Evaluating the Role of the Private Sector in a Changing Climate

In the run-up towards the GEF's seventh replenishment period (GEF-7 starting in 2018), the Independent Evaluation Office of the GEF undertook an evaluation focused on the GEF's private sector engagement. The study analyzes the environmental finance landscape, assesses the GEF's private sector engagement activities, and provides recommendations for roles, instruments and tangible measures that the GEF could incorporate to strengthen its collaboration with the private sector. The evaluation is based on extensive desk research, a survey among 60 GEF stakeholders, and in-depth interviews. The full evaluation can be accessed here.

GEF's private sector engagement

In a world with a changing climate, rising populations, natural resource demands, and increasing environmental degradation, the Global Environment Facility's (GEF's) mandate to partner with the private sector to tackle environmental challenges, especially in the developing world, is as strong as ever. This mandate has been reinforced by explicit guidance to the GEF on private sector engagement from the various multilateral environmental agreements that it serves. There is increased recognition within the GEF of the fundamental role the private sector plays in achieving the GEF's mission to tackle the planet's biggest environmental issues. However, despite an increasing volume of financing towards private sector projects from US$ 180 million in GEF-1 to US$ 450 million in GEF-6, and the structuring of engagement and specific priorities set in GEF-6, the GEF's private sector engagement is still limited. The GEF's current core strategic documents, which include the GEF 2020 Strategy and the GEF CEO Vision, all emphasize that private sector engagement needs to be enhanced.

Private sector drivers to address environmental issues

The evaluation of the Independent Evaluation Office of the GEF found that climate change projects feature heavily in the private sector portfolio. Two-thirds of the projects in this portfolio are in the climate change focal area, amounting to 63 percent of the GEF's total investment in private sector projects. The private sector increasingly sees the need to adapt to the changing climate and market places in which they operate. Based on a survey with private sector actors, the evaluation found three core factors that drive this change. They are 1) natural resource scarcity and its associated business costs, 2) societal expectations, and, 3) specifically for the financial sector, the risk of stranded assets. It is interesting to note that GEF private sector stakeholders appear to regard managing environmental issues from an opportunity rather than a risk perspective, and cite developing new business models and revenue streams as the main driver for developing new environmental products, services, and technologies.

Climate finance landscape

In the environmental finance landscape, there are generally four key types of actors. Private sector companies initiate projects, governments provide the location and regulation, capital providers (e.g. institutional investors, pension funds) are the source of financing, and financial intermediaries (e.g. banks, investment funds) link capital to investable opportunities. As specialized financial intermediaries, (semi)public development and environmental finance institutions such as the GEF are critical players in the flow of finance to developing countries for environmental finance. They have the mandate to invest in riskier environmental projects directly, and they are also well-positioned to catalyze additional private sector investment towards relevant environmental projects.

GEF environmental projects vary in size, maturity, and extent to which a concept is proven as an investment opportunity. For each type of project, different financial instruments are suited: from grants for innovative, unproven opportunities to public equity for large, well-established projects. To have real impact at scale, the trick is to move environmental projects gradually towards standardized, commercialized and scaled forms of private finance. Three financial instruments that are particularly suited to help environmental projects or companies grow and attract finance are 1) indirect investment through specialized environmental investment funds, 2) risk-sharing mechanisms and 3) green bonds. The evaluation found that there are opportunities for the GEF to increase support for environmental projects through these instruments.

Hurdles and opportunities in environmental finance

The climate finance market is hampered by several hurdles that hold back the effective flow of private financing from capital providers to projects. The evaluation identified six main hurdles: (i) an inconsistent regulatory environment (particularly in developing countries); (ii) the limited scale of most environmental projects that presents a mismatch with the minimum capital requirements of institutional investors; (iii) the lack of track record for many innovative projects as well as financial intermediaries; (iv) the lack of a common framework that allows performance comparison of projects; (v) a conservative risk perspective by some investors that are still wary of new green financial products and returns that fall outside the traditional return on investment (ROI) timelines; and (vi) the high transactions costs for new innovative projects or financial products that are not yet sufficiently scaled or bundled.

Meanwhile there also are several recent developments that have the potential to positively influence the flow of private capital towards environmental projects. The four main developments are (i) several promising international agreements (notably the SDGs, COP21 in Paris and the Addis Conference on Financing for Development) that provided a boost to the private sector's focus on environmental issues; (ii) the low interest rate environment that forces institutional investors to explore new investment opportunities with reasonable risk-return profiles that have little correlation with other investments, such as forms of environmental finance; (iii) the increased availability and quality of technology and tools to measure environmental impact; and (iv) the rise of impact investing, where environmental issues are one of the core focus areas.

