This chapter highlights the challenges facing intermediary cities in accessing climate finance. Given the pressing nature of climate issues and the scale of investment required for mitigation and adaptation, urgent and innovative strategies are needed to address cities’ financing needs. The chapter examines constraints on access to finance from two angles: the actors that implement climate investments in urban areas and the actual systems of financing. It presents a typology of climate financing mechanisms available to intermediary cities, provides examples of successful financing of urban climate projects in developing countries and recommends actions that can be taken by national and local governments to help intermediary cities mobilise urban climate finance.
Intermediary Cities and Climate Change
5. Financing low-carbon and resilient intermediary cities
Abstract
Introduction
Intermediary cities host a large share of the world’s population that is vulnerable to climate change. These small and medium-sized cities are also increasingly contributing to the greenhouse gas emissions that cause global warming. They face an urgent need of finance for climate action.
Yet climate finance for cities is facing an investment gap. A recent study estimated that investment in urban climate finance in 2017-18 amounted to USD 384 billion annually (Negreiros et al., 2021[1]). This is far below the trillions of dollars of investment in urban infrastructure that will be needed to meet the Paris Agreement targets – an estimated USD 4.5-5.4 trillion per annum from 2015 to 2030, the study notes.
As they seek to mobilise the finance necessary for addressing climate change, intermediary cities often have limited human and fiscal resources. This may be because of their size and generally lower per capita income. Figure 5.1 shows that GDP per capita in intermediary cities skews sharply lower than the national average and is well below the mean for larger cities.1 The financing capacities of intermediary cities can also vary greatly within a country. This implies a need for flexibility in the structuring of finance for climate investments.
Figure 5.1. Differences in the city/country ratio of GDP per capita in intermediary and large cities
Source: Authors’ computation using GHS Urban Centre Database (2019[2]).
What do we mean by urban climate finance? Climate finance is not limited to specialist financing or financing instruments that are labelled “green” or “climate”, e.g. green bonds.2 Rather, to be able to implement the scale of investment required to meet the Paris targets, all financial flows must be viewed as potentially climate finance. The idea is to reframe climate finance as mainstream financing that supports the transition of all aspects of urban investment into investments that either reduce greenhouse gas (GHG) emissions or build resilience, or both. Previous OECD publications have set out important areas of opportunity relating to repurposing and extending the revenue base, expenditure priorities and financing systems for city climate investment (OECD, 2019[3]). In this context, urban investment financing systems should:
promote the concept that all urban finance must include climate objectives as an integral part of its operation, incentivising all urban infrastructure and services investment to be more environmentally sound;
count as climate finance existing sources of finance and funding that are not from specialist/dedicated climate/green sources and that are used for climate-related investments (financing any eligible mitigation and/or adaptation projects);
ensure that specialist climate finance (from dedicated climate finance sources) will leverage additional resources and be used to promote pilot initiatives addressing investments beyond the capacity of existing financing sources.
This chapter sets out the constraints and opportunities involved in providing urban climate finance to intermediary cities. It examines issues faced by the agencies that are making the investment decisions in cities (the “demand side” of the urban climate-finance market) and by the institutions that are potentially supplying the finance for these investments (the “supply side” of the market).
Given that existing revenue sources are insufficient for the investments required for climate action, even in larger cities, and that mobilising non-traditional finance for climate investment requires new capacities that challenge even larger cities and financial institutions, there is a clear need for national urban programmes that bolster demand-side capacities to formulate and structure bankable climate projects at the city level and that also structure supply-side enabling frameworks for appropriate financing mechanisms and instruments that provide access to needed finance by intermediary cities.
The key message of the chapter is that both sides of the market need to be strengthened, particularly when addressing the needs of intermediary cities.
Who are the users of climate finance in intermediary cities?
Before proceeding to examine the context of climate finance for intermediary cities, it is important to have a clear idea of which entities are to be financed. In the context of this chapter, the focus is on finance that facilitates the implementation of investment in climate-related activities (mitigation and adaptation) in urban centres and surrounding areas. The critical issue then becomes, who are the local users of climate finance? Which actors implement climate investments in urban areas? Collectively we will henceforth refer to these actors as “urban investment agents” (UIAs).They include:
local governments. Often there are two or more local governments in an urban area. Many intermediary cities have outgrown their original administrative boundaries and cater to a significantly larger share of population, including rural population in adjacent jurisdictions. This raises issues of metropolitan government investment and burden sharing.
urban institutions. City utilities may be public, private or public-private partnerships (PPPs)3. Often state or provincial-level entities such as development corporations and utilities operate within and across local government jurisdictions. For instance in some countries, such as in Indonesia, national institutions may play a large investment role in housing and upgrading.
manufacturing/processing firms and other services located in the city. The primary GHG emissions of cities often come from enterprises and private-sector actors. Many of these firms and actors also process agricultural and other resources for surrounding rural areas, and have linkages to, and influence on, farming and other actors in these areas. Many of these actors will have an impact on emissions and are also impacted by climate change. Thus these actors will need to make investments to achieve needed mitigation and adaptation targets.
individuals and community organisations. Individual decisions on issues such as mobility and the energy efficiency of housing can make a large impact on emissions. Further, the resilience of neighbourhoods is often determined by the capacity of community-based organisations operating at a neighbourhood level. Thus financial support of these actors can accelerate and complement climate action led by other actors.
Reaching the targets of the Paris Agreement will require the involvement of these local financial actors. Systems of urban climate finance have to take into account the needs of all actors within urban areas. Nationally determined contributions (NDCs) represent national government promises of aggregate cuts in emissions and increased climate resilience. In reality, these promises in the urban sphere will be fulfilled by investments undertaken by the actors listed above. NDCs do not necessarily cover all investments required for mitigation actions to meet the Paris targets, nor do they encompass the breadth of adaptation actions required in cities to respond to climate impacts. This further widens the scope of actors.
Eligible climate finance investments
How is climate investment defined from the viewpoint of the financial sector? A “taxonomy” defines which investments are eligible for climate finance and may provide criteria on how to judge their relative performance in different sectors. There are numerous such taxonomies. The Climate Bonds Initiative (CBI) Taxonomy (CBI, 2021[4]). one of the first, most developed and most used, is used to screen bonds and identify whether investment projects are eligible for green or climate financing. It “identifies the assets and projects needed to deliver a low-carbon economy and gives greenhouse gas screening criteria’’ (CBI, 2021[4]). The People’s Bank of China (PBOC) taxonomy (PBOC, 2020[5]) was the first national taxonomy and is institutionalised in a broader “green finance” system. The EU’s framework to facilitate sustainable investment (2020[6]), known as the Taxonomy Regulation, is considered the most sophisticated taxonomy in terms of breadth of coverage, which includes performance standards.
Figure 5.2 provides an overview of the sectors in which eligible investments may be found under the CBI taxonomy.
Figure 5.2. Climate Bonds Initiative taxonomy
Source: Adapted based on https://www.climatebonds.net/standard/taxonomy; see also for further information, including eligible project types and eligibility criteria.
Taxonomies are structured according to the focus of their designers and can be both too detailed and too broad for easy application by city project sponsors. Further, current taxonomies underdefine the multiple investments involved in adaptation investment, particularly in relation to the consequences of sea-level rise, flood control and drainage, and this can be confusing. For example, it might be unlikely for a city to consider investing in “fisheries and aquaculture”, yet the building of storm-surge barriers may involve just such industries. To an extent, this reflects a lack of clear business models for green investments. Further dialogue with financial regulators is needed on this issue. It should be noted, however, that as countries seek to draft taxonomies for sustainable or climate investment that match their circumstances, existing taxonomies such as the CBI taxonomy can be used.
Climate-related infrastructure development needs in intermediary cities
The OECD estimates that limiting the rise in global temperatures to less than 2°C by 2100 will require an annual investment of USD 6.9 trillion in global infrastructure between 2016 and 2030. Developing countries account for approximately two‑thirds of the estimated investment needs, or about USD 4 trillion per year over the same period (OECD, 2017[7]). This amounts to an additional 10% in infrastructure spending (World Bank, 2019[8]). The associated annual incremental up-front costs of future infrastructure investments that are required to adapt to climate change consistent with the below 2°C scenario have been estimated at around 10%. This reflects costs in addition to business-as-usual infrastructure requirements and is in addition to mitigation costs. The World Bank estimates that there are significant benefits for such investment, with a net estimated benefit of USD 4 net for every USD 1 invested in resilience (World Bank, 2019[8]). However, achieving a sustained 20% increment over existing capital spending to meet adaptation and mitigation needs is an enormous task for many intermediary cities.
Given the pressing nature of climate issues and the scale of investment required, it is important:
to address the key constraints on mainstreaming and upscaling climate finance
to identify the challenges faced by intermediary cities around financing climate investments
to examine whether these challenges are the same issues in all contexts.
