Blended finance: Unlocking renewable energy’s promise

| Interview

McKinsey interviewed Ben Caldecott (director of the Oxford Sustainable Finance Group at the University of Oxford), and Rachel Kyte (dean of The Fletcher School at Tufts University) about key challenges for Asia’s transition to net zero, and the role of blended finance in extending the reach of renewable energy to all parts of society.

Rachel Kyte

McKinsey: Do you think blended finance is important for a region like Asia?

Rachel Kyte: Blended finance, or using public money to crowd in private money, is important because—notwithstanding very clear evidence that renewable energy is cost effective and will be a good investment over time, and that the technologies are proven at scale—these are still markets which are at the beginning of their journey in many cases.

To manage the risk, I think public money has to go in together with a very clear signal, from a regulatory perspective, that this is a long-term direction of travel, and that private investors have faith that that direction is not going to keep changing. Regulatory certainty, together with clear evidence that storage options are going to be developed and renewable energy is going to be competitive, is the only way that this all provides a clear pathway.

Public money is needed to guide the private sector into that, and is particularly important in order to make sure the renewable-energy revolution reaches everybody: rural as well as urban, low income as well as high. Blended finance is about risk mitigation and credit enhancement. I think sometimes what the market is actually demanding is not particularly innovative. It’s as if, in the development-finance world, everybody wants to do the next, new, innovative thing. But actually, if we just extended good-quality credit enhancement at the local level, across markets, that would have a huge impact for entrepreneurs trying to get access to finance. I think blended finance is important in helping technology deploy more quickly, speeding up the transition, and making sure the transition reaches all parts of society.

McKinsey: Which sectors would benefit the most from innovative financing schemes through blended finance?

Rachel Kyte: I think organizations and companies focused on extending renewable-energy access into communities that have very low levels of coverage would benefit from blended finance. Asia has a huge clean-cooking problem and there’s room for financial innovation there. I think there are other ways to bring financing to those in desperate need, to provide reliable, affordable, clean cooking for millions of people. There’s room for blended finance to extend the renewable-energy revolution quickly into rural, low-income, or off-the-grid communities.

Blended finance is important in ensuring that refugees and displaced peoples have access to electricity. There’s room for blended finance at the bottom end of the pyramid and also in big industrial applications of renewable energy, as we start to look at green ammonia and green hydrogen economies.

Will there be a role for multilateral finance or bilateral development finance to come in and make some very big statements? An example at scale is the extraordinary success story of Morocco pursuing a pathway of concentrated solar power, and being a solar-power generator for the whole of the Maghreb. That started with a $750 million package of development finance that attracted private investment and showed the way for the domestic Moroccan banking sector to understand this new technology. These kinds of things will be important for the parts of Asia that want to pursue green ammonia or green hydrogen as part of their story.

McKinsey: The example of Morocco is fascinating. What are some other communities or countries that have made significant progress in innovative financing structures to achieve net zero?

Rachel Kyte: There are examples within the energy sector itself. The development-finance industry has used results-based financing, sometimes with great success, to help private operators set up in a country that doesn’t have a long track record in renewable energy, or to help them get to scale. In Nigeria, results-based financing from the multilateral banks has allowed the solar sector to grow at exponential rates.

Results-based financing is well understood in Asia. We have to ask: what is the policy objective? I think with clean cooking, there were interesting policy reforms in Asia, which were fundamental to the uptake, for example, of liquefied petroleum gas (LPG) in India. Policy reforms have allowed important innovations in clean cooking in India and Indonesia.

So you need policy reform and a policy objective. You need perhaps to use some public money to induce private operators into the space, and then stand back and see if it works. The question is, as the market matures, how do you withdraw that public funding? But I think beyond energy, we can look to microfinance, some kinds of financial innovation, and also some explosion of activity off the back of telecoms and mobile banking.

Microfinance, in the early days, couldn’t even legally operate in some countries, so you had to go in and change things like company law and banking. The analogy to energy is that utilities and energy regulation are written for a grid-connected, independent power plant. Well, that doesn’t work anymore, so you need to have different regulations and regulators, and you need to work on that quickly. Then you use public money to bring in the first operators.

Microfinance started off in two or three countries, and once those operators knew what they were doing, public money went to those operators and asked them to set up branches in other countries. For example, we took groups that were working in Eastern Europe and Central Asia and helped them set up in West Africa. Lessons learned in mobile banking in East Africa were taken to Indonesia; in Cambodia, much of the understanding of setting up mobile-phone banking came from other countries that had gone ahead.

Interestingly, as we talk about blended finance, the Inter-American Development Bank’s private-sector arm IDB Invest is asking itself very profound questions about its purpose, given the state of development in Latin America and the challenge of net zero. They’re examining the way they do business, and I wouldn’t be surprised to see them moving very quickly into a business model where they originate to distribute, not originate to hold. Now what’s the equivalent conversation for the bilateral entities within the Asian region?