Private sector experience in working with the GEF

The evaluation states that if the GEF wants to become more geared towards the private sector, it will need to make specific adjustments to its private sector operations. It will need to further leverage its strengths, and address the weaknesses that private sector actors experience when interacting with the GEF. The GEF's core strengths according to private sector stakeholders are its offering of flexible financing instruments, its risk appetite, its longstanding and well-respected reputation, its technical expertise and, in particular, its network.

At the same time, stakeholders identified four main weaknesses in the GEF's private sector engagement and operations. The most pressing one is the approval procedure for projects, which is perceived as complex and too slow for private sector actors. Other serious hurdles in working with the GEF are the difficulty to obtain information on opportunities for cooperation and financing, insufficient guidance on what the GEF actually expects from projects, and a general lack of private sector mindset. Moreover, stakeholders perceive the environmental finance landscape as being difficult to oversee, and have difficulties in identifying the right (semi)public environmental finance mechanism that would form the best partner for a particular project. GEF internal stakeholders consulted largely acknowledge these challenges for the GEF.

Roles and focus in private sector engagement

The GEF has the mandate and instruments in its toolbox to engage with the private sector in all areas/stages of the environmental finance landscape. However, to do so effectively, the GEF needs to clearly identify where it has the greatest additionality and avoid crowding out of other sources of finance. Three key roles the GEF could focus on are: initiator, catalyst and facilitator.

The initiator role, closest to the GEF's traditional focus, focuses on helping to initiate new, innovative concepts and/or early stage environmental projects, companies or funds that have the potential for up-scaling or replication through grants, technical assistance or venture capital. In the catalyst role the GEF should focus on attracting additional private financing for environmental projects or companies, thereby covering investment gaps and/or risks that investors would not have the incentive to cover. In the facilitator role the GEF should focus on bringing parties together and creating an enabling environment for larger scale financial intermediaries and capital providers to operate effectively. Private sector stakeholders consider all three roles as impactful, with a particular emphasis on the catalyst role.

The evaluation recommended the following:

1. GEF should address operational restrictions to private sector engagement through pursuit of a private sector window. Procedures that allow for private sector engagement based on broad approvals best serve the rapid timelines of private sector decision-making leaving specific tailoring to GEF Agencies in partnership with sponsors and initiators.
2. GEF should encourage policy and regulatory reform for its cascade effect on private sector environmental investments. Lack of a standardized regulatory frameworks and environmental policies can impede in-country compliance with standards and affect the achievement of global environmental benefits while creation of supportive conditions is a factor in successful private sector participation. GEF's ability to support legal and regulatory reforms and incentives along with institutional capacity building strengthens country ownership is a comparative advantage and is required to provide long term certainty to reduce investment risks and create the enabling environment for projects to go to scale.
3. Intensify efforts to develop a broader strategy for private sector engagement beyond climate change. The GEF is uniquely positioned to develop a pipeline of investment-ready projects in areas of environmental protection that attract private resources beyond the climate change focal area and include partnering with larger entities as well as SMEs in developing countries.  As conservation and ecosystem services finance continue to grow with active private sector participation, the GEF can leverage its appetite for small, diverse, and innovative projects to expressly promote both supply and demand for new geographic and sectoral environmental finance markets such as water, waste, forests, biodiversity, and ecosystem services.
4. Improve outreach to GEF recipients of funds, GEF Agencies and private sector entities. Easier access to information will lead to increased awareness among countries, Agencies and private sector stakeholders of opportunities for cooperation with one another and the GEF. This could include more private sector specific content on GEF's website, the development of “how-to” guides for countries wanting to work with the private sector, and organization of “investor roadshows” for private sector to promote cooperation opportunities. Ideally, these efforts should be coordinated with GEF Agencies and embedded in multi-stakeholder coalitions to entice targeted private sector stakeholders to engage.
5. Dedicate appropriate resources to tracking, monitoring and evaluation of the private sector portfolio by improving tagging and retrieval capabilities of the PMIS database. An accurate monitoring of the portfolio of projects that engage the private sector is currently not possible. Projects should be tagged to allow for systematic retrieval. As part of the tagging, further definition within the GEF of what is considered private sector engagement should ensue.