As discussed in previous chapters, intermediary cities, defined in this report as cities of 50 000 to 1 million inhabitants, have often been a neglected area of national and regional economic and urban development and investment. As a result, there are growing levels of disparity and inequity between metropolitan regions and small and medium-sized cities in terms of development, fiscal transfers and productivity. In Indonesia, for instance, the per capita GDP of Jakarta, a city of 10 million, is more than four times greater than that of Denpasar, a city of 900 000 (BPS, 2020[9]).
Overall, the development of intermediary cities is hindered by poor infrastructure, inadequate human capital and weak urban governance, leading to a poor tax revenue performance. This is particularly the case for less developed regions: the average taxation yield of national GDP for local governments is 5.3% in Southeast Asia, 4% in Latin America, 3.2% in Africa and 1.5% in South Asia, compared with 13% in Europe (UCLG, 2008[10]). Moreover, spatial constraints relating to distance, remoteness and the complexities of a mixed formal/traditional tenure system present additional challenges for some intermediary cities particularly in Small Island Developing States (SIDS). For these reasons, industries in intermediary cities (including in most industrial clusters) often struggle to achieve scale, and may well face higher transaction costs for financing. This undermines their competitiveness and efficiency.
The macro context sets the scene for climate-related investment by urban investment agents in intermediary cities, but it is important to understand the scope of needed investment. Local government and other government agencies bear very little responsibility for carbon emissions and climate vulnerability, while investment decisions by local households and enterprises have a large influence on both. But the scope of city policies can be limited. Indeed, the larger-scale impact of enterprises based in the city with respect to emissions – broadly, Scope 3 emissions as defined by the International Panel on Climate Change (IPCC) (GHG Protocol, 2011[11]) – will not be amenable to action by city agencies. Action on the broader national climate impact of enterprises based in the city (Scope 3 emissions) will require action at the national level. Figure 5.3 shows the limits in intermediary cities on the scope and impact of direct climate investments by UIAs (“City operations” in the diagram).
Figure 5.3. Investment scope for climate-change finance
Source: Authors’ own elaboration.
Intermediary cities are potentially bigger emitters proportionally than megacities and, as we have seen from OECD data (Figure 5.2, above), have fewer resources for addressing these emissions. This argues for much more focus on financial support for intermediary cities – especially when considering that adaptation investments are likely to be at least proportionally shared by these cities.
Objectives for urban climate investment in intermediary cities in a post-COVID world
The COVID-19 pandemic will exacerbate the constraints on the structuring of climate finance. This will particularly be the case in relation to own-source revenue used to finance investments or service debt. The pandemic has had a large negative effect on city finances in multiple ways:
It reduced the level of financial inflows to financial institutions, as incomes and profits were impacted, and savings were drawn down. This increased the pressure on financial institutions to reduce lending and increase reserves (including buying national government bonds), which reduces the financing available to local governments. Meanwhile, local governments have had to increase spending on health at a time when tax yield is lower, requiring them to issue more bonds or seek bank lending. Although the bonds could be used to fund green/climate projects and programmes in green recovery programmes, the space for financing climate investment will likely be less (this will be further discussed below).
COVID-19 has often reduced the revenue base of UIAs, thus reducing both off-take income from city services and tax revenues and the debt service capacity for climate investment by cities and city implementing institutions. This is particularly the case if central governments pass a significant part of the burden of economic recovery to subnational levels of government.
Differing perceived rates of impact of the virus on economies has lowered the credit ratings of some emerging market and developing economies (EMDE), leading to a rise in the cost of debt.
COVID-19 curtailed economic growth and thus the potential for cost recovery from user charges for climate/environmental services. This may be partly offset, however, as many mitigation investments reduce costs in the long run.
In the context of “green recovery” from the pandemic, economic recovery and resilience strategies ought to provide immediate high-priority opportunities for climate finance. Such strategies are likely to emphasise labour intensive, critical and strategic import replacement (sustainable recovery) industries, which can also be made low carbon and resilient (Cities Alliance, 2020[12]). They should also prioritise health infrastructure and infrastructure to support the industries mentioned, and should promote other investments that will have significant co-benefits, such as pollution reduction, and that are preferably cost recoverable. As such, climate finance investments need to be formulated to include a focus on implementing these strategies, which are, in any case, a “no-regret” option and provide tangible benefits to communities.
When addressing these priority strategies, it is necessary to consider the economic and spatial context of climate finance. Intermediary cities constitute rungs in the urban hierarchy, but this characterisation is too simplistic as a basis for climate investment, and consequently for climate finance strategies. The supply chains of industry clusters based in the capital city, or large metropolitan cities, weave in and out of those cities; other clusters are based in intermediary cities or networks of small and medium-sized cities (Cities Alliance, 2019[13]). As such, their spatial circumstances and economic functions are interdependent. Different types of networks are established among economic actors in such cities. Climate finance mechanisms need to be able to address investments that will be made flexibly, enabling access to proponents across a range of sectors and in a wide variety of spatial and economic contexts.
As an indication of the range of economic circumstances encountered, Figure 5.4 shows differences in per capita GDP growth rates across intermediary and large cities. While large cities tend to be clustered around national average growth rates, intermediary cities extend in a much wider distribution, with some growing much more slowly and others much more quickly than the bulk of big cities. These rapidly growing small cities may well be those in overspill areas of megacities or in quickly growing innovative clusters. Again, the range of circumstances in intermediary cities reinforces the need for very flexible financing mechanisms that can enable access to as wide a range of cities as possible.
Figure 5.4. Differences in the GDP per capita growth rates of intermediary and large cities
Source: Authors’ computation using GHS Urban Centre Database (2019[2]).
Designing climate financing solutions becomes more complex when they span local government areas with different scales in terms of population, economic development and wealth. Yet certain large-scale, boundary-crossing investments – such as metropolitan public transportation systems (for mitigation) or restored wetland buffers against storm surges (for adaptation) – may be among the most desirable climate investments, and must not be neglected. At the level of the climate finance facility, systems of project assessment that determine financing eligibility need to reflect the broader objectives of the nation in order to be viable, and to justify potential concessional finance. Climate investments in industry clusters and infrastructure will have environmental, finance, economic and social dimensions. Green Climate Fund (GCF) investment criteria include these dimensions, which must all be considered for the investment to be viable (Green Climate Fund, 2020[14]).
Cities play a key role in implementing the adaptation and mitigation investments required under nationally determined contributions. Indeed, cities have dominant roles in national economic and climate policies, considering their dominance with respect to both the economy and GHG emissions. Thus, in the context of the NDCs, they should detail and prioritise investments in the sectors of renewable energy, energy efficiency, transport, waste and adaptation, as determined by assessments based on local GHG and climate vulnerability profiles. Important factors such as the sustainability of essential services, labour intensity, total benefits to citizens and financial sustainability should also be heavily weighted by UIAs in assessing priorities for investments. These priorities are referred to henceforward as “localised NDCs”.
Given the above objectives and context, what are the likely high-priority climate investment opportunities that will also foster a green recovery? Investments with a focus on building a resilient economy should be considered to be the priority. They should encompass investments in enterprises that provide appropriate renewable energy and energy efficiency equipment, including designs appropriate to small and medium-sized enterprises (SMEs) and the informal sector. They should also focus on reinforcing the resilience of vulnerable communities and building inclusive and strong health systems. Furthermore, investment in resilient common-user infrastructure and intermodal logistics networks, hubs, facilities and systems is also very important.4 This may include resilient and low-carbon local energy, waste and water networks, and ecosystem services investment in water/wastewater and coastal zones. Investments that should also be considered as priority are those that aim to strengthen city and intercity clusters (specifically those that build on local resource endowments) and that support cluster associations and communities of interest. Such investments should also provide support for collaborative research and development, innovation, knowledge sharing and data management focused on reducing carbon footprints and building resilience.
National, subnational and local government development strategies, budgets and intergovernmental transfers need to align so as to identify and support these priorities. Climate investments need to be seen as, and structured for, delivering the employment, infrastructure and energy required for a green recovery.
Constraints on access to climate financing in intermediary cities
Intermediary cities face many constraints on access to climate finance. The challenges can be associated with uncertainties around climate risks due to modelling limitations, the structure of the financial system, limited political will and/or the capacities of local authorities and other urban institutions. It is important that national, subnational, and local policy makers approach urban climate finance as something that all economic and sectoral policies need to internalise. They should also address shortfalls in existing financing and funding mechanisms.
