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Blended Finance for Renewable Energy Financing in Emerging Markets: Deep dive into structuring approaches

The energy sector is the source of approximately three-quarters of global GHG emissions,. Meeting the Paris Agreement’s target of limiting global warming to 1.5°C requires significant reductions in atmospheric carbon dioxide. This objective is also heavily dependent on the capacity and ability of emerging markets and developing economies (EMDEs) to transition to cleaner energy systems. The intertwined issues of energy access and climate change create a significant demand for investment in clean energy. Although, the global renewable energy investments are abundant, only one-fifth is being allocated to EMDEs (excluding China).

The influx of finance for renewable energy projects in EMDEs is contingent upon mitigating the multifaceted factors that impede investment. Elevated levels of risk, both real and perceived, coupled with uncertainties within the policy and regulatory frameworks, can serve as a deterrent for investors. This aversion translates to a significantly higher cost of capital in EMDEs, reaching up to seven times that of developed nations. On the other hand, the cost of mitigating a tonne of CO₂ emissions in EMDEs is demonstrably lower compared to advanced economies. The most commonly identified risks that prevent investments in renewable energy projects include off-taker risk, currency risk, policy risk, and liquidity and scale risks. In addition, many early-stage projects and clean energy companies face barriers in accessing financing. Thus, it necessitates an unparalleled mobilization of all financial resources, both public and private.

Blended finance is an effective tool for mobilizing capital for renewable energy projects in emerging markets by combining public, philanthropic, and private funds to mitigate risks and enhance investment appeal. It is particularly effective in regions with political instability, currency volatility, and weak financial markets, which is a typical situation in many EMDEs. Blended finance uses concessional money (typically from public or philanthropic sources) to spur private-sector investment. The primary goal is to make high-risk projects, having significant impact and addressing development goals, viable by removing specific restrictions that discourage private investment. Blended finance is a structuring approach and not an investment approach or end solution. As per the Blended finance report by Convergence, the energy sector is the most active segment in the blended finance market, contributing to one third of the total deals/activities in 2023 globally.

Some key components of blended finance include:

  • Risk Mitigation: tools such as guarantees, insurance, and first-loss capital all reduce the financial risk for private investors
  • Concessional Capital: development finance institutions (DFIs) and charitable organizations provide loans or shares at below-market interest rates, lowering the overall capital cost
  • Technical Assistance: grants or in-kind assistance to strengthen the capacity of local stakeholders and increase project bankability

The effective structure of blended finance for renewable energy projects requires careful balancing of multiple financial tools as well as strategic stakeholder alignment. The following are the key structuring approaches:

  • Credit enhancement mechanisms: credit enhancement improves the creditworthiness of investments/ financing. Common mechanisms are:
  • Guarantees and insurance: provided by DFIs, these instruments cover specific risks such as political instability, currency fluctuations, or technical performance, improving the project’s credit profile
  • First-loss capital: public or philanthropic funds are utilized to absorb initial losses, thereby safeguarding other investors and instilling confidence
  • Others include- interest subventions, insurance, extended moratorium or tenor
  • Public–Private Partnerships (PPPs): PPPs are collaborative frameworks in which the public and private sectors share risks and benefits. In the context of renewable energy funding, PPPs can take different forms:
  • Co-financing models: public funds are combined with private investments to share both the financial burden and the profits
  • Concessional agreements: governments provide private organizations with the right to construct and run renewable energy projects for a set period, ensuring long-term stability and cash streams.
  • Results Based Financing (RBF): RBF connects financial support to the achievement of established goals, assuring responsibility and performance. In RE projects, this could imply disbursing funding based on milestones such as capacity installation, energy output, or emission reduction. This method aligns incentives while encouraging efficiency and effectiveness. Common forms include impact bonds, conditional cash transfers, debt swaps and outcome- linked interest rate loans
  • Layered fund structures: Layered or tiered fund structures establish a hierarchy of risk and return profiles, attracting a wide spectrum of participants. These often include:
  • Senior debt: owned by private sector investors, with less risk and higher priority in the event of collapse. DFIs or impact investors frequently provide mezzanine finance, which has an intermediate risk-return profile
  • Equity: high-risk, high-return funding typically sourced from public or philanthropic organizations.

This structure ensures that the riskiest levels are absorbed by those ready to take on greater risk, while the safer layers appeal to conservative investors.

Of the above-mentioned structuring approaches, blended finance transactions in the financial services industry exhibit a significantly higher prevalence of concessional guarantees and risk insurance compared to others. Over 55% of deals within financial services utilized these instruments (compared to a market average of 34%).

Case studies:

The Africa Renewable Energy Fund (AREF) illustrates an effective blended finance structure. Berkeley Energy manages AREF, which focuses on small to medium-scale renewable energy projects across Sub-Saharan Africa. The fund uses a tiered structure, with equity contributions from DFIs and private investors complemented by technical assistance grants. AREF’s success is due to:

  • Risk mitigation involves using first-loss money from public sources to entice private investment.
  • Local Engagement: collaborating with local developers and stakeholders to ensure that the project meets regional needs.
  • Diverse Portfolio: investing in a variety of technologies (solar, wind, and hydro) to diversify risk and maximize reward.

Project preparation grants can significantly enhance project viability by defraying upfront planning costs, enabling developers to present a more robust investment case for commercial financing. African Clean Energy Finance Initiative (US-ACEF), a dedicated US $20 million project preparation facility. US-ACEF offers grants to cover non-operational expenses associated with early-stage clean energy access projects and companies. The program’s primary objective is to prepare these ventures for subsequent investment by the Overseas Private Investment Corporation (OPIC), ultimately facilitating project scale-up. US-ACEF currently operates in ten African nations: Ethiopia, Kenya, Morocco, Namibia, Nigeria, Rwanda, Senegal, South Africa, Tanzania, and Uganda. The initiative demonstrates the power of leveraging public and private funding. Estimates suggest a 75x multiplier effect on the initial investment. This demonstrates the case of successfully implementing renewable energy projects. The model has been replicated in India as U.S.-India Clean Energy Finance initiative.

Key considerations for blended finance:

When constructing blended finance for renewable energy in emerging nations, several aspects are paramount:

  • Market context and regulatory environment: Understanding the local market dynamics and regulatory framework is critical. Tariff structures, regulatory stability, and government backing all have a substantial impact on the feasibility of renewable energy projects. Engaging with local stakeholders and policymakers ensures alignment and lowers the likelihood of regulatory obstacles
  • Currency and exchange rate risks: Currency volatility is a critical issue in emerging nations. Structuring solutions can include- Hedging instruments (financial derivatives used to manage currency risk) and local currency financing (obtaining loans in the local currency to avoid exchange rate swings)
  • Project viability and bankability. Ensuring project sustainability necessitates thorough research and financial modelling

Blended finance is an important mechanism for increasing renewable energy investment in emerging nations. Blended finance, by carefully designing financial instruments and matching the interests of multiple stakeholders, can successfully reduce risks and improve project bankability. Achieving secure, affordable and sustainable energy (the energy trilemma) is a complex challenge. Blended finance offers a solution by attracting investment for a clean energy transition that benefits everyone, including those impacted by the energy transition and communities as a whole. As the need for renewable energy solutions rises, unique methods to blended finance will be critical to realizing the full potential of renewable energy in emerging and developing economies