This article first appeared on Impact Alpha
Another month, another climate record smashed. This time it is the warmest January ever recorded. Even climate scientists are mystified about the extent of the rise.
While some eyes are naturally drawn to daily headlines out of Washington, the climate emergency continues to worsen.
As I write this, the temperature in Svalbard, deep in the Norwegian Arctic Circle, is about 20 degrees Celsius warmer than normal, putting it on a par with an only-slightly-chilly-for-the-time-of-year south London.
We have all been made well aware of task ahead of us: The Independent High-Level Expert Group on Climate Finance puts the amount of climate finance required by emerging economies (minus China) at as much as $2.5 trillion per year by 2030.
Unless the world unlocks the vast pools of capital that exist in pension funds, life insurers and other large institutions, we won’t get close to getting the job done.
That’s why the UK Development Minister Anneliese Dodds announced £100 million in additional funding for MOBILIST, the UK’s flagship public markets program. This is expected to unlock an extra £400 million to £600 million of additional investment towards delivering the UN’s sustainable development goals (SDGs).
And why, two weeks ago, British International Investment and Mercer, the investment advisory group, launched a global competition to attract hundreds of millions of dollars or more into climate investments in emerging markets. This competition will give the world’s most significant asset managers an opportunity to tap into funding announced by UK Prime Minister Kier Starmer at the United Nations last September.
These single initiatives by DFIs like BII (and those from MDBs), small as they appear, will contribute over time to systemic change and a retooling of the business models of the development industry.
DFI’s have historically taken a “buy-to-hold” approach to investing: investing capital, often alone, and patiently holding onto investments for years or even decades. This model has generated much impact, especially in markets otherwise starved of long-term capital. But it is impact that is hard to scale because it is yoked to the size of DFIs’ own balance sheets.
If DFIs are not to be submerged by the enormity of today’s – and future – climate and development challenges, they need to act as benign forces to galvanise private capital, especially if further capital injections from their shareholders are not forthcoming.
BII believes that this has to be a primary role in the years to come. The best way for BII and other DFIs to further scale their impact is to better harness private dollars.
The launch of our global competition in partnership with Mercer is just one example of how we are thinking about this work of “private capital mobilisation.”
The potential for private capital mobilisation for global development has been earnestly discussed ever since the 2015 Addis Ababa UN Financing for Development conference. Yes, the “billions to trillions” slogan that emerged from 2015 was perhaps unrealistic (some argue it’s downright unhelpful). And yes, progress on private capital mobilization since 2015 has been less self-evident than we might have liked. But the original logic was, and remains, irrefutable.
The call for more mobilisation will again be preeminent at the next UN Financing for Development conference in June this year in Seville, Spain. Will it be Groundhog Day for those present at Addis a decade before? Not likely. This time DFIs have a better diagnosis of what is preventing private capital from flowing to emerging markets, and a better toolkit to unlock it.
The enormous pools of long-term savings held by pension funds and life insurers of every OECD country, and which are quickly growing in middle and even low-income countries, has a fairly simple set of needs. They want a decent return, appropriate exposure of risk, a degree of liquidity, and professional management of all of the above.
Most large private investors have been reluctant to invest large sums in emerging markets because of perceptions of systematic weaknesses across the risk-return-liquidity-professional management continuum in those countries, compared to more advanced markets. One recent study puts emerging markets exposure at 5% to 15% for large North European pension funds, and zero to 5% for large North European insurers.
Most of the emerging markets exposure they do have is to public securities in investment-grade countries like China, India and Brazil. Allocations everywhere else is paltry.
Here’s why these risk perceptions are overstated: Over a recent 20-year period, emerging market equity markets have matched US stock market growth, and outperformed other developed equity markets. Over the last decade or so, emerging market sovereign bonds have outperformed US Treasuries and other developed sovereign bonds.
- The risk (or volatility) of private debt originated by DFIs and multilateral development banks in emerging markets – as defined by annualized expected losses measured over several decades – is akin to the risk of a portfolio of B- rated corporate debt.
- Liquid products do exist, including corporate and sovereign bonds, and thriving public equity markets in some markets. The range of secondary market transactions is also growing.
- A huge range of professional emerging market-focused asset managers has emerged, such as Meridiam, Helios and AIIM. Specialist managers such as Blue Orchard, Responsability and LeapFrog Investments bring dedicated impact focused strategies.
- Large global asset managers like Blackrock and Macquarie are growing their emerging market investing focus. The leading manager of emerging market blended finance solutions is the asset management arm of insurance giant Allianz.
So, the fundamentals are in place, as well as a cohort of professional managers. What else needs to be done to unlock flows of capital to emerging markets? This is where DFIs like BII have a bigger role to play – a role we are confident will be cemented at the Seville conference in June.
By then, Spain and the rest of Europe, could well be in the midst of another record heatwave, with wildfires and water shortages again afflicting the continent.
DFIs always were and will remain specialist originators, with in-market teams and deep market knowledge, and with a strong track record in terms of risk-adjusted returns and impact. Going forward we can do a lot more i.e:
- More regularly distribute new investments to asset managers who bring complementary skills in fundraising and fiduciary management.
- Inject concessional finance into structured funds or via guarantees to provide the additional risk protection that is critical to spur investments from some investors (such as insurers) who otherwise face punitive capital charges under the solvency system. Pushing the frontier of such structures is what BII hopes to elicit through the competition we have just launched.
- Work with our shareholders and each other to improve the availability of empirical data on emerging markets asset performance, including through the GEMS database.
- Look at our own funding models, taking advantage of our own access to capital markets to leverage shareholder equity, albeit not excessively lest we lower our own risk appetite.
If, as a development finance community, we systematically distribute half of our new investments, hold the retained amount for half as long, and leverage our balance sheets 1:1; we can create 8x the impact for each shareholder dollar. That is the scaling of impact that is possible through mobilization, and it’s possible within the next decade both for BII and for the DFI community at large.