Five structural shortfalls in existing climate financing mechanisms prevent effective engagement with cities. The shortfalls particularly affect intermediary cities, as they are constrained by their own limited resources and capacity (CCFLA, 2015[15]). Climate finance, whether through existing financing and funding streams or through specialist climate funds, needs to address these shortfalls. They are:
lack of green/climate budgeting, green taxes/fees and green procurement systems that recognise the linkages between budgeting; appropriate revenues (taxes and fees incentivising low-carbon and resilient development); expenditure; and levels of investment vis à vis the investment needs required for localised NDCs. This dependent and/or limited revenue base also impacts cities’ credit ratings, which in turn can limit financing options and consequently impact the cost of financing. Such options can also be, and often are, constrained by explicit regulation by higher levels of government. The OECD has undertaken significant work to provide a framework for tracking climate finance and maximising the impact of funding and financing flows (OECD, 2019[3]; OECD, 2022[16]; OECD, 2021[17]).
lack of planning and project development. In the past, city planning processes generally did not consider climate issues, and thus provided a poor basis for funding applications. This is changing as cities develop climate action plans to address localised NDCs, but cities still need support. Similarly, city project-development systems need to be structured to foster green design solutions, which may require higher levels of co‑ordination and design integration. They need to include climate finance in the design of the funding mix and the required monitoring, reporting and verification (MRV) systems in the project design. These are specialist skills that many cities may never need “in house”, but that must be available if they are to access climate finance.
shortfalls in technical capacity and resources to access climate finance. In many countries, assistance to negotiate with the main entry points for climate finance is needed by most cities. Local governments and other UIAs have few structural relationships with such agencies and speak a different technical language. Although local governments increasingly have environmental officers, they are generally institutionally removed from financing units. In order for financing to be accessible, applications must involve objectives couched in language that is familiar to city officials, as well as data that they are able to collect. Such information can be supplied by specialised consultants, but cities have limited consultancy budgets. More consultant inputs may be required to verify performance during implementation, and this increases costs. Finally, lead times and approval processes can be very long, which creates difficulties when officials are elected for mandates of, say, three years. In summary, it is necessary to reduce the very high transaction costs of access to climate finance for local governments and groups of local governments.
lack of capacity to manage the financial aspects of the project. Once approval has been secured, understanding and managing the financial aspects of the project is very important to project success. This will often depend on capacity to manage the type of instrument used and to understand the performance metrics associated with it. Failure to achieve projected emissions reductions may involve paying back financing, while success means that cities can apply for another grant, with the same transaction costs. These potential costs are a significant deterrent to many local governments. Where finance is dependent on market pricing, cost uncertainty can deter investment decisions. Additionally, cities often also require help in putting together the underlying financing of the project, particularly public-private partnerships (PPPs).
lack of funding flexibility and partnerships. Cities need to be able to access appropriate funds and to leverage/combine them for more impact. Given that most available sources of finance do not cover all aspects of project preparation and implementation, cities generally have to cobble together a combination of funding sources to develop and construct the project. This is difficult given varying objectives and access criteria. Further, cities often have limited ability to use a wider range of funding sources, such as land value capture, and when such funding is available the taxation rates may be capped. A lack of sources of funding to repay finance and to cover the unfinanced part of investments is perhaps the major constraint on up-scaled urban climate finance.
These shortfalls in access to climate finance stem from two main structural challenges: the ability of UIAs to develop, structure and implement climate projects (the “demand side” of the climate finance market), and the actual systems of financing (the “supply side” of this market). This is discussed below.
Demand-side prerequisites for climate financing in intermediary cities
Once climate investment needs are identified, it is important that UIAs be committed to following through with effective investment and have the mandate and resources to do so. In other words, the prerequisites for effective climate finance must be in place (Colenbrander et al., 2018[18]).
Governance is one of the main factors that will influence climate investment in intermediary cities. Given that mayors and other elected officials may have short-term mandates, strengthening governance to help ensure continuity of political will can have an important impact. Local enabling environments can be improved by structuring incentives for low-carbon and resilient investments, and by ensuring the efficient and transparent operation of implementing agencies. While intermediary cities may have limited powers to change governance systems, transparency can help to provide continuity and reduce perceived risk. For instance, if a given local bond issuance is approved through a public referendum, this could bolster investor confidence in the community’s long-term support for servicing the debt.
Good governance provides a secure context for boosting local investment capacity.5 It enables long-term integrated planning of green and resilient infrastructure, as well as effectiveness in the use of fiscal transfers. It also helps to build capacity to formulate and implement climate projects that are suitable for finance. Strong governance is also critical for the structuring and operation of vehicles that facilitate the participation of the private sector and institutions. However, intermediary cities may have lower levels of planning capacity than larger cities, and their lower income and the relatively small size of their projects can make them less attractive to the private sector, especially given the complexity of PPP contracts. Intermediary cities may thus not be able to fully leverage these processes.
Demand-side constraints on access to climate finance in intermediary cities
The overall lower fiscal capacity of intermediary cities can limit their access to adequate financing. They may be limited in their ability to take on debt due to the limited size of their urban economy and revenues. They may also have limited ability to raise the fees and taxes required to provide needed revenue streams and debt service capacity. Similarly, intermediary cities generally have lower land values and provide less leverage than larger cities. This limits their ability to react to and influence the commercial conditions that provide the context for private investment through instruments such as land-use controls.
Addressing these bottlenecks is critical, and the challenge increases when we consider the kind of transformational investments needed to address climate change. The main structural constraints faced by intermediary cities in terms of access to finance are outlined below.
The inflexible structure of intergovernmental transfers to intermediary cities can be a major constraint on access to climate finance. It is established that intermediary cities have greater dependence than larger cities on intergovernmental transfers – this is known despite the overall lack of disaggregated data that would allow a detailed assessment of the relative impacts of the structures of intergovernmental transfers on intermediary cities (Farvacque-Vitkovic and Kopanyi, 2014[19]). The structure of such transfers is important for intermediary cities, which can be disadvantaged and/or disincentivised by formulas based on population or by transfers being tied to specific uses or staffing levels, for example. In particular, inflexible systems tend to reduce a city’s ability to undertake more innovative financing.
The limited capacity of intermediary cities to take on debt is another challenge. The ability to take on loans and/or issue bonds (green or otherwise) depends on the creditworthiness of a specific UIA. For a local government, this entails the ability to generate surplus. It thus becomes very important that: a) transfers are used effectively; and b) revenue is maximised. There are many examples of cities that do not collect all mandated taxes and fees and that do not maximise the potential revenue streams of their assets (such as markets). For instance, the specific location of infrastructure investment matters because it will lead to an increase in land value in surrounding areas. Many countries provide a legislative basis for capturing some of the value added that results from this process: this is referred to as land value capture (UNESCAP, 2019[20]). Various countries have successfully used this concept. OECD countries use it under names such as “development levies”. Colombia and Brazil6 have used it extensively, and similar land-linked mechanisms (land pooling) have been used in China, Vietnam and Nepal (Smolka, 2013[21]). Other innovative financing methods include “green taxes”, such as congestion charges, on environmental “bads” (UNESCAP, 2019[20]). However, it is often harder for intermediary cities than for large cities to put such arrangements in place, and the yield is proportionately less for them.
The structuring and operation of debt financing mechanisms can also be more difficult for intermediary cities. Debt financing at the subnational level requires sufficiently large, economically viable projects or, in the case of many intermediary cities, pooling vehicles to aggregate smaller projects. Such vehicles can be within financing institutions (see below), but can also be achieved by the use of development corporations or regional utilities.
Good financial management is important for reassuring potential investors that financing projections are based on a sound fiscal system. Movement towards compliance with the International Public Sector Accounting System (IPSAS) and International Financial Reporting System (IFRS) is desirable at both national and local levels. This is the stated policy of many countries. Yet intermediary cities have limited resources for putting the required systems in place.
Supply-side constraints on access to climate finance in intermediary cities
Intermediary cities also face supply-side barriers to mobilising large-scale private institutional and commercial (PIC) finance. These include: a) lack of viable investment opportunities (project development), enabling environment, etc.; b) lack of investor “capability”, including the ability of supply-side institutions to structure systems of accessing finance that are appropriate for UIAs; and c) inadequate conditions for investment, including macroeconomic issues/policy (OECD, 2014[22]). Supply-side constraints have been exacerbated by the effects of the COVID-19 crisis, with revenue shortfalls arguing in favour of maximum private financing of projects.
In addition, the returns on urban climate investments need to be competitive. Indeed, even if structural barriers are addressed, there will be competition for institutional funds in the “alternative investment” category, which provide high risk-adjusted returns. Many EMDE climate investments will fall into this category. Key supply-side issues facing intermediary cities are examined below.
Lack of suitable investment opportunities
The large variations in what constitutes “suitable” investment can present a challenge for accessing climate financing. Suitable investment encompasses the concept of an acceptable risk-return profile. Institutional investments, which achieve relatively lower but steady and reliable returns, are often acceptable, and many urban investments can be characterised as being long lived, low risk and with stable returns. But the level of returns deemed adequate and the level of liquidity required will vary according to the circumstances of the investing institution. As such, developing suitable investment conduits can be a challenge for climate projects, which must meet climate objectives in addition to the general requirements of technical, financial and regulatory standards.
