By Akhilesh Tilotia
Green transition requires trillions of dollars of investments over the next several decades. This point is, by now, well known and understood. Two important concepts deserve more attention: (a) investment is not the same as financing, and (b) reducing the cost of capital does not come from low-cost capital — it comes from intelligent structuring of the capital stack.
Investment and financing are different
In a column last year, we discussed how professionals in climate finance come from diverse backgrounds and interpret key terms differently. For instance, we noted that “equity” means the riskiest part of the capital stack for investors, while social and climate practitioners view it in terms of justice and inclusion.
Similarly, the terms “investments” and “finance” often get mixed up. People frequently link the total capital needed for investments directly to the amount of finance required. While this connection can hold true at specific times, it changes significantly over time.
From a company’s perspective, investments represent the asset side of the balance sheet. This represents the money invested in assets like factories, solar farms, or green hydrogen plants, or investments in research and development. In contrast, finance refers to the liability side — how these investments are funded, whether through equity, debt, grants, etc. Initially, if an investment requires Rs x million, one will need to arrange Rs x million in financing.
Over time, several developments occur. Ideally, the investment begins generating positive cash flows, reflected as profits and retained equity on the company’s balance sheet. This allows the company to generate its own capital and repay external financiers — debt holders get repaid and, in some cases, some equity is also returned. As investments start yielding returns, the nature and amount of financing required changes significantly.
When companies repay their financiers, those freed-up funds can be used to support new projects and investments.
When we talk about the billions of dollars needed annually for the green transition in India, it is essential to remember that this figure relates to the asset side of the equation. The liability side is constantly evolving. Depending on the types of investments being financed each year, the requirements for equity, debt, or other forms of capital will vary. As industries stabilise and become self-financing, they will need less external capital.
Understanding the distinction between investments and finance is crucial for developing effective macroeconomic plans. The total financing requirements are expected to be significantly lower than the anticipated investment amounts. Additionally, it is important to specify the types of financing instruments involved.
Lowering the cost of capital
A chimera in the green transition landscape has been the elusive promise of capital available at lower costs than traditional funding. The concept of “greenium” — the idea that financing green assets would somehow lessen the fiduciary duty of asset managers to pursue adequate returns — had gained traction.
However, real-world evidence from sovereigns, public, and private entities, along with extensive academic research, shows that any reduction in cost is minimal, typically around 1 to 2 basis points (one-hundredth of a percentage point). In India, for instance, the government has even had to cancel the issuance of sovereign green bonds due to the absence of a greenium. Regular readers of this column will not be surprised to not find any “greenium”.
Yet, there is still hope for reducing the overall cost of capital. If we focus on lowering the weighted cost of capital, we can address this through smart financial structuring.
One key principle of corporate finance is that cash flows and associated risks can be segmented into tranches. By breaking down semi-variable cash flows, we can create a stream that is more certain (lower risk) alongside a riskier portion that takes on more volatility. A broader range of investors — like banks, insurance companies, pension funds, and sovereign wealth funds — are interested in lower-risk securities, while other investors can handle the riskier segments.
Many industries driving the green transition are still emerging and face various risks, including technology, financial viability, regulatory, and competitive challenges. These uncertainties keep capital costs high. To tackle this, we need a tranche of capital designed to absorb the risks while providing some reassurance to other investors about the company’s viability. This risk-absorbing tranche can offer high returns when successful, while also accepting the potential for total loss.
Multilateral development banks, climate-focused institutions from the global North, philanthropies, and governments could collaborate to establish an entity dedicated to pooling high-risk capital. Let us call this the National Green Finance Institution. Such an institution could play a crucial role in the financial capital stack for green transition industries. By providing this buffer of capital, it could enhance the availability and affordability of other funding sources, ultimately lowering the overall cost of capital for green transition.
About the author: Co-chair, Climate and Sustainability Council, Indian Venture and Alternate Capital Association.
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