“Bankable” Projects

The de-risking paradigm focuses on eliminating the obstacles to investing in any individual infrastructure project. These are distinct from the preferences and constraints that institutional investors face when evaluating their wider portfolios. Some project-level obstacles are:

• Overall country risk, including the currency, political, and demand risks. Anything from electoral uncertainty to foreign exchange volatility to inadequate consumer uptake of the investment might deter foreign investors from financing public works.
• Inadequate project data, particularly risk disclosures for investors. Institutional investors have pushed development banks to make their Global Emerging Markets database public, arguing that its data on the country-level default risks of infrastructure investments can help familiarize them with emerging markets.
• Land acquisition issues. Securing land title and project permits from local authorities takes time, and construction is the highest-risk phase in most infrastructure projects.
• Regulatory risks. Shifting or unclear tax burdens, price controls, tariffs, and labor protections can all impact returns. The Investor Leadership Network of pension funds identifies taxation in particular as a “hard-to-insure risk” to their members’ investments in emerging markets.

An investment’s cost of capital — the cost of financing a particular project — effectively puts a price tag on these projects; where the cost of capital for a solar photovoltaic project in the United States might be as low as 3 percent, a similar project in Brazil might carry a cost of capital around 12.5 percent. Deploying guarantees and blended finance arrangements to de-risk these project-level obstacles helps lower a project’s cost of capital, thereby making that project more “bankable.”

Some large private institutional investors speak enthusiastically about investing in bankable projects in emerging markets, a topic of discussion at every major climate and development summit since 2015’s Paris Agreement. When Mark Carney, cochair of the prominent Glasgow Financial Alliance for Net Zero and former governor of the Bank of England, stated at a development finance summit in June that “the scale of investment required in emerging and developing economies can’t be met with public money alone,” he spoke with the backing of the International Monetary Fund, the World Bank, and the COP presidency. But despite Carney’s confidence, the institutional investors he leads struggle to package these green infrastructure projects into financial assets they can hold.

False Profits

Even if governments stepped in to make green investments “bankable” by mitigating every significant project-level obstacle, a more expansive set of portfolio-level constraints would still hinder the mobilization of private capital.

First, fiduciary duty requirements and commitments to shareholders prevent fund managers from making investments unless they meet certain profitability or earnings quality thresholds that enable them to pay carried interest and adequate dividends. Investors set those thresholds — known as “hurdle rates” — on a whim, virtually independent of economic conditions or the cost of capital. As a result many projects with otherwise healthy returns and low costs of capital may never secure investment.

The pressure to pay dividends to shareholders underlies the high-leverage, low-transparency financing strategies of infrastructure-focused private equity giants. Macquarie, for example, has been described as the “vampire kangaroo” corporation that has contributed to sewage, maintenance, and water bill crises across the UK. Peter Folkman, a former British Private Equity and Venture Capital Association council member, summarized it well: “If my financial incentive is that I will be paid if I satisfy my investors, then I will do things that will satisfy my investors . . . and that’s the problem.”

Second, many institutional investors refuse to hold assets with lower credit ratings. Because the three leading credit-rating agencies (Moody’s, S&P, and Fitch) unfairly downgrade emerging markets, they not only raise the cost of capital for all investments in those countries beyond what macroeconomic fundamentals might indicate, but also threaten institutional investor participation there.

Research from the UN Department of Economic and Social Affairs finds that, “By losing investment grade status, an issuer may face a wave of forced selling as investment mandates of many asset managers and funds only allow for investment in investment grade” assets. Capital pours into and out of emerging markets at the whims of the credit rating agency oligopoly.

Third, the liability management strategies of pension funds and other institutional investors transform necessary public services and infrastructures in emerging markets into vehicles for speculation. Most emerging market infrastructure assets are denominated in local currencies prone to lose value against a foreign investor’s home currency, often leading to their placement in investors’ higher-risk “growth portfolios.” However, this “growth” category is traditionally meant to yield quick returns rather than hold to maturity alongside assets like government debt. Bruno Bonizzi, a researcher of financialization in emerging markets, argues that institutional investors’ demand for these assets ends up being “volatile and independent of [economic] conditions in these countries” as a result.

Fourth, many institutional investors exhibit dangerous short-termism. Asset management scholar Brett Christophers explains that institutional investors manage infrastructure through short-term closed-end funds: they buy an asset, cut costs, delay maintenance, sell it within a decade, and make a profit. Moreover, many portfolio managers themselves have performance bonuses tied to the returns on their portfolios within months, rather than years. When it comes to emerging market infrastructure assets, institutional investors are hardly patient investors, despite their pleading to the contrary.

Risk disclosure requirements, which should compel transparency from investors when a region has been identified as particularly vulnerable to climate disaster, might actually dissuade them from directing funds where adaptation spending is most needed. Even within the United States, major insurance companies are exiting Florida and California over climate risk concerns. Where vulnerability drives divestment, divestment exacerbates vulnerability.

Infrastructure as an Asset Class?

These constraints on institutional investors are compounded by the fact that infrastructure rarely has the properties of a good financial asset. Infrastructure assets are heterogeneous; unlike mortgages or US Treasury bonds, they are not easily priced or traded on capital markets. Nor do they see consistent investor demand. In other words, infrastructure is illiquid, all but ensuring that its value tanks first and worst during a market crunch. Even in those situations where holding illiquid assets to maturity may be profitable, many institutional investors’ profits depend on trading fees. Greater liquidity leads to more trades, which in turn leads to more profits.

