Development Bank (UDB) and Ensibuuko which provides an opportunity for smallholder farmers to access credit through digital solutions that reshape the financial system in ways that align it with environmental sustainability.
Several financial institutions have created green/climate funds that mobilize concessional capital and provide tailored products for green investments through blended instruments. A recently launched Climate Finance Facility at UDB is expected to mobilize green finance, lead and structure deal transactions and build a quality pipeline of investments that demonstrate climate finance engineering solutions in the local market. This is in addition to other already existing funds at national and international level such as the Green Climate Fund, Global Environment Facility, and the Adaptation Fund.
Green frameworks are institutionalized under such entities and provide project screening mechanisms, monitoring, reporting, and verification which give greater confidence to investors. Such facilities also support projects at various stages of development to access capital markets through innovative financing mechanisms such as carbon markets and green bonds to raise further capital.
With their dynamic capacity to power innovation and change, financial institutions have a critical role to play in advancing mitigation and adaptation efforts. They have the ability to scale up solutions that are important in decarbonizing the economy. As such, the growing awareness of the urgency to address climate change and environmental degradation calls for a better alignment of the financial system with green growth policies supporting sustainability while reducing environmental risks.
Pius Wamala is a Senior Green Finance Officer at the Uganda Development Bank.