The world’s fastest-expanding cities are now in the global South. Rural to urban migration, combined with the effects of urban population growth, could add another 2.5bn to the world’s urban population by 2050. According to the UN, close to 90 percent of this increase will be in Asia and Africa.
At the same time, low-income countries are most affected by climate change and rarely have the means to finance resilience and adaption efforts. The cost of climate change adaptation in Africa has been estimated by the African Development Bank to be in the range of $20-30bn per annum over the next 10 to 20 years. The financial options available to cities in most emerging markets have not kept pace with the growth and looming threats.
Green Finance on the rise
Many are looking towards ‘green finance’ as a potential solution to help governments plug the climate change and infrastructure financing gap.
Green finance covers the funding of investments that generate environmental benefits as part of a broader strategy to achieve inclusive, resilient and sustainable development. Financiers are often willing to take slightly lower returns in return for better environmental outcomes, which can reduce the cost of financing from the perspective of borrowers.
Green finance can cover any financial instrument – for example insurance products or tax credits – In exchange for the delivery of positive environmental externalities that are real, verified and additional to business as usual.
Within the available instruments, Green Bonds are becoming increasingly popular. According to the City of London’s Green Finance Initiative global green bond issuances have increased from $2bn to almost $55bn over the past 10 years.
Yet the Global South is forgotten
However, cities in the Global South are mostly left out. A 2013 World Bank report demonstrated that less than 20 per cent of cities in developing countries have access to local capital markets, and only 4 per cent are deemed creditworthy enough to access international capital markets.
The ability to access markets obviously a precondition for issuing a green bond. Hence, cities in the South have a steep road ahead towards launching the first Green Bond.
To be clear, even in the North, cities make up only a small portion of the overall issuers of green bonds. The majority are issued by energy and utility companies, banks or (in the case of developing countries) development finance institutions such as the World Bank. Within sub-Saharan Africa, only Johannesburg and Cape Town have successfully issued a municipal green bond.
Analysis from the Climate Policy Institute shows that $2.3b in value is linked with city-based projects in developing countries, including urban mass transit systems, district heating and water distribution networks.
The key barriers
There are three key barriers that prevent cities in the South from issuing green bonds:
Weak enabling environment and unsuitable regulatory frameworks
Many low and middle income countries lack a transparent and sound regulatory framework for investment. This trickles down to the inability of the city to raise finance, as investors lack confidence that contracts will be upheld, that local governments will be protected from expropriation, and that commercial disputes will be arbitrated.
Additionally, the municipal policy and legal framework must make it legal and feasible for local governments to borrow and to mobilise the resources to repay credit. In many developing countries, the municipal law either does not allow for borrowing, or limits it to a very short term of a year or two.
Financial market rules prevent deployment of capital
The policy and legal framework of global capital markets limit most investors in municipalities in the global South. Large institutional investors such as pension funds and commercial banks in the global North are guided by strict fiduciary rules that govern the handling of funds. Most can only invest in assets that are rated ‘Investment Grade’ by the big three credit rating agencies (Standard & Poor, Moodys, Fitch).
Kenya’s B+ rating by Standard & Poor’s for example, puts the country into the ‘highly speculative’ bracket. This by default precludes most institutional investors from deploying capital there. There is little Nairobi or any other municipality can do.
Lack of bankable projects and skills
Cities must identify sustainable bankable projects as part of their capital investment plans. To demonstrate creditworthiness, local governments must:
(i) provide accurate information about the operational and financial activities of the local government;
(ii) identify and prepare sustainable bankable projects;
(iii) provide a strong repayment stream and demonstrate or mobilise local willingness to pay; and
(iv) manage the financed projects during the life of the bond issue or other financing to ensure continued operation and maintenance of the investments, and collection of associated revenues, where relevant.
This requires specialised technical and financial skills as well as strong management, evaluation and reporting processes which are often in short supply in local municipalities in the global South.
Overcoming these constraints will need concerted efforts and collaboration between cities, governments and the financial markets. Intermediaries such as non-government agencies and donors can play an important role in brokering these contacts, reducing risks and help municipalities in preparing for a green bond.
There are a number of cities that are in the process or have already accessed the financial markets through regular municipal bonds. Since 1999, for example, 12 municipalities in India have issued tax-free bonds to finance road constructions and upgrade water supply systems. Most recently, the Pune Municipal Corporation launched a bond in late June 2017.
Over the coming five years, the city plans to borrow a total of $350bn to help fund a major infrastructure program for universal residential access to water. Other cities in India are similarly planning issuances, including Ahmedabad, New Delhi and Greater Hyderabad.
We have identified three immediate steps that cities could take to get ready to tap into the capital markets.
Creating an the enabling environment
Central governments in the global South should support their municipalities by reviewing and reforming legislation to create a more permissive environment. In particular, central governments need to clearly articulate that municipalities can borrow from local capital markets, how much they can borrow, in which currencies and with what collateral.
Without a clear legal framework, prospective investors will not be confident of the security of their investment. South Africa offers a good example to other countries.
Build the financial capacities of municipal authorities.
Cities themselves can improve their creditworthiness through improving the transparency and accountability of their financial arrangements. This includes adopting clear budgeting and reporting requirements, and clarifying internal administrative coordination between city departments.
Cities can work together through initiatives such as C40 Cities Finance Facility or the World Bank’s City Creditworthiness Initiative to learn how to package projects for investors and to engage with investors in a targeted way.
Form strategic partnerships to improve risk-return ratios
Investors assess all investments based on risk and return. However, few global investors are familiar with municipal projects or with investments in low-income countries, which makes the evaluation of return and risk often too difficult.
Cities can overcome this barrier by working with partners who can increase investor confidence: for example, USAID offered to guarantee municipal bonds issued by Dakar, Senegal. Municipalities can also interact with alternative investors such as faith-based organisations or impact investors, which are able to deploy capital to more risky locations and have longer time horizons for their investments.
Although the green bond market has had relatively little impact on cities in developing countries to date in terms of financial flows, it is growing rapidly, with more investors engaging and more domestic market actors participating. Cities should therefore consider how the issuance of green bonds may expand their access to regular, low-cost capital over the long-term. Even where cities may not be able to launch green bonds in the near future, there are immediate benefits to improving their revenue generation and financial management processes.
These early steps towards creditworthiness can increase trust in city planning and management, and therefore unlock larger investment flows for urban infrastructure.
Katharina Neureiter is investment and political economy lead at the Infrastructure & Cities for Economic Development (ICED).This article is from the CityMetric archive: some formatting and images may not be present.