Various Financing Mechanisms
There are many financing mechanisms and incentives that can promote decentralized sustainable energy investments in the SEMCs region. Various financiers can play complementary and differentiated roles and responsibilities, such as commercial banks, multilateral development banks (MDBs), regional development banks (RDBs), and United Nations organizations. (UNs), government institutions and the private sector, as well as public-private partnership instruments, pension funds, or sovereign wealth funds. Five comprehensive forms of financing mechanisms can be identified, as described in the following sections.
Grants and capital support: Governments, development partners and financing institutions usually provide grants and capital subsidies for projects that are not considered technologically or commercially viable, allowing developers and entrepreneurs to opt out after meeting pre-specified conditions. They help reduce costs for producers and beneficiaries alike while de-risking investments and expanding markets. The ultimate goal is usually to enhance the fairness of the distribution of income or wealth by addressing capital market inefficiencies that exclude access or discriminate against some groups. Such grants should be designed to ensure fair competition and overcome market entry barriers while leveraging private financing mobilization in a sustainable way beyond their term.
Green loans, bonds, and Sukuks: Green loans, bonds, and Sukuks are typically used to finance new sustainable energy projects, or expand an existing project or programs in the form of loans and bonds. Financial institutions and government agencies provide loans while bonds and sukuks are issued to the capital market. Loans can be in the form of senior debt, lines of credit, soft loans, subordinated debt and lease financing. Senior debt and lines of credit obtained from both the public sector and local banks give low returns, expose low risks to investors, are repaid first before all other obligations and are secured with guarantees which is a major concern for many beneficiary groups in different countries. This is why soft loans at low interest rates with long grace and repayment periods are of particular interest to consumer groups seeking decentralized sustainable energy solutions. Subordinated debt is debt in which investors are offered a fixed interest rate that is paid before repayment to equity holders but after the senior debt is settled. Subordinated debt is less common in financing sustainable energy projects and is mostly used as a form of mezzanine financing. There is a noteworthy global trend, which is financing the project with cooperation from more than one party, where a group of banks provides loans to the project as a non-recourse loan. Here, the project assets and power purchase agreements are considered collateral for the loan and are repaid from the project’s cash flows only and not from the company’s income. Banks currently prefer project financing over corporate lending due to increased oversight of projects as well as the possibility of sharing credit risk among banks involved in project financing.
Lease or right-of-use financing is provided by the equipment manufacturer, third-party lessor, and vendors to allow beneficiaries of sustainable energy projects to use energy production equipment without purchasing it through an off-balance sheet operating lease or an on-balance sheet capital lease. This financing structure is fast, simple, and accessible with low contractual complexity. A common example is leasing or renting a solar electricity system, where the owner of the system provides the energy produced to a different consumer (or group of consumers) and may also benefit from tax breaks. Depending on the type of lease, at the end of the lease term the consumer may have the option to buy the asset, return it again, or extend the lease term.
Green bonds are debt securities issued by governments, banks, or companies in the capital market to acquire an existing sustainable energy project or develop a new project as well as to build related infrastructure, implement efficiency measures or implement adaptation measures in industries and cities facing climate change risks. Bonds are repaid from the projects’ cash flows, usually through a fixed or variable coupon. Bonds are increasingly gaining interest as a cheaper source of financing compared to commercial loans because bond interest is tax deductible. There are many different forms of green bonds and they are all rated as AAA securities by many financing institutions to speed up the process of raising capital for green projects from socially and environmentally responsible investors who require fixed income securities.
Sukuk are Islamic bonds, that are securities that provide their holders with ownership rights and reveal the risks related to the underlying asset or project. They provide the owner of the sukuk with fixed returns (in the case of Murabaha or Ijara sukuks) or variable returns (in the case of Musharaka or Mudaraba sukuks. Sustainable energy businesses can likewise issue green sukuks to raise funds for their projects. Sukuks are used by the issuer to borrow money from sukuk holders to purchase assets, start a project or implement a project. The concept of sukuks is in accordance with Islamic rules (Sharia), as transactions must be free of interest, speculation, and activities harmful (such as alcohol, tobacco, etc.) and must be linked to physical assets that represent the center of ownership. The growth of the sukuk market was not limited only to Islamic countries, but it began to expand globally.
Capital and Equity: Equity is the capital raised from individuals or shareholders in a company or project to obtain a return through net profits that are distributed or from the sale of shares. It increases financial solvency by freeing up cash flows, but it involves the highest risk and cost among all financing sources as shareholders have a residual claim to the company in cases of dividends and liquidation and expect higher returns. Capital can be raised through multiple channels, such as a venture capital fund, a private equity fund, or by issuing an initial public offering on the capital markets. Venture capitalists are typically found more in the early stages of venture investing anticipating high risks but also high returns. On the other hand, private equity investors prefer to invest in mature stages of projects with the hope of obtaining a safe exit within 3 to 5 years after returning their investments. A noteworthy trend in the SEMCs region is the involvement of pension funds and sovereign funds as equity investors. They offer a significant amount of money as they look for stable profits and strong growth over the long term that could extend to 25 years or even more if technology allows.
Tax Incentives: Tax incentives are government incentives typically used to encourage private investment, production, and consumption of sustainable energy. A prominent feature of tax incentives is the increased availability of cash for investors and their liquidity position. Investment tax credits, property tax reduction, indirect tax reduction, production tax credit, value-added tax reduction, import duty reduction, accelerated asset depreciation, tax exemption, tax incentives for research and development, domestic equipment manufacturing, fossil fuel tax, and carbon taxes are all examples of possible policy measures to promote sustainable energy projects. These incentives also provide many social and economic co-benefits such as job creation, poverty alleviation and improving the productive capacity of the economy.