Credit rating is a central element of investment decisions by a financing institution. It measures the amount of risk set against the income to be derived from extending finance. A higher risk of not being repaid implies that the financing institution needs to be compensated by higher returns. The issue of risk/credit rating is central to the participation of institutions in a particular investment or investment vehicle. Yet the majority of cities, particularly intermediary cities, do not have credit ratings. Thus, government attempts to transfer inappropriate levels of the risk of project failure to the private sector and institutional financiers can be counterproductive. Such efforts can result in very high costs as the private sector and institutional financiers build the risk premium into the project or, more generally, in a failure to secure institutional finance. The definition of what is considered inappropriate risk is a big challenge. Many institutions are reluctant to take “greenfield” (construction and commissioning) risk. Others may not want to take the risk of new technologies or geographies. The OECD (2014[22]) recommends that governments use risk reduction/credit enhancement mechanisms such as public or private guarantees.
Well-resourced project development mechanisms are often needed to bridge the gap between planning and a project that is ready for financial due diligence. This is especially the case for climate projects, which will have different, and sometimes unfamiliar, technical and regulatory characteristics. The lack of long-term planning focused on reduction of emissions and resilience remains a key issue for climate investment. The OECD (2014[22]) has recommended national infrastructure plans as a means of addressing this gap.
The concept of suitability also involves the size of investment required or the volume of resources needed. To get to a scale that makes the urban infrastructure projects of intermediary cities attractive to institutional investors, these projects will require aggregation in the financing structure, either at the level of the financial instrument used or in the structure of the sponsoring entity. This has implications for project development, as standardised approaches must be used in the bidding, the contract and financial documents.
Lack of investor capability
Investors can also face critical problems on their side. First, the close attention paid by analysts to quarterly market benchmarks fosters a short-term orientation. This incentivises investors to seek quick positive returns and militates against investments that have long pre-operation periods. It also fosters a need for liquidity in investments due to the ability of pension contributors in some countries, such as Australia, to withdraw their pension proceeds at short notice (for example, to change pension providers). Second, investors lack experience with urban investment, which increases their perceived risk and thus the required return. This discourages small-scale institutional and private investors, especially national investors that would otherwise be more comfortable with financing in cities. Third, lack of appropriate financing vehicles can limit investors’ capacity to provide financing – i.e. vehicles that can accommodate numbers of investors and aggregate numbers of smaller projects, and that align the interests of the managers of such vehicles with those of the institutional investors, in fee transparency and liquidity in particular. This has been a problem, for example, between private equity funds and pension funds. Fourth, regulatory barriers also constrain the mandate of investors to invest. Examples include “market to market” regulations, which incentivise institutions to avoid volatility whatever the cause; asset-class regulations that limit or ban participation in, for example, direct equity investment and unlisted funds; and credit-rating limits. These factors often impact climate investments hardest given that they are not yet fully established in the market.
Conditions for investment
The conditions that determine levels of financing of climate investments can be broken down into three categories: a) macroeconomic; b) policy; and c) demand-side capacity (discussed above).
Macroeconomic conditions can have a large influence on multiple factors that determine levels of climate investment. Macroeconomic conditions determine aggregate demand (both on the revenue side in use of services, and in the capacity to raise taxes or issue debt to fund government investment) and influence inflation, foreign exchange and interest-rate risks. The international perception of macroeconomic conditions may unfairly impact cities. Indeed, irrespective of a city’s intrinsic fiscal soundness, its credit rating is generally considered to be bound by the rating of the sovereign government.
The policy and regulatory environment is rapidly evolving, particularly in terms of environmental and climate legislation and regulation. Policy consistency and transparency in areas such as standards, subsidies, incentives, carbon pricing and dispute resolution are important to investors across all infrastructure and economic development opportunities. This environment determines the size, growth potential, structure, stability/risk and profitability of markets. Policies are important at all levels, including national, state/provincial and local. The policy environment at the city level is a particular issue in view of short electoral cycles and the potential for lack of alignment between city governments and higher levels of government. Lack of alignment carries through in terms of the levels and conditions of fiscal transfers, the ability to enter into PPP contracts, lending limits and caps on fees and taxes. The policy environment also determines the quality, timing and scope of data available to investors. The cumulative effect of these issues will determine investors’ perception of risk and value in the urban climate investment space.
In response to these issues, support for building climate financing capacity needs to focus on mechanisms of finance. This implies the need to develop systems of assessing enterprise proposals. Further, infrastructure-financing decisions need to ensure that the investment is the most effective possible given the country and technological context. As such the question becomes: How can urban climate financing for intermediary cities be structured to address the demand- and supply-side constraints?
Approaches to effective climate financing in intermediary cities
Approaches to effective climate financing in intermediary cities need to encompass effective action on both the demand and the supply sides. On the demand side, there is a need to assess the capacity of UIAs to plan and arrange funding for projects; on the supply side, there is a need to assess the capacity of financing institutions to respond to the needs and circumstances of UIAs. To provide context, it is important to understand the structures of financing that are applicable to urban climate finance. Figure 5.5 illustrates the flows of funds from international sources through the sources available at national levels to the sources available to the city UIAs themselves.
Figure 5.5. Flows of financing across different institutions
Note: Exim = export-import agencies; IFIs = international financial institutions; UIAs = urban investment agencies; RED = development assistance flows; GREEN = institutional and commercial finance flows; BLUE = national government flows; YELLOW = all other finance flows.
Source: Authors’ own elaboration.
There are myriad potential sources and structures for a given investment. It is beyond the scope of this chapter to go through the advantages and disadvantages of every possible combination of financing sources, which can vary widely from city to city and country to country. However, it is possible to establish principles of structuring demand- and supply-side responses so as to maximise the potential efficiency of a climate financing process in intermediary cities. Box 5.1 outlines some of the main financing sources for climate investment across different categories.
Box 5.1. Sources of financing for climate investment at city level
Intermediary cities wishing to pursue climate investment have various options in terms of financing. Here are some of the main sources.
International development assistance agencies and IFIs provide the most concessional resources at the international level (red flow lines in Figure 5.5). These sources are limited by budget constraints and the capital backing of the IFIs. This said, these programmes are increasingly shifting to focus on climate issues, so there is significant potential if UIAs can work with national governments to tap into such flows.
Institutions have substantial amounts of finance available in theory (top green flows in Figure 5.5). Indeed, data from the OECD (2020[23]) for 2019 shows that pension funds held USD 32.3 trillion in assets under management, while insurers held approximately USD 33 trillion (Carter, 2020[24]) in 2020 and Sovereign Wealth Funds USD 8.8 trillion in the same year. However, tapping into even part of these funds requires addressing the critical constraints on investment identified by the OECD, as set out above.
Dedicated climate funds promote urban climate investment and have dedicated programmes to this end (under IFIs above, with red flow lines in Figure 5.5). Cities can turn in particular to the Green Climate Fund, the Global Environment Facility (GDF) or Climate Investment Funds (CIF). The GCF has the larger resources and can help fund significant capital costs. But these funds require that an intermediary partner with a UIA. In the GCF’s case, this may be an accredited entity, such as an IFI, or a local (direct access) entity. Arranging such partnerships is difficult for many intermediary cities.
The international (and national) private sector requires the use of project structures that allow its participation – PPP structures and the like (yellow bottom box in Figure 5.5). In specific circumstances, such as the supply of transport equipment, the international private sector can mobilise lower-cost financing from export credit agencies of particular countries. Such funds, of course, tie procurement to sources from the donor country. UIAs in many intermediary cities struggle to develop projects of the scale that will attract such finance.
National and subnational governments are still the dominant funders of infrastructure (more than 75% globally) (Estache, 2010[25]). But intermediary cities, for reasons outlined above, are in a weaker political and fiscal position to demand an equitable share of such finance. Even where dedicated financing institutions, such as national development banks (NDBs), are established to direct finance to cities, they are constrained by their inability to formulate “bankable projects”. This caveat applies even more for private-sector financial institutions (banks, funds, etc.).
National private-sector entities are familiar and often comfortable with the scale and general fiscal and regulatory context of the projects of UIAs, but their participation is often limited by government processes of project formulation and implementation. Added to this in a number of countries is reluctance on the part of citizens and politicians to see changes in government-focused procurement. This reluctance is sometimes well founded on the experience of adverse outcomes of projects involving the private sector.
Demand-side financing support structures and examples
National and local authorities and other UIAs involved in city development can take actions to better mobilise their resources for low-carbon and resilient development in intermediary cities. Strengthening the capacity of UIAs is important for building structures that address the constraints set out above. Key elements for strengthening capacity include:
planning for mitigation of GHG emissions and climate resilience through evidence-based city climate action plans. The plans should be informed by climate vulnerability assessments and developed with the input of local communities and with the support of stakeholders across relevant investment sectors.
use of project development entities (such as project preparation facilities) through national governments or development assistance and IFIs that can support the development of bankable projects of high climate performance. This process should assist UIAs in structuring projects so that the private sector can participate when appropriate in a manner beneficial to citizens.
improving fiscal management, particularly in relation to maximising own-source revenue and leverage of public resources.