In general, institutional investors remain biased against infrastructure investments in smaller economies. “Markets [in Africa] . . . are simply too small and immature to have materialized as an investment opportunity for us,” said Anders Schelde, the chief investment officer of a Danish public sector pension fund. On the other hand, investing in larger deals, whether individual projects or an aggregated pipeline, allows institutional investors to spend less time vetting smaller, more localized projects, and ostensibly enables them to turn their infrastructure portfolios into standardized financial assets that can be traded on a secondary bond market.

Investors have asked emerging market governments to build “country platforms” that aggregate these projects for them, but this strategy is best suited for larger, middle-income markets in Asia and Latin America, where private investment already flows, not the lower-income countries most in need. In short, a preference for liquidity leads institutional investors to larger projects in larger economies with larger capital markets.

The ultimate constraint on both institutional investors’ preferences and the value of infrastructure investments is the price of a US Treasury bond, which sets a floor on the global cost of capital. Higher dollar interest rates and other global liquidity tremors that raise this price can precipitate a flight to safety from emerging market assets toward more liquid and comparatively higher-return dollar assets.

All these constraints will still exist even if governments de-risk a project’s cost of capital or eliminate regulatory barriers to its construction. These portfolio-level constraints highlight the limits of institutional investors’ ability to finance infrastructure within the existing global financial system.

Investors’ biases, incentives, and restraints produce a hierarchy of investability, with financial assets from the Global North at the top. No matter how much project-level de-risking an institutional investor can secure, they will always prioritize the perceived safety of their portfolio over the apparent necessity of any specific infrastructure or public service investment; adequate project preparation is no match for the Federal Reserve’s rate hikes. If inadequate investment in emerging markets is the collateral damage of decisions to preserve margins, so be it.

Risk and Responsibility

In the face of these obstacles, governments can still take action to de-risk some portfolio-level obstacles. They could provide liquidity backstops to cater to investors’ distaste for illiquid assets, for example, or use loan guarantees and credit enhancements to circumvent credit rating agencies’ judgments. Either instrument would see the state backstop the value of otherwise risky private assets.

The European and Chinese central banks already provide a liquidity backstop to green bonds by treating them as a safer, more collateralizable asset than dirtier debt instruments. Still, many constraints lay outside the purview of a state or central bank, neither of which can change a fund manager’s pay structure. Nor can the World Bank pause the Federal Reserve’s rate hikes or calm liquidity tremors in US Treasury bond markets to prevent a flight to safety.

It’s also not clear if governments should attempt to de-risk institutional investors’ portfolios, even when possible. For example, there’s no reason for governments to provide a liquidity backstop for private pension funds to incentivize them to hold emerging markets infrastructure assets, when they can alternatively use their own greater risk tolerance and lower borrowing costs to invest in illiquid assets themselves. Loan guarantees to overcome sour sovereign credit ratings offer short-term promise, but when a downturn brings sharp, and unwarranted falls and the bill for those loan guarantees unexpectedly skyrockets, governments may wish that they had rather built a public-rating system with climate and development outcomes in mind.

Most worryingly, de-risking these portfolio-level constraints threatens to deepen financial fragility without accelerating the global green transition. Institutional investors’ inability to weather a global liquidity shock contributed to $78 billion of outflows from emerging markets in March 2020, and another $69 billion of outflows from January to October 2022, as dollar interest rates spiked. 

Governments that choose to de-risk future waves of volatility through liquidity or currency depreciation guarantees would be handing private investors a blank check to preserve their balance sheets. Not only would these measures fail to fix the financial system that perpetuates cyclical liquidity crises, they would also leave governments and multinational development banks on the hook for the consequences.

In simpler terms, governments that engage in de-risking are paying the private sector to build and provide services that, for whatever reason, governments won’t or can’t provide themselves. While de-risking project-level obstacles may sidestep limited state administrative capacity for fixed investments, it runs headlong into the choices made by institutional investors.

If de-risking and blended finance fail to mobilize sufficient private finance, it’s likely due to the structural limitations of companies like those represented at the World Bank’s new Private Sector Investment Lab, not necessarily their level of moral commitment to the green transition. Even if policymakers agree that the green transition requires trillions of dollars per year, it’s clear they haven’t found an economically coherent program through which to mobilize it.

At minimum, policymakers should be prepared to better regulate how investors manage their portfolios, forcing the private sector to fix its own deficiencies. But a lasting solution would see governments investing in global public financial institutions that could overcome portfolio-level obstacles to undertake long-term, illiquid investments of all sizes in climate adaptation and mitigation projects without thought to short-term profit. A global version of the National Investment Authority, backed by government guarantees and chartered to support public investment in specific green projects, could soak up institutional investor demand for liquid assets while accelerating the pace of decarbonization.

Relying on de-risking — to the exclusion of more coherent public investment programs and financial reforms — means abandoning the world’s most vulnerable to the escalating violence of the climate crisis. If institutional investors remain ill-suited to holding crucial investments on their own balance sheets, then governments must take it upon themselves to do the job.