In 2015, an international architecture for sustainable development began to take shape. Building on the United Nations’ Financing for Development Agenda in Addis Ababa and then the formal adoption of the Sustainable Development Goals in September, the year culminated in the Conference of Parties (COP) 21 in Paris. Almost 190 countries, accounting for more than 98 percent of greenhouse-gas emissions, agreed to a global climate-change strategy.1 Each country submitted a voluntary plan, or intended nationally determined contribution (INDC), that set out how it will move its economy onto a lower-carbon growth pathway. Signatories have agreed to update their progress in 2018, and the terms of the Paris Agreement envisage higher targets for the INDCs over time, beginning in 2020. With this structure in place, attention is shifting toward how to implement and finance more sustainable growth.
While the INDCs will take years to play out, one likely effect is to shift investment, both public and private, toward more sustainable projects, including infrastructure. There are already substantive changes in the financing landscape. Each of the six major multilateral development banks, for example, has committed to significantly increasing its allocations to climate finance, by as much as two to three times.2 The 20 governments that represent 80 percent of current global clean-energy research and development have pledged to double such investment in the next five years.3
This has been matched by increased interest and commitments in the private sector. A coalition of corporate leaders from around the world, the Breakthrough Energy Coalition, has pledged to invest billions in research and development of green energy.4 Major institutional investors have pledged to decarbonize their investment portfolio and to assess the carbon footprint of their assets as part of the Portfolio Decarbonization Coalition.5 As these commitments reverberate through the markets, they will reveal stubborn challenges—and also create new economic opportunities.
How countries build and operate infrastructure will be a major factor in whether they can deliver on their INDCs. In light of Paris, many countries are likely to scale up their investment in sustainable infrastructure—defined as infrastructure that is socially inclusive, low carbon, and climate resilient. Given the scale of investment required, creating the right conditions for private-sector investment is essential.
From 2015 to 2030, global demand for new infrastructure could amount to more than $90 trillion, according to the New Climate Economy’s 2014 report, Better Growth, Better Climate; the value of the world’s existing infrastructure is $50 trillion. In a sense, then, we will be literally building our world—for better or worse. Doing it sustainably will likely increase up-front capital costs by 6 percent or more for individual projects. Over a project’s life cycle, however, sustainable infrastructure can save money and generate healthy economic returns, while reducing risks and negative externalities at the local and global levels.6
Current infrastructure spending of $2.5 trillion to $3 trillion a year is only half the amount needed to meet the estimated $6 trillion of average annual demand over the next 15 years. More than 60 percent of this financing gap is likely to be concentrated in middle-income countries—those with per capita incomes between $1,045 and $12,745—and more than 50 percent in the power sector. Domestic capital markets will be pivotal to financing investment, particularly the banks, pensions, and insurance companies that are growing fast and hold more than 80 percent of institutional assets under management (AUM) in middle-income countries.
What is sustainable infrastructure?
In this report, infrastructure includes projects relating to power, transport, telecoms, and water and waste. “Sustainable infrastructure” is projects that are socially, economically, and environmentally sustainable.
Socially sustainable: Sustainable infrastructure is inclusive and respects human rights; it is designed to meet the needs of the poor by increasing access, supporting poverty reduction, and reducing vulnerability to climate change. For example, distributed renewable power in previously un-electrified rural areas can increase household income and improve lives by reducing time spent on household chores.
Economically sustainable: Economically sustainable infrastructure provides jobs and helps boost GDP. It does not burden governments with unpayable debt or users with painfully high charges. It also seeks to build the capabilities of local suppliers and developers.
Environmentally sustainable: Environmentally sustainable infra-structure mitigates carbon emissions during construction and operation and contributes to the transition to a lower-carbon economy, for example, through high energy-efficiency standards. It is resilient in the face of climate-change risks such as sea-level rise and the possibility of extreme-weather events. It also addresses local environmental challenges, especially regarding water provision and air quality.
Sustainable infrastructure can also employ different ways of meeting infrastructure service needs, such as demand-side management systems and responsive power grids.
The financing gap for sustainable infrastructure is in large part the result of poor policies, institutional failures, and lack of investor familiarity with greener technologies and projects. Because infrastructure has strong public-good characteristics, typically requires large-scale capital mobilization, and is highly sensitive to local politics, governments have always played a central role. However, the scale of infrastructure spending required over the next 15 years, coupled with widespread public-sector fiscal constraints, means that private finance will be increasingly important. A positive “enabling environment”—that is, one characterized by sound policies, effective institutions, transparency, reliable contract enforcement, and other sector-specific factors—makes it easier to mobilize private finance. Conversely, a poor enabling environment—one characterized by distorting subsidies, unreliable counterparties, and flawed procurement processes—can raise the cost of private finance to the point where infrastructure projects are no longer economically viable.
- Lack of transparent and “bankable” pipelines: Even in the G-20, only half the countries publish infrastructure pipelines.
- High development and transaction costs: Thirty percent of investments in new clean-energy capacity go to small-scale projects such as rooftop solar; such projects do not naturally generate the economies of scale that can keep costs down.