Best practices in planning for climate investment
Various examples can serve as reference points for effective planning for climate investment. For instance, Durban (South Africa) developed an impressive Climate Action Plan based on a rigorous analysis of the city’s GHG emissions and well-modelled climate vulnerabilities. The process involved wide consultation across the agencies that would undertake the investments and the broader community. This process produced a concrete set of actions in nine thematic areas: energy, transport, waste, water and flooding, health, biodiversity, food security, sea-level rise and vulnerable communities. These actions were sufficiently detailed to provide a basis for prioritising investments in each area.
The resources for climate action plans can be provided by a range of entities. The C40 Cities Climate Leadership Group (C40), a global network of mayors taking urgent action on climate, has been supporting the development of a number of such plans. Its processes are rigorous. The C40 caters to larger cities, although some are “intermediary” in the context of their countries. Other sources of support include the Global Covenant of Mayors for Climate & Energy (GcoM), which helps cities to develop sustainable energy and climate action plans, and certain multilateral development banks (MDBs). However, these resources are very limited, and smaller intermediary cities often struggle to access them.
Best practices in project development
The need to support cities in project development is increasingly recognised. From early examples such as the Cities Development Initiative for Asia (CDIA), a variety of project development support mechanisms have been established (CDIA, n.d.[26]). They vary in countries covered, sectors covered, scale of assistance and independence from financing entities (in terms of being open to a range of possible financing sources).
At the global level, the C40 Cities Finance Facility (CFF) has provided resources for project preparation across a range of sectors (C40, 2021[27]). As an example, the process of project development for climate-positive transport projects in Mexico began with support to Mexico City (not an intermediary city). This involved a rigorous process of assessment of the type of electric vehicles the city would use for its bus system; it was determined that upgrading and expanding the existing trolleybus network was the most effective way forward. A cost-effective, locally manufactured solution was recommended and adopted. Building on this experience, the CFF then supported three Mexican intermediary cities (Guadalajara, Monterrey and Hermosillo) in relation to developing e-mobility public transport projects. The CFF also focuses on building local capacity for project development, conducting an assessment of city technical and finance skills as well as organisational options relating to implementation and financial structuring.
Other international sources provide similar support for similar projects. These organisations include the World Bank and European Investment Bank (WB/EIB) Gap Fund, supported by the German government and others (CCFGF, 2020[28]); the World Bank’s Public-Private Infrastructure Advisory Facility (PPIAF) (PPIAF, n.d.[29]); the ADB Cities Development Initiative for Asia (CDIA) (CDIA, n.d.[26]); and the technical assistance component of EBRD Green Cities, a programme of the European Bank for Reconstruction and Development (EBRD) that is co-financed by the Green Climate Fund (GCF, n.d.[30]). However, the available resources are very limited, and smaller intermediary cities struggle to access them.
At the other end of the spectrum, there are project development entities at the national scale that focus on specific sectors and/or types of project. Project development facilities have also been established within regional and national development banks, such as the Development Bank of Southern Africa, Findeter in Colombia and Banobras in Mexico. Findeter’s facility is used predominantly by intermediary cities.
An example of a facility focused on specific types of projects is the Project Development and Monitoring Facility (PDMF) established by the government of the Philippines (Republic of the Philippines, n.d.[31]). The PDMF facilitates the development of well-prepared and bankable PPP projects by engaging experienced and internationally recognised project preparation and transaction support consultants. A revolving fund, the PDMF initially shoulders the cost of consulting services for PPP projects. Upon successful PPP tendering, the winning private proponent reimburses/pays the actual cost of consulting services, plus a fixed percentage cost-recovery fee. Since its creation in September 2010 with financial support from the Australian government and the ADB, the PDMF has successfully facilitated the roll-out of PPP projects. As of 2020, nine PPP projects, valued at USD 2.35 billion, had been developed and successfully tendered with PDMF support. The PDMF has also enhanced private-sector confidence. The credible pipeline of PPP projects, which are mostly PDMF supported, has encouraged both local players and international investors to participate in the PPP tendering process.
Such national facilities have a good understanding of national context and the financial and governance issues relevant to a specific project. It is important that national governments provide policy continuity and allow project development entities technical independence in order to foster their capacity and reputation for supporting viable and well-designed projects. As an example, Colombia’s Findeter has significant independence and high standards of technical capacity.
Best practices in fiscal management
In terms of successful revenue maximisation, just collecting what is owed is a very important first step. For instance, Quezon City in metropolitan Manila increased property-tax collection threefold between 2005 and 2008 by computerising tax rolls, making payments easier and eliminating corrupt middlemen (Roy et al., 2020[32]). Reformulating taxes to simplify them and minimise avoidance is also important. Cities should consider their ability to levy taxes on “bads”, such as the use of fossil fuels and consequent pollution, and national governments should facilitate this process. Porto Alegre (Brazil), which is internationally recognised for pioneering participatory budgeting, substantially improved tax compliance through local participatory mechanisms. Revenue yields increased substantially during a period of national fiscal reform that included major increases in intergovernmental transfers, which might have been expected to dampen local revenue efforts (UN-Habitat, 2015[33]). Property-tax reform has yielded very significant increases in own-source revenue. International support for improving urban revenue mobilisation is also available, for example from the World Bank’s City Creditworthiness Initiative (World Bank, n.d.[34]).
There are also agencies that are able to engage in comprehensive planning, co‑ordinate across sectoral silos and enter into long-term contracts and PPPs. They can do so by using a diverse range of financing partners and modalities, enabling them to leverage private-sector finance and oversight implementation. An example is the Pune Smart City Development Corporation in India, which includes structures for interorganisational co‑ordination and co‑operation fostered under the national Smart Cities programme. Participating cities need to establish a credible Special Purpose Vehicle (not the conventional use of the term, which is used for PPP financing structures) (Pune Smart City, n.d.[35]). This vehicle has the mandate to co‑ordinate all necessary agencies and establish appropriate implementation vehicles for projects (including PPPs) under the Smart City programme.
Cities need to mobilise to bolster finance, both as a response to COVID impacts and in anticipation of future impacts on revenue streams from climate threats. Coastal cities suffering from seawater intrusion are likely to see property prices decline, and thus property taxes, too. Intense rainfall events that overcome drainage defences can bring entire regions to a halt. This occurred in Bangkok and its surrounding region (including intermediary cities) in 2011, when record rainfall caused severe floods, leading to 815 deaths and property damage estimated at THB 1.425 trillion (Thailand baht), or USD 46.5 billion.
Challenges in scaling up financial resources to address the costs related to the adaptation and mitigation investments of intermediary cities are particularly large in small island developing states. The remoteness of smaller settlements on islands with respect to the capital is a huge handicap. Local income sources such as tax revenues from the tourism sector need to be retained on the islands, where they can be used for viable adaptation investment in particular. Public revenues in SIDS may be affected by the COVID crisis via a variety of channels, most notably the sharp decline in global and domestic trade (as many SIDS have a high share of revenues coming from taxes on goods and services), declines in commodity and natural resource prices, and the decrease in tourism activity. To recover from the crisis, enhanced management of key sectors, including fisheries, tourism and natural resource extraction, may provide opportunities to enhance domestic revenue mobilisation in SIDS. Policies to reduce “leakages” from these sectors, especially tourism, and to support backward and forward linkages with other domestic sectors (e.g. food and agriculture, consumer goods, construction), could expand the taxable production base (OECD, 2020[36]). Special facilities are available to some least developed countries and SIDS, often at a regional level, such as the Pacific Region Infrastructure Facility (PRIF) (PRIF, n.d.[37]).
Supply-side financing structures and examples
A number of steps can be taken in efforts to establish effective financing responses to address the supply-side constraints of the finance market. One is supporting the development and sustainable implementation of bankable projects that perform well in relation to reducing emissions efficiently at scale and/or reducing vulnerabilities in a cost-effective way. This will require supporting the development of the project as well as the establishment of diverse financing structures capable of financing a variety of sectors. Another is providing support to financing facilities that are structured for a diverse range of financing contributors at fund and project levels (public/private), and that maintain flexibility with respect to the type of support (debt/equity) and type of entity supported (local government, state-owned enterprise, company and household). Providing structure to foster aggregation where investments are small, as is often the case in intermediary cities, can be particularly useful for such cities.
These interventions are common across countries, but their depth and sophistication will differ according to the human and financial capacities of the cities and relevant institutions. Because of this differentiation, a general typology of climate finance mechanisms is difficult to develop. However, the structures outlined in Table 5.1 have been, or could be, used for climate finance in intermediary cities.
Table 5.1. Typology of climate finance mechanisms
Source: Authors’ own elaboration.
