Innovative finance for cities tackling the net-zero carbon transition

EIT Climate-KIC partner Bankers without Boundaries (BwB) is a not-for-profit financial advisory firm that works on projects with an environmental and/or social impact. Read on for a lightly edited extract from BwB’s original blog post describing interesting insights on innovative finance from BwB and other “design partners,” which emerged during their work on EIT Climate-KIC’s Healthy, Clean Cities Deep Demonstration.

Bankers without Boundaries has been working as one of a number of design partners with EIT Climate-KIC, the EU’s main climate innovation initiative, in a Deep Demonstration programme called Healthy, Clean Cities. We are partnered with 15 cities across Europe working collaboratively to create strategic experiments to test new ways of achieving climate change mitigation and adaptation and scaling these initiatives to drive the required level of change. This involves combining technical innovation, policy, regulation, governance, engagement, and finance to create new ways to tackle the transition to net-zero carbon in the urban environment.

 

What is “innovative finance”

What do we think of when we hear the term “innovative finance”? The most obvious component is new ways to raise finance, however it is much more than just that. As a simplification we think of three areas.

  1. Raising money

The first as stated is the ability to go out and raise money for existing spend requirements—we have a project with a funding gap—how can we “innovatively” raise money to pay for it? We are talking with a number of cities in Europe about the potential to directly raise municipal green bonds, with the proceeds ringfenced to specific climate adaptation and mitigation projects. We believe there is demand for these from the investment community.

We are also looking at a variation of this—performance-based green bonds—where the return to the investor is directly correlated to the impact that the city achieves through spending the funds raised. The cost of debt falls as targets are met creating a clear financial incentive for successful execution on plans.

Then we also work with cities on how to finance specific projects, for example, how to finance the electrification of a bus system. Essentially this usually boils down to structuring a project in such a way that a large up-front capex bill is turned into opex over the life of the project making it fit better into the annual civic budget cycle and matching the capital outflow to the benefits that accrue such as reduced fuel and maintenance costs.

Finally, while maybe a smaller component in terms of potential to raise money, there is growing interest in community investment structures where citizens themselves can invest in the transition of their neighbourhoods. This can be valuable in terms of engagement and helping drive some of the behavioural changes that will be required.

  1. Creating an innovation led community

The second area that we do a lot of work on, is more broadly how to use financial tools to enable a community led culture of innovation around the green economy. We know that we don’t have all the answers today to fix the issues that need fixing. Entrepreneurialism will have to play its part in finding the answers. We are working with cities to set up city run green angel investment funds, seeded by public money but also looking to partner with the private sector. Giving grants out to early-stage local projects and ideas to turn them into investible start-ups and then providing that all-important early seed funding through angel equity stakes. Building incubation capability to help that start-up sector not just with money but in other ways to improve chances of success. By doing so, over the medium term, the city can participate in the upside of successful start-up businesses and align them with the city’s own climate missions as well as generating a return so that the capital can be recycled and help further businesses. We are also working with other cities to set up funds specifically to drive the circular economy sector again targeting specific areas of the economy that will enable the city’s broader goals.

  1. Switching to an investment mindset in project design

The third area is perhaps the least explicitly tangible, but in our view the most important and is what we will concentrate on in the remainder of this note. It comes back to how we create projects in the public sector that are fit to be invested in by the private sector given the huge amount of money required to do everything that we need to do.

This is about designing the responses of cities to climate change in a way that maximises their potential to be funded. We will illustrate with some specific examples. How we can work directly in a collaborative way with teams of city staff on the problems that they are trying to address, across built environment retrofit, large scale development, green infrastructure, mobility transition, behavioural change etc. Based on our experience over the last nine months, this is where the EIT Climate-KIC programme comes into its own. By bringing together a range of smart individuals from multiple disciplines and then working together with engaged and ambitious city staff across different often siloed departments, plus other actors within the city like academic institutions, industry leaders etc., there is a collaborative effort combining best practices from around the world with deep local knowledge. This is building relevant, ambitious and innovative projects, initially through tests of change, that can show us what will and won’t work—learning-by-doing and learning at times by failing. This isn’t about acting as consultants to cities with a menu of off the shelf solutions, but acting as collaborators, co-creators to drive change in a specific environment.