- Lack of viable funding models: Up to 70 percent of water provided by utilities in sub-Saharan Africa is leaked, unmetered, or stolen; therefore not enough revenue is generated to maintain or expand the system.
- Inadequate risk-adjusted returns: Investors may be willing to take on sustainable infrastructure but want higher returns to compensate them for the perceived risks. Infrastructure projects are also notoriously prone to corruption, creating significant additional risks.
- Unfavorable and uncertain regulations and policies: Basel III and Solvency II regulations could have the effect of reducing investment in infrastructure at the global level; uncertain tax policies can do the same at the national level. The fact that sustainable-infrastructure projects typically have higher up-front capital costs makes them even more sensitive to the cost and availability of capital.
To build sustainable infrastructure on the scale needed, all kinds of investors have to increase the quantity and quality of their financing—the private sector most of all. Right now, private investment accounts for up to half of total infrastructure spending—$1 trillion to $1.5 trillion a year; 65 percent to 75 percent of that comes from corporate actors, and the rest from institutional investors, such as private equity (PE) and pension funds. Private institutional investors could fill up to half the financing gap—provided that they can identify projects that are bankable and sustainable (Exhibit).
There are a number of ways this investment can be made more efficient and effective. A critical first step is to strengthen the enabling environment and to reassure investors that policies will be consistent. Second, actions that improve underlying institutional performance, especially around procurement practices, will boost confidence. This is particularly important in regard to cross-border finance, which carries extra risk because of exchange-rate movements. Finally, every project needs to fulfill a social need with economic benefits that are greater than the project costs. If these conditions are not met (at least to a first approximation), no amount of fine-tuning the design of financial instruments will make a difference in changing the risk perceptions of private investors.
While capital markets exist to mobilize large-scale investment, they are naturally skeptical about sectors and asset classes that they are unfamiliar with or where they perceive high political risks or project failure. There are six ways to encourage more capital to go toward sustainable infrastructure:
- Scale up investment in sustainable project preparation and pipeline development. Governments and development banks should focus investment on project-preparation facilities and technical assistance to increase the “bankability” of project pipelines (meaning those that have an attractive economic profile). This is the highest-risk phase of the project life cycle; it is critical to get right; and it is subject to significant rent-seeking conduct. Given a chronic shortage in many developing countries of the right developer equity/expertise, this is an arena in which the right financing facilities could have disproportionate returns.
- Use development capital to finance sustainability premiums. Encourage development banks and bilateral-aid organizations to provide financing for the incremental up-front capital spending required to make traditional infrastructure projects sustainable, in economic, social, and environmental terms. Attract private-sector financing by demonstrating that risk-adjusted returns can be competitive with those of traditional infrastructure, even if the policy settings and prices do not fully reflect the total benefits of greater sustainability.
- Improve the capital markets for sustainable infrastructure by encouraging the use of guarantees. Increase development-bank guarantee programs for sustainable infrastructure by expanding access to guarantees. Insofar as these guarantees price in sustainability benefits, they could help to overcome the policy-sensitivity of these investments, reducing risks for private investors.
- Encourage the use of sustainability criteria in procurement. Governments should strengthen sustainability criteria in both public-procurement processes and public-private partnerships.
- Increase syndication of loans that finance sustainable-infrastructure projects. Encourage development banks to expand loan syndication and create a larger secondary market for sustainable-infrastructure-related securities. This would increase institutional-investor familiarity with the asset class, reduce transaction costs, and allow the recycling of development capital.
- Adapt financial instruments to channel investment to sustainable infrastructure and enhance liquidity. “Yieldcos” or “green bonds” have characteristics similar to traditional investment instruments, but with an emphasis on sustainability. Increasing use of these instruments could unlock investment from previously restricted investors, lower transaction costs, and reduce barriers to entry.
Provided that countries are putting the prerequisites of better policies, institutions, and project-development practices in place, there are opportunities to improve the speed, scale, and pricing with which private capital could flow into sustainable-infrastructure investment. If capital markets were perfect or could respond instantaneously, then it is possible that some of the actions proposed in this report would be redundant. However, in the real world, there is ample evidence of pervasive imperfections in the capital markets, partly due to policy and regulatory rules (for example, which result in risk mispricing or excess capital weighting for specific asset classes) and partly due to institutional conduct and agency factors. Given their limited direct exposure to infrastructure risk, institutional investors are naturally cautious about increasing their exposure to this asset class. That is why a muscular set of nudges and risk-sharing instruments are required: they can shift perceptions and get capital to flow.
If the world is serious about meeting the Sustainable Development Goals, including climate goals, accelerating the flow of private capital into sustainable infrastructure has to be part of the answer to building and sustaining urban, transport, water, and energy systems that the world needs. This report examines how to make that possible.
Aaron Bielenberg is an associate principal in McKinsey’s Washington, DC, office, where Melissa Roberts is a consultant; Mike Kerlin is a principal in the Philadelphia office; and Jeremy Oppenheim is a director in the London office.