Of specific interest are OECD institutions and sovereign wealth funds. These institutions have huge resources, but they also have very specific requirements in relation to mobilising their funds. To move resources at scale as envisaged by the initiatives announced at the 2021 UN Climate Change Conference (COP26),7 OECD institutions need to be able to tap into a liquid pool of products that meet the criteria and credit ratings established in their major asset allocation strategies, which are in turn based on qualifying projects or corporate investments. Key to increasing institutional investor allocation to climate-related investment is to ensure that these investments compete on a risk-return basis over different time horizons. This is because institutional investors have varying appetites for risk, investment preferences and constraints. Pension funds and insurers have to invest in accordance with the “prudent person principle”, achieving required security, profitability, liquidity and quality (Kaminker, 2013[38]). In addition, in order to achieve higher allocations to low-carbon solutions, many sovereign funds would need to undertake major investments in capacity building – at the levels of board, management and staff, and across several areas. They would need capacity to engage with portfolio companies on climate-related issues; capacity to select and monitor asset managers based on their climate-related performance; and, for the stronger sovereign funds, capacity to invest directly in low-carbon infrastructure (OECD, 2020[39]).8
Any of the financing structures outlined in Table 5.1 can potentially be augmented with the GCF, Global Environment Facility (GEF), CIFs or development assistance finance to increase potential concessionality, given appropriate partnerships. These different mechanisms address different UIAs. A given country will almost certainly need more than one type of climate financing structure to address the range of UIAs in intermediary cities.
Where mechanisms are not specifically designed to focus on climate projects, they can be made so by applying a relevant taxonomy and changing the project-level assessment criteria to screen for quality climate-positive projects. The GCF has an assessment process that is applicable at project level. While not perfect, its investment framework does take into account both specific climate outcomes and a range of non-climate factors that are critical to ensuring that a project will actually be implemented. An example is the Shandong Green Development Fund (SGDF) project (described below).
Figure 5.6 sets out the GCF’s investment criteria, which were used to assess the SGDF (GCF, n.d.[30]). After initial screening through a modified Peoples’ Bank of China (PBOC) taxonomy, the impacts of the project were assessed across multiple metrics and quantified. Such assessments consider the levels of GHG reduction and adaptation benefits; the project’s potential for scaling up and replication (paradigm shift); delivery of co-benefits/sustainable development (e.g. pollution reduction and employment); value added of the financing; the capacity of the proponent to implement (needs of recipient and ownership); as well as efficiency and effectiveness. The resulting performance of the project determines the level of concessionality awarded.
Figure 5.6. Global Climate Fund investment framework
Source: Adapted based on (GCF, n.d.[30]).
Example of an IFI-catalysed blended facility
According to the Asian Development Bank (ADB) the Shandong project responds to the key challenges facing climate finance in China by using blended finance and leveraging private-sector funding (ADB, 2021[40]). As identified by China’s Ministry of Finance (MOF) and the ADB, these challenges are: a) a lack of viable climate positive projects, particularly new technology projects; b) inability of the capital market to address higher-risk profiles of climate investments and to attract private, institutional and commercial (PIC) finance to such investments; and c) inadequate systems for defining, monitoring and evaluating climate investments. Given the scale of the problems in relation to green investment in Shandong Province, and its previous track record with IFI financing, the MOF approved Shandong as a pilot for the Green Finance Catalyst Facility (GFCF) concept in China, which led to the establishment of the SGDF. The SGDF provides finance for intermediary cities (by Chinese standards). Figure 5.7 shows the financial structure of the SGDF.
Figure 5.7. Financing structure of the SGDF
Source: Adapted based on (ADB, 2021[40]).
The GFCF concept constitutes a powerful mechanism for leveraging finance for climate investments. The basic form of the concept is to establish a green window within a credible and capable national financing institution that can act as the conduit for both international concessional and private finance flows to climate projects that are “warranted” as climate positive through a robust assessment process. Critical is the capacity to include PIC finance into the facility itself and at the project level. It is replicable in many forms: it may be based in a government entity, a national development bank or a private-sector financial institution.
Certain key characteristics need to be present for effective operation of the GFCF concept. One is the capacity to blend effectively and support a variety of financial instruments as appropriate to client needs. Project development capacity will be necessary to achieve required scale and quality, especially in small, poorer countries. The facility must also be able to design access to concessionality (enough to compensate for external benefits) for a particular project, in cognisance of: a) target market; b) local capital market; c) participating organisations (banks, development banks, pension funds, etc.); d) clients (companies, local governments, development co‑operation, utilities, etc.); e) concessionality (for example, an incentive reduction in the interest rate applicable to a good-quality climate investment, as determined by standards attached to the taxonomy); this must be linked to project climate performance. The facility also needs to be able to provide effective feedback, knowledge and learning to national and provincial/state policy, and it must be open for, and structured to able to utilise, the range of sources of finance, including the need to achieve an appropriate credit rating if international institutional money is sought.
An example of direct subsovereign lending
The EBRD engages with independent borrowing entities (usually utilities), which in turn have clear contracts with local or state governments. The contracts can be in the form of public service agreements or contracts (PSAs/PSCs); local governments warrant their payment to the utility and supply any subsidy if needed (EBRD, n.d.[41]). Local governments also enter into agreements with the EBRD called municipal support agreements (MSAs). Figure 5.8 illustrates how these structures operate within the range of EBRD subsovereign instruments. The model generally applies to a utility company, such as a municipal transport operator. The operator’s revenue model is “ring fenced” by a binding agreement (the PSC). The local government also agrees that it has the responsibility to ensure repayment to the EBRD (the MSC). The EBRD then lends to the operator and is repaid by them. The use of insurance helps to reduce risks.
Figure 5.8. EBRD Municipal Support Agreements
Source: Adapted based on EBRD (n.d.[41]).
Although the EBRD and the International Finance Corporation (IFC) are exceptions in that they are able to retain a significant amount of subsovereign finance in their portfolios, their investments have mainly been project by project for a particular sector. In principle, the model could be used by private international banks, but the transaction costs for such entities are high at the subsovereign level in emerging market and developing countries (EMDCs). The mechanism can be applicable directly to intermediary cities, and indeed has been used in regions such as Eastern Europe. But the principle can apply to utilities that span several local governments, such as water district agencies in the Philippines (LWUA, n.d.[42]).
An example of NDB-led financing: Aggregation structures for smaller local governments
The capacity to aggregate smaller investments has been developed in India by the Tamil Nadu Urban Development Fund (TNUDF) over many years. The TNUDF has long had a pooled lending instrument that provides loans to groups of smaller cities. Lending based on its balance sheet still predominates in its portfolio, but it has also set up a Water and Sanitation Pooled Fund (WSPF-Special Purpose Vehicle) capitalised by bond issuance taken up by Indian institutional investors. The projects were selected by 13 small and medium urban local bodies (ULBs). The WSPF has a separate management structure managed by banks. There is a debt-service reserve fund capitalised by the state government; individual ULB escrow accounts and debt-service reserve funds; a state revenue-intercept mechanism; and a United States Agency for International Development (USAID) partial credit guarantee for the bonds.
Given the success of this transaction, similarly structured bonds have been issued In Tamil Nadu and Karnataka states. In 2006, the government of India established a central government office accountable for scaling up pooled funds across the country at the state level. This office, the Pooled Finance Development Fund (PFDF) Scheme, was intended to provide credit enhancement facilities to urban local bodies based on their creditworthiness, enabling them to access market borrowing through these state-level pooled funds. Figure 5.9 shows the structure of the TNUDF.
Figure 5.9. Structure of the Tamil Nadu Urban Development Fund
Source: Adapted based on FMDV (2021[43]).
Example of the use of local capital markets
Some cities can address the aggregation issue through issuance of general aggregation bonds or, for climate projects, green bonds, which allow a range of projects to be financed with one instrument. Generally, this course of action is more open to larger cities, such as Johannesburg. However, there is a problem in that the transaction costs for such bonds are higher than for loans. This has been solved in some countries, such as Sweden, where smaller local governments participate in a joint financing mechanism, Kommuninvest, that issues green bonds to finance their collective portfolio (Kommuninvest, n.d.[44]). This is an effective way to spread the costs of issuing green financing instruments over numerous investments from a number of local governments. Critical is the rigorous evaluation of candidate projects for their climate eligibility and strong monitoring, reporting and validation (MRV) systems that verify that the claimed performance is actually achieved, as confirmed by an independent evaluator. These systems provide the infrastructure for the issue of green bonds. Also of note is the wide range of eligible sectors. Figure 5.10 shows the key characteristics of Kommuninvest.
Figure 5.10. Characteristics of the Kommuninvest Green Bonds Framework
Source: Adapted based on (Kommuninvest, n.d.[45]) and (Albuquerque, 2020[46]).
An example of national private-sector financing
As private-sector financing depends on capturing a stream of revenue to make a profit, it has mainly been used on mitigation-related projects, especially those related to energy. One example is the use by Philadelphia of a power purchase agreement (PPA) to finance the conversion of the source of the city government’s power to renewable energy (City of Philadelphia, 2020[47]). A private renewable energy company entered into the PPA with the city, agreeing to build 80 megawatts of installed capacity, and the city agreed to pay the power provider what it would normally pay for power. Such arrangements depend on the ability of independent producers to “wheel” power across the grid to consumers. But other arrangements are possible, such as the use of energy service companies when they commit to reduce the government’s energy bill in return for a share of the savings. Such arrangements are becoming more common in EMDCs but still face some regulatory and financing constraints (Ellis, 2010[48]).