From a finance perspective this is most often about timeline. Business As Usual in a city tends to be 12 months forward planning and lends itself to an incrementalist annual budget mindset—which is totally appropriate to the normal business of running a city. Prioritising between competing projects with a limited annual budget to nudge as many things forward as possible year by year. The challenge posed by decarbonisation is of a totally different timescale. We are talking about decade-plus long investment programmes. We are talking in many cases about transitions to completely different systems of operation. And programmes that are of a completely different financial scale (e.g the retrofit example given earlier) but often with some very clear direct returns over a long payback period, potentially a nice fit for pension type investment profiles. This requires thought about how to internalise some of those benefits.

 

Green infrastructure

As an example, let’s consider green infrastructure: Milan, a city of 1.9 million people, is in the process of planning to plant and then maintain three million trees across the city centre at a considerable cost. But there are also considerable benefits. Mental and physical health of inhabitants improves, with a positive impact on healthcare requirements. Water runoff and flood risk are abated, with impact on water company capital budgets. Real estate prices go up. Propensity to spend in commercial districts improves. Air conditioning costs are reduced through anti-heat island effects. How can we think of a tree planting programme as a utility and an investment programme rather than as a green vanity project? How can we leverage real-time data technologies to track and measure co-benefits? How can we co-opt other budgets in, to share in costs, as a preventative measure? How can we engage with communities to ensure maximum impact? How can we turn some of those benefits into direct monetary return for the tree planting agency so that up-front costs can be financed?

This is what we refer to as the investment mindset.

 

New urban development

Another example common to many cities are large-scale urban redevelopment plans, where a neglected area, perhaps post-industrial, is put forward for regeneration. When we look at these kinds of projects, they tend to be thought of in fairly traditional terms as a typical public urban redevelopment project. Residual land value methodology, to bring private developers in to take away risk and some of the cost. There is often a lot of talk about how to turn these new communities into examples for a new way to build a community and a built environment; to demonstrate net-zero build techniques and renewable energy generation, but, all too often, that comes up against the hard economics of the traditional development model which is overwhelmingly focused on how much is it going to cost and how we can defray as much of that cost as possible from the public purse. Almost inevitably this ends up with a huge value transfer to the private sector based on land value uplift with all the unwanted consequences of that model—developers who are incentivised to minimise cost (and therefore standards) and push up sale price to maximise their profit in the near term. This drives the cycle of gentrification and unaffordable living, while retarding the development of innovative building methodologies or land economy models such as ‘design for manufacture and assembly,’ off-site construction, ‘fairhold leases,’ and community investment.

But there are wonderful opportunities to change this dynamic to achieve the real ambitions of cities. Plans often lead to large blocks of housing with ground-floor commercial spaces which are the most efficient output of traditional on-site construction techniques to yield sufficient densification in an economic way. This often leads to cities recouping little value for their land while developers gain the ability to create significant profit. Does this approach yield fantastic places to live which will support thriving communities? How can we reimagine projects looking at the incredibly diverse assets that plots of land often represent and thinking about the direct value that could be created there in terms of renewable energy generation, eco-tourism, residential rents, commercial rents, etc. and how those value streams could be used to finance parts of the up-front capital requirement. How communities could be engaged to invest in and build village-like communities of low-carbon buildings. Thinking of the whole project in effect as a long-term business opportunity rather than a short-term cost problem to be financed will help bridge the gap between budgets and the genuine ambitions of city councils. Collectively, we are very excited about the potential of council-led new developments with ambition to build new net-zero carbon communities, but these will require risk appetite from cities to try new models—the same old input will yield the same old output.

 

Deep community retrofit

A third example is going back to the thorny problem of existing building retrofit with the hefty price tag that we have talked about previously. The current model globally for achieving deep building retrofit is to encourage individual building owners to undertake the work. And everywhere you look the net result of that is essentially zero take up. We are asking building owners to take on significant debt, make incredibly complex decisions on which set of interventions to choose to minimise heat/energy demand and maximise generation for their building and then manage the various contractors in the project. All to yield long-term savings that are not actually all that attractive if going beyond superficial decarbonisation.

