Design elements for a facility to finance energy transition

• by Anant Jayant Natu and Bhavya Reddy
• Nov 30, 2023
• 6 min

Enabling energy transition across sectors is the need of the hour. Through the use-case of the transport and mobility sector (one of the highest contributors to GHG), this blog lays out a template for financing of energy transition and explores the pivotal role that public finance institutions can play.

Climate change is among the biggest challenges of our times. What role can innovative finance play to enable the transition to net zero? We scout for answers in a recent project that sought to catalyze finance in the electric mobility sector. We draw out a model to finance the energy transition from the insights.

India’s transport and mobility sectors contribute more than 12% of its total carbon emissions. It significantly contributes to its import dependency on crude oil as well, making the adoption of electric vehicles (EVs) an imperative to a greener and more sustainable future.

Supply-side interventions, such as the FAME subsidy in India or the policies focused on the EV supply chain and batteries in Europe and the US, have enabled the push toward EVs. But demand-side interventions, such as access to affordable finance, are also necessary. While 77% of all vehicles are financed in India, experts estimate that only 5% to 10% of EVs are financed. The estimated financing gap of USD 6 billion is even more surprising given the favorable economics of switching from internal combustion engine (ICE) vehicles to EVs for the end users.

MSC’s work to finance energy transition in the e-mobility sector shows that certain basic approaches to design innovative financing structures are applicable across various sectors from mobility to energy efficiency, to climate smart agriculture. These structures, however, presume that the participating financial institutions (FIs) will have robust credit underwriting mechanisms and strategic intent to penetrate new market segments. The key elements of the approach are to:

1. Build a de-risking framework for FIs that reduces their credit losses;
2. Identify key market segments that will likely be the growth drivers;
3. Enable the ecosystem via market-making, that is, identify missing pieces in the delivery of critical services that preclude the market from taking off.

Elements for designing a facility to finance energy transition

The creation of the de-risking frameworks

Financiers hesitate to invest money into projects where:

• Products are based on technologies with unproven market standards;
• The cashflows generated from the financed assets are uncertain due to the high probability of downtime or other operational issues;
• The salvage value of an asset is either not readily determinable, or where the repossession itself is costly, or both.

Over and above the risks associated with lending to any specific asset class, financiers have to factor in the customer and counterparty risks inherent in any segment to which they lend. Most nascent markets are riddled with such risks that elevate the financiers’ risk perception and credit losses. To de-risk the ecosystem, the FIs must have tools to implement de-risking measures. Few examples of such tools can be strict onboarding criteria for the product companies, or guidance on attuning FI’s internal credit processes to the asset class’s specific nature.

Focus on the market segments that are the growth drivers

Identifying the existing, emerging, and high-potential market segments helps the FIs to pick pockets of growth and risks that arise from different segments. For instance, two-wheelers account for about two-thirds of the EV market in India and are the fastest-growing type of EVs. Moreover, the B2B channel is a bigger market than B2C (retail), with fleet operators who rent out EVs to drivers who work as gig workers. The segment knowledge is essential to identify and prioritize the risks that emanate from them and design suitable de-risking responses.

Market-making to enable the ecosystem

Market-making requires three specific actions:

• Create conditions for near-perfect competition. This requires a balance between setting acceptable standards for products and services and ensuring that these are non-exclusionary. Thus, FIs must be nudged to take calculated risks by encouraging new entrants who meet set quality and fiscal criteria.
• Create suitable conditions that incentivize private players to offer currently underdeveloped or absent products and services. For instance, the lack of a market for secondary sales significantly hinders EV financing. Players that deal in secondhand EVs have a clear opportunity.
• Consider data as a public good and gather data on key parameters, such as product performance and repayment trends. This data will enable FIs to assess risk accurately and move the market pricing from perceived risk to actual risk.

The creation of an innovative finance structure for energy transition based on the three elements of segment focusing, de-risking, and market-making requires initiative from stakeholders with a sharp impact focus and an appetite to absorb risks from nascent or underdeveloped markets. Public financial institutions (e.g., the multilateral and bilateral institutions and development finance institutions) are best placed to play this role. They have a mandate to drive large-scale impact, which enables them to provide catalytic capital.

They can support a facility that generates impact and financial returns, and absorbs risks posed by nascent markets focused on energy transition, such as EV and carbon. More importantly, these institutions can lead the way for the private sector to enter markets it may hesitate to explore. They can then help establish a market and create a supportive environment that eventually attracts private investment.

One such ongoing effort is the EVOLVE-RSP Electric Vehicle Risk Sharing Program in India. It is a joint effort of the World Bank, the Korean Economic Development Cooperation Fund (EDCF), NITI Aayog, and the Small Industries Development Bank of India (SIDBI). It seeks to accelerate two- and three-wheeler EV uptake through a partial credit guarantee and concessional loan facility to help India achieve its 30@30 goal. Similarly, USAID launched the South Asia Regional Energy Partnership (SAREP) to accelerate the energy transition in South Asia.

Structuring a blended finance facility

A blended finance facility (BFF) is a structure that helps mobilize capital for sustainable development from the private sector through anchor funding from public and philanthropic sources. It “blends” concessional funding with other sources of capital, such as debt or equity, to maximize funding and social impact capacity. Public financial institutions play a vital role to set up a BFF as their name lends credibility and trust required to gain investors from the private sector. This includes philanthropic, commercial, or impact-focused investors.

MSC played a key role in the design of a BFF structure for EVOLVE-RSP aligned with the three elements discussed above. Based on that experience, here are the key design features for the BFF facility:

1. Access to wholesale finance for FIs at affordable rates and on terms that promote market-making. Besides lower interest rates, the concessional loans offered under EVOLVE-RSP also nudge the FIs to make their loan terms less restrictive to end customers, such as through increased loan tenures and loans-to-value.
2. Access to suitable risk-sharing arrangements allows the participants to extend their services and products to underserved segments, markets, and geographies. For instance, EVOLVE-RSP’s partial credit guarantee product enables FIs to take calculated risks and offer EV loans to new-to-credit customers, as they can now invoke the credit guarantee if the borrower defaults.
3. Embed de-risking measures in the BFF’s structure and its financing mechanisms. For instance, it must offer incentives or rewards for participants who adopt best practices in their processes. In the EVOLVE-RSP program, the facility set standards for collection, repossession, battery tracking, and secondary sales, which will likely become industry benchmarks. These policies may even spur the markets for underdeveloped services, such as the lack of a secondary sales market, which hinders EV lending.

While the facility does all of the above, it has to price its products and services to meet its operational costs and ensure its long-term sustainability. Thus, the BFF itself must have a viable business model that keeps the investors’ interest alive and attracts other potential investors.

The above framework enables the design of a suitable strategy to finance energy transition. It yields an understanding of ecosystem risks, identifies key market segments, and focuses on market-making functions. The time is ripe for governments and multilateral and bilateral organizations to join hands and establish BFFs to ensure a green and sustainable future.