City climate funds
A city climate fund is an institution set up to finance projects that reduce emissions or improve climate resiliency. The design and operation of these funds vary by city, but common themes include a degree of independence from political decision makers in making investment decisions; specialty finance projects and terms; and investment decision criteria linked to a city’s broader environmental, social or economic policy objectives. There are numerous examples of city-based climate funds (C40, 2016[49]). They vary in size, but in intermediary cities they will tend to be relatively small. Well-documented examples of city funds are generally from large OECD countries. But community development and other funds are not uncommon even in intermediary cities in EMDCs; they are usually financed from general revenue or from a specific new revenue source. Extensions of such funds, or green windows within them, can be a base for attracting other contributions from local, national and international sources. In 2020, Baguio City in the Philippines set up a green financing mechanism funded by an environmental users’ fee.
Recommendations for action to facilitate access to climate finance
This chapter has been structured by consideration of the demand and supply sides of the climate finance market. This section provides recommendations for action, which will be structured as:
demand-side actions on the part of national, subnational and local governments, and UIAs, with the aim of strengthening their capacity to finance climate projects
supply-side actions by national and subnational governments with the aim of strengthening the enabling framework for climate financing
actions by the international community to support the demand- and supply-side recommendations.
These actions need to produce transparent processes for defining clear city climate objectives and for detailing the programme of investments that will meet those objectives. For the required investments to be financed efficiently, they need to be structured as financing mechanisms that are appropriate to intermediary cities. Competent and effectively mandated implementing agencies need to be assigned clear responsibility for: investments in green infrastructure; enterprise capital for renewable energy (RE) and energy efficiency (EE); cluster support systems; and human capital development. These can be initially linked to COVID-19 recovery, but as recovery from the pandemic proceeds they will need increasing emphasis on the implementation of nationally determined contributions.
It is important that the demand and supply sides of the climate finance market be strengthened together. Strengthening financial institutions will be of limited use if cities do not have the fiscal space or capacity to utilise the available finance, on both sides of the market and at national and subnational/local levels. As such, interventions need to address structural issues, the enabling framework, regulatory issues, operational issues and capacity-building needs.
Extensive examples of operational instruments on the demand and supply sides of the market have been set out above. Their effectiveness depends on the strength of enabling frameworks and other capacity support structures. Figure 5.11 llustrates the process of defining the key actions at both national and sub-national levels. In this process, the enabling frameworks, the institutional structures for implementation of climate investment and the supporting capacity development systems need to be assessed.
Figure 5.11. Analysis of the demand and supply sides of climate finance
Source: Authors’ own elaboration.
Priority actions for addressing demand-side constraints
For urban climate finance that is accessible to intermediary cities, national governments should promote better governance structures and effective enabling frameworks. Key actions include:
localising NDCs. Processes can be designed for designating responsibilities to subnational governments for making the required investments under the NDCs and for matching these with resources.
establishing adequate structure and incentives for intergovernmental fiscal transfers. In terms of required resources, transfers are likely to have a substantial role, especially for intermediary cities. These transfers need to make up for local resource shortfalls, as determined by local revenue-raising capacity versus needed investment levels. They should be structured to maximise the incentives for local revenue mobilisation and be both flexible and encouraging of innovation in using and leveraging them (Martinez-Vazquez, 2021[50]).
creating market incentives in NDC sectors and green government finance. For many NDC-related investment sectors, such as energy, significant non-transparent subsidies can be present and/or regulation complicates the entry of alternative service providers. In many cases, such subsidies are well intentioned and aim to benefit lower-income groups. However, such structures make entering the market difficult for suppliers using lower-carbon processes or more effective means of resource use/reuse. Making such subsidies available in non‑distorting ways, and incentivising green procurement processes, can open additional investment pathways. Enabling the creation of flexible partnership structures for investment through the use of regional utilities and area-based development corporations (as in the Pune example), each with their own sustainable funding sources, can also open new investment pathways (for example, using PPPs). Green budgeting – the tracking and maximisation of resources deployed to efficient climate investments – needs to be strongly promoted (OECD, 2022[51]). This approach allows local governments to align expenditure and revenue-raising decisions with their green objectives; prioritise green and resilient investments; identify funding and financing gaps; and mobilise additional financial resources to bridge these gaps.
Local governments, in the above context, should:
establish urban climate planning and project development systems. This may entail setting up mechanisms of planning for implementation of localised NDC investments, undertaking city climate assessments (mitigation and adaptation), and developing climate action plans (with project pipelines and budgets).
set up corporate structures and local area development. Intermediary cities and networks of small and medium-sized cities should assess the most efficient spatial unit of investment for localised NDCs and design appropriate organisational structures to finance and implement required NDC investments. These actions should take into consideration interjurisdictional structures that include a number of local governments, such as a metropolitan authority, a development corporation, a regional utility, etc. As part of the structuring of such entities, consideration should be given to enabling them to provide planning and other incentives for green development.
promote green financial management. Local governments and other UIAs need to maximise their own source revenue using green taxes and fees where possible. They should adopt green procurement processes, maximise the use and leverage of their assets in green investment (land, etc.) and structure to maximise the leverage of PIC finance. In addition, UIAs need to adopt and adhere to the principles of green budgeting, internationally recognised accounting standards and other means of transparent and accountable financial management.
Addressing challenges related to operational and implementation issues on the demand side of climate finance requires the following actions:
project development support. Local agencies, particularly those in intermediary cities, may need support to develop projects suitable for climate finance. National support for local governments and other UIAs in establishing climate risk assessments and GHG baselines can be important, together with advice on options for project financial structuring. This support should also foster a structured process of city climate planning such as the C40 Climate Action Planning (CAP) process, which defines the investment programme that will enable the city to deliver on its fair share of NDC commitments (or Paris targets if NDCs are insufficient). In the post-COVID-19 context, these investments need further economic resilience and employment. Such support can be provided via a dedicated facility or sectoral ministries.
technical support. Many UIAs may not know which technical options exist for NDC-related investments that are applicable to their particular circumstances. International sources of support for technical assessment are available, for example through the Climate Investment Funds (CIF, n.d.[52]) and multilateral development banks. Such support can be provided via a dedicated facility or sectoral ministries.
In this context, local governments should:
establish urban investment agencies. These agencies need to be mandated to develop green investment programmes, aggregate projects for efficient financing, assess projects as per appraisal systems (see below) and build climate project development and structuring capacity, including through local consultants and/or local tertiary institutions, etc.
implement investment appraisal systems. These systems need to be able to assess the viability of a programme of investment. They need to take into account: the scale of resources needed; the fiscal context of the UIA; the financial risk associated with the investment; the operational risk, including the availability of service; access and reliability of performance; the cost and affordability to consumers; and the complexity of proposed implementation structures relative to the UIA’s technical capacity. The UIA should also be able to obtain expertise to assess the mitigation and adaptation benefits of a project, as well as its eligibility for required licences, its financial viability, other co-benefits and compliance with safeguards.
Addressing capacity gaps in access to climate finance requires multistakeholder engagement by national and local governments. Actions may include:
building capacity development institutions. National governments should establish and disseminate best practices in climate technologies, green budgeting and technical and financial assessment through local government academies, professional development mechanisms and other means, ensuring that there are no barriers to the participation of intermediary city participants.
promoting multistakeholder involvement. National governments should undertake dialogue with policy makers from intermediary cities and CFOS with financial institutions to build databases of city financial data and performance in NDC sector investment. They should open pathways for NDC investment by developing systems for assessing, monitoring and evaluating climate investments. This will provide data that can support investment risk assessment and project design.
promoting international support. There are multiple avenues of international support for project development (CFF, Gap Fund, etc.); NDC implementation (NDC partnership, UN-Habitat, etc.); and policy development (IFIs, GEF, OECD, etc.). Special facilities are available to some LDCs and SIDS, often at a regional level (e.g. PRIF). National governments should encourage and support intermediary cities to band together and merge their potential project pipelines in order to achieve the critical mass of investment needed to justify the engagement of such agencies and facilities.
Figure 5.12 and Figure 5.13 summarise demand-side actions that can be taken at the national and subnational levels to facilitate the access of intermediary cities to climate finance.
Figure 5.12. National actions for facilitating access to climate finance
Source: Authors’ own elaboration.
Figure 5.13. Subnational (city) actions for facilitating access to climate finance
Source: Authors’ own elaboration.