I think there’s so much private money and sovereign funding that the purpose of development finance now is to lay the groundwork, help with the policy environment and institutions needed for this net-zero transition, do some of the early high-risk stuff, and then move that into sovereign funds and into Asia’s own resources. The Private Infrastructure Development Group in London, an entity funded by five or six different countries’ development finance, has this mandate of a development financier. It’s taken a large chunk of its portfolio and sold it on to a sovereign within the Asia region. This is how you release public capital to take the risks necessary to create the environment where private finance will flow more quickly.

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Shapers of Sustainability

Ben Caldecott

McKinsey: What are the key challenges that you see in terms of Asia’s transition to net zero versus more developed parts of the world?

Ben Caldecott: One of the major challenges is coal. The use of coal is a massive contributor to global warming and Asia is still using a lot of it. If we can’t phase out coal use in that region, then aspirations for decarbonizing the power sector are completely out the window.

Another big challenge is deforestation and land-use change. The reason it’s so big is that it takes many forms, from illegal logging to land-use change driven by agriculture. Palm oil is obviously a large driver. That’s a problem not just for mitigation, but also for adaptation. It’s also a massive problem for biodiversity: the fact that so many habitats are being destroyed so quickly, at a pace that has increased with higher commodity prices. It’s of global significance and, with few exceptions, we haven’t made much of a dent in it across the region.

A third challenge is the capacity of institutions in different parts of Asia to react and make the sorts of decisions that we need to tackle climate change. These issues are prevalent in different ways and they differ by jurisdiction; they range from technical capacity to things like access to capital and issues around governance. There’s the capacity of the public sector to mobilize in a productive way—as well as the private sector. It’s a challenge everywhere, but I think particularly so in the least developed countries in Asia.

McKinsey: Could you share what you think are potential unlocks for some of these issues?

Ben Caldecott: The key unlock with coal—and with power generation—is alternatives, particularly renewables; also storage. And then there’s the fact that in most of these markets those alternatives are actually cheaper than coal. The issue is often that the price signal doesn’t get transmitted into economic and financial decisions in many of these jurisdictions, in part because they’re mediated by a variety of vested interests.

Some of those are not within countries, but are external to them. If you take China’s Belt and Road Initiative, for example, there have been decisions recently around coal that are very positive. But not long ago, you had Chinese state-backed financial institutions providing cheap capital to get coal-fired power stations built by Chinese companies in Southeast Asia. Even though economically it doesn’t stack up, there are these interests at play. So it’s essential to make sure the economic signals get taken into account, and that alternatives can flourish at a rapid pace, particularly given the growing demand for energy across the region associated with increasing prosperity.

With deforestation and land-use change, again, the economics is completely one-sided—in the direction we don’t want. This has worsened recently, because it’s even more attractive to liquidate natural assets in favor of palm-oil plantations, for example, than it was previously. It’s really difficult to deal with that economic equation. Part of it is going to be making sure forests are worth more left standing, and creating the cash flows and economics for that. This is one of the biggest gaps at the moment and it’s a real public-policy challenge.

How do you promote the rule of law and good governance? It’s easier said than done. In other contexts, it involves technical assistance and exposing key decision-makers in certain enterprises to new ideas and giving them the ability to execute on them. When we’re thinking about nature, the biggest barrier often is absent cash flows. We need to create cash flows in different ways.

McKinsey: As you describe, some market decisions are made for political reasons. But there’s also a willingness to get things done, rather than look for the perfect solution. Would you agree that there’s an opportunity to be pragmatic?

Ben Caldecott: I agree with that one hundred percent. Dynamism necessitates rapid decision making. But equally, when we’re thinking about economic decisions in an Asian context, the role of governments or state-owned enterprises, or vested interests, looms large. That can result in some pretty suboptimal economic decisions.

McKinsey: How does a country start to act on some of these pragmatic decisions?

Ben Caldecott: In terms of getting a big, big transaction done that can actually move the dial, it’s probably going to be achieved in a large emerging economy in Asia. This is probably going to require some degree of domestic public financial support, combined with international support. You’re going to need some big companies—state-owned or not—to be involved, and you’re probably going to want some local financial institutions too, whether in the region or in the country in question. And then you want to pick an issue, such as agriculture, transport, or something that can make a dent in our mission to achieve net zero. As the economic crisis gets worse and the fiscal conditions deteriorate, those conditions exist in fewer and fewer jurisdictions.

This interview is part of an ongoing series on Shapers of Sustainability, where we convene leaders on sustainability to discuss challenges and opportunities in the Asia-Pacific region’s transition to net-zero.

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