We are working with several cities on an alternative model to set up city-owned renovation funds. These funds would carry out deep community retrofit as a public service for all segments of the built environment regardless of ownership. And in return, the fund will contract with residents to provide long-term heat and cooling comfort with resident payments indexed from historic spending patterns (but linked to the property so they remain over time with whoever lives there not who was living there when the contract was signed). Though it is important to say that the costs could also be adjusted in certain areas as a lever against energy poverty.

With this structure, the energy savings are turned into a revenue stream for the fund and this can be used to service the debt taken on to carry out the work in the first place. By centralising procurement, significant economies of scale are generated improving the overall economics.

And the fund can work district-by-district. We believe this creates an opportunity not just to improve thermal efficiency and the net energy system of buildings but also while in-situ invest in these communities at a lower marginal cost than would otherwise be the case. For example: To add in green infrastructure or add in community assets like community centres or co-working spaces to provide a third option beyond working at home in cramped shared apartments or commuting to the city centre office, driving up resilience. So that this programme makes communities not just more energy efficient but makes them safer, more liveable places and creates incentive for communities to sign up and co-design this regeneration.

Our financial modelling in a number of European cities suggests that, while some public funding will absolutely be necessary, it can be blended with long-term impact investment from the private sector, yielding reasonable returns over a long investment horizon with fantastic positive impact credentials.

This third area is the most critical—it is about having a new set of tools within councils to think about how to tackle these issues and how to use the long-term benefits as a mechanism to raise the up-front capital. Our goal is to work with cities to come up with good ideas but in doing so also change the way cities approach these issues in the first place making us increasingly not required. The old adage of “Give a person a fish, they will feed themselves for a day, teach a person to fish and they will feed themselves for a lifetime.”

 

Governance and stewardship

The final thing to say is that the timeline of the work that needs to be done to move cities to net-zero carbon is such that it also requires thinking about stewardship and governance. This is ten to twenty years work, which doesn’t fit in neatly with our typical political cycle. Setting up governance structures in a way that avoids these programmes being derailed by politics every three to four years is critical to their chances of success. And those structures will also create the bandwidth, capacity and long-termism to drive this work forwards, mobilising stakeholders (including citizens themselves) and building shared legitimacy in the transition pursued. Other new institutional arrangements that enable regulatory and policy innovation as well as the deployment of new technology and data capabilities will be necessary to steward these complex programmes of work. 

Climate change adaptation and mitigation are unfortunately not things that can be done as an extra for already stretched staff. A strong team is required to drive the change, working in different ways with different tools and frameworks, across a city’s council departments, institutions and communities.

Read the full blog post on the Bankers without Boundaries website.

 

The information and opinions expressed in this publication were produced by Bankers without Boundaries, hereafter referred to as “BwB,” as of the date of writing and subject to change without notice. This publication is intended for information purposes only and does not constitute an offer or an invitation by, or on behalf of, BwB to make any investments. Opinions and comments of the authors reflect their current views, but not necessarily that of other group entities or third parties. Services or products mentioned in this publication may not be suitable for all recipients and may not be available in all countries. Persons interested in these products and services are kindly requested to contact BwB in order to be informed about the services and products available in a specific country. 

This publication has been prepared without taking account of the objectives, financial situation or needs of any particular investor. Before entering into any transaction, investors should consider the suitability of the transaction to individual circumstances and objectives. Nothing in this publication constitutes investment, legal, accounting or tax advice, or a representation that any investment or strategy is suitable or appropriate for individual circumstances, or otherwise constitutes a personal recommendation for any specific investor. BwB recommends that investors independently assess, with a professional advisor, the specific financial risks as well as legal, regulatory, credit, tax and accounting consequences. Past performance is not a reliable indicator of future results. Performance forecasts are not a reliable indicator of future performance. The investor may not get back the amount invested.

Although the information and data herein are obtained from sources believed to be reliable, no representation is made that the information is accurate or complete. BwB and its affiliated companies do not accept liability for any loss arising from the use of this publication. This publication may only be distributed in countries where its distribution is legally permitted.

 
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