Priority actions for addressing supply-side constraints
On the supply side, national governments need to foster capital market institutions, which address higher risk profiles of intermediary cities and their enterprises. These are structures such as those used by TNUDF in India and Kommuninvest in Sweden. Key actions that national and local governments can take to enhance the enabling frameworks of supply-side climate financing include:
greening the financial system. National governments need to put in place a regulatory and reporting framework for green instruments (green bonds, insurance, etc.) that are accessible to UIAs. They also need to create incentives to maximise the deployment of these green instruments. Climate and transition risks need to be incorporated in macro prudential regulation (to avoid stranded assets, etc.). It is important to ensure that regulations and processes do not inadvertently exclude UIAs in intermediary cities (for example with minimum revenue levels).
greening government finance. Government financing needs to refocus revenue mobilisation by taxing “climate bads”, such as GHG emissions, pollution and congestion, with green taxes and fees. In doing so, governments should ensure that assistance for transition is available to smaller cities, which may be more reliant than larger cities on small-scale vehicular transport. Generalised debt limits and restrictions on PPP for green investment could be revived to ensure that intermediary cities are not disadvantaged.
capital market regulation. National governments can maximise potential financing for climate investments through local institutions by, for example, including NDC-sector infrastructure in permitted investments in pension funds and insurance. National governments should track NDC-sector expenditure by capital market participants. They should ensure that access to finance by intermediary cities is maintained by enabling the use of support aggregation structures, whereby a number of smaller investments can be bundled into a financing structure.
In this context local governments should:
identify opportunities for greening finance planning. Subnational agencies need to be able to assess opportunities for the use of green financing instruments in the context of the investment needs of intermediary cities and their ability to undertake the funding/revenue mobilisation required for debt service and counterpart funding. Each of the instruments – green bonds, green insurance, equity, etc. – will have structural prerequisites. For example, In the case of equity, a corporate vehicle is needed. Potential green finance sources (green facilities) must be assessed in relation to the conditions they require, for example the establishment of specific MRV systems.
establish local climate finance instruments and incentives. Subnational agencies will need to establish a regulatory base for new funding instruments/incentives, such as land value capture (LVC), in order to establish a funding base for UIAs. They may also need to develop a regulatory base for financing structures that support the use of aggregation instruments by financing institutions.
National governments also have a large role to play in implementing actions to address capacity gaps in the supply side of climate financing. Actions can include:
development of taxonomies. Taxonomies define what is “green”, and it is important that the definition be clear. The OECD has made specific recommendations on taxonomies applicable to governments (OECD, 2022[51]). To this end, it will be necessary to nominate a lead agency (Central Bank, Ministry of Finance, etc.) to co‑ordinate and oversee the development and use of MRV systems. Finance ministries have a key role in facilitating the dissemination of systems to financial institutions and their clients. Special outreach systems may be required for the CFOs of intermediary cities.
establishing technical support for green instruments. Finance ministries and associations of financial institutions will have a key role in fostering the dissemination of appropriate structures and the capacity to assess and structure green investments and to utilise such instruments as green infrastructure debt/equity funds and green bond systems. It is important to reiterate that support for financial institutions and their clients regarding the use of these instruments may be necessary.
establishing catalyst facilities. In order to catalyse financing of NDC-linked investments, special-purpose financing facilities may be needed (such as the Shandong Green Development Fund, discussed above). This is necessary to address issues of unfamiliarity with investment types and instruments and to leverage government finance. Such facilities can be stand alone or developed inside a public or private financial institution (typically a national development bank), and may include project development capacity, use of blended finance to leverage PIC finance and other aggregation instruments. The aim is to improve accessibility for UIAs with smaller investments (in particular, in intermediary cities).
In response, local governments should:
implement green financing systems. Subnational governments (or groups of local governments) can establish local green funds and develop mechanisms such as PPPs to leverage their own resources or those of established funds. They need to prioritise lowest-cost funds for non-revenue earning projects (whether or not these funds are labelled “green” or “climate”), and to use higher-cost financing for more financially viable projects. Local funds should also consider using instruments that enable the aggregation of small projects.
implement green funding systems. Subnational governments should implement new green taxes/fees, including LVC-type taxes, etc. Where structures are developed in partnership with other stakeholders or governments, taxes and fees on pollution, such as congestion charges, ensure that the mechanisms of cost sharing and co‑investment are clearly established and sound.
In relation to reinforcing capacity, national and local governments should:
build required capacity development. National governments can encourage capacity development institutions to establish and disseminate best practices in climate technical and financial assessment and in MRV systems focusing on investments in NDC sectors. These are institutions such as banking associations and institutions providing professional development for the staff of financial institutions.
facilitate international support. International agencies can support the development of appropriate enabling environments and operational measures, including with the provision of finance. Numerous projects have been structured to include access for intermediary cities. Specifically, IFIs, the EU, GCF and GEF have supported blended finance facilities. The NDC partnership, UN-Habitat, the Green Bank Network, IFIs, GEF, development agencies such as Germany’s GIZ, and the OECD have supported the development of more effective enabling environments. Development banks in some countries have support facilities such as project development assistance for intermediary cities, and sometimes for specific sectors, such as low-carbon transport.
Figure 5.14 and Figure 5.15 summarise supply-side actions that can be taken at the national and subnational levels to facilitate the access of intermediary cities to climate finance.
Figure 5.14. National actions for addressing supply-side constraints
Source: Authors’ own elaboration.
Figure 5.15. Subnational actions for addressing supply-side constraints
Source: Authors’ own elaboration.
Conclusion
Intermediary cities in developing countries will require huge resources to meet the challenge of a warming climate. Their investment needs on the path to becoming low-carbon and resilient cities require access to climate finance, but at present they face major constraints in accessing the climate finance market. To overcome these constraints, it is important that the supply and demand sides of the climate finance market be strengthened together, as strengthening financial institutions will be of limited use if cities do not have the fiscal space or capacity to utilise the available finance.
On both sides of the market, and at national and local levels, interventions need to address structural, enabling framework and regulatory issues, operational issues and capacity-building needs. On the demand side, competent and effectively mandated implementing agencies need to be assigned clear responsibility for investments in green infrastructure, enterprise capital for renewable energy and energy efficiency, cluster support systems and human capital development. On the supply side, actions need to be taken by national and subnational governments with the aim of strengthening the enabling framework for climate financing. Measures by the international community are also needed to support these actions.
To be able to implement the scale of investment required to meet the Paris targets, all financial flows must henceforth be viewed as potentially climate finance. It is important to strengthen networks of local governments to enable them to lobby higher levels of government to ensure that the support provided for climate finance is accessible to intermediary cities. The accumulation and dissemination of best practices can be fostered through entities such as the Cities Climate Finance Leadership Alliance, while international support is needed to further comparative research and assessment of best practices globally in relation to the structures for urban climate finance for intermediary cities.
It is important to strengthen the networks of local governments to enable them to advise and lobby higher levels of government to establish relevant enabling frameworks in place and ensuring support provided is accessible to intermediary cities. National and local government associations will have a key role in this effort and international organisations should mobilise international urban networks such as UCLG and GCoM to strengthen these associations.
The accumulation and dissemination of best practice can be fostered through entities such as the Cities Climate Finance Leadership Alliance (CCFLA) and its partners. CCFLA could be resourced to further develop activities focused on the needs of intermediary cities under its action groups. In addition, international support to further globally comparative research and assessment of best practice needs to be undertaken in relation to the structures for urban climate finance for intermediary cities.
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Notes
← 1. In this data set, OECD defines “big” as cities with more than 1 million inhabitants. Thus some cities that are regarded in larger economies such as China and India as intermediary cities are excluded from the “intermediate” categorisation.
← 2. In this document we use the words “green” and “climate” interchangeably, but it is important to note that green investments may include investments that are not climate relevant – for example, an investment that reduces a specific non-GHG pollutant may be “green” but is not a climate investment. Although most climate investments are green, in some circumstances it is possible that a climate investment could harm biodiversity and thus not be “green” in that sense. “Sustainable,” an even broader concept that encompasses not only environmental but also economic and social sustainability, is also discussed when appropriate.
← 3. Project implementation structures in which governments have a key role in structuring the project so that the private sector can participate – usually by providing finance, technology and management expertise – in a way that adds value to the project.
← 4. Transport networks where efficient transfers of freight and people among different types of transport are facilitated by purpose-built facilities and IT solutions.
← 5. Good governance, as it relates to climate finance, is the capacity and willingness to mobilise revenue efficiently and deploy that revenue in a consistent, transparent and accountable way to maximise the climate outcomes of investments.
← 6. Smolka O, (2013) Implementing Value Capture in Latin America: Policies and Tools for Urban Development Martim. Lincoln Land Institute. Washington DC. https://www.lincolninst.edu/publications/policy-focus-reports/implementing-value-capture-latin-america (accessed 7 December 2021).
← 7. For example, the Glasgow Finance Alliance for Net Zero.
← 8. OECD (2020), The Role of Sovereign and Strategic Investment Funds in the Low-carbon Transition, Paris. https://www.oecd-ilibrary.org/sites/ddfd6a9f-en/index.html?itemId=/content/publication/ddfd6a9f-en (accessed 7 December 2021).