Public Private Equity Partnerships and Climate Change

7/31/2019 Public Private Equity Partnerships and Climate Change

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In partnershIp wIth:

Public Privatequity

PartnershiPs:AccelerAting the growth of

climAte relAted PrivAte equity investment

IFC AdvIsory servICes In sustAInAble busIness


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e sa ................................................................................................................1

1 i .....................................................................................................................3

2 t d cba Pa e a v capa

ma ca ca ............................................................................................5

2.1 th r Pe/vC i emi Ma Cima Fiac ...................................6

2.1.1 Ca tch dpm ..................................................................7

2.1.2 Ca Pw Iac...........................................................................8

2.1.3 e efcic ...........................................................................................9

2.1.4 la u a F...................................................................................9

2.1.5 tap Iac ..............................................................................102.2 Hw Pe/vC Ii A va .........................................................................10

2.2.1 Fi ri nw tchi a bi M ..........................12

2.2.2 Iii a dpi Im oppii ..........................13

2.2.3 Hp Cmpai d bi b ..........................................................13

2.2.4 bi h C I .................................................................14

3 Ba dp Pe/vc ma ca i ...............17

3.1 bai ha sw F Maa Fmai .....................................................19

3.1.1 l-F raii Pi d Pia Maam tam ..........19

3.1.2 Pia Maam tam lac Capia .............................................19

3.2 bai ha sw Capia raii ........................................................................20

3.2.1 F Maa lac tac rc ...........................................................20

3.2.2 nw Im Aa lac a Hi r ....................................20

3.2.3 nw Im a Pci ri ...............................................20

3.3 bai dpi Capia i Cima Fi Im .........................22

3.3.1 Pii a Ma ha Hih C ..........................................................22

3.3.2 difci i Capi a h r m Pii Im ...22

3.3.3 th bf Ca Aam a n eai Mi ..............23

4 ma aa Pa e i ..........................................25

4.1 Achi ...............................................................................................................26

4.2 Fiaci F dpm ...............................................................................28

4.3 Pic Capia i h Waa ..............................................................................30

4.4 sppi Pii Im .....................................................................34

4.5 Imp Ca Pam ..................................................................................37

5 c ......................................................................................................................39

tbl o Conn


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APPendicesApp A: t Ba Pe/vc .............................................................................41

App B: r ..............................................................................................44

tABles

tab B.1: Ba ................................................................................44

tab B.2: s a a r ..................................................44

igures

2.1: nb ca da c b Pe/vc b 2000 a 2010 b gap ...........................................................5

2.2: da h ca i ma,

b Pa i ............................................................................................5

2.3: eap s a ma ca ca .......................................6

2.4: s ca- i a n Pe/vc .................................11

2.5: Pe/vc a Pj b ip dp ................15

3.1: dp da Pe/vc ma ................................................17

3.2: w d a Pa e i n o a

ma Pa ha r .............................................21

4.1: i o Ba Pe/vc i ..................25

4.2: ic r i t Pe/vc

op a i Ba (2000-2010) ........26

4.3: A waa s a ia up la ra

a Pa Pa s ...................................................................................32

4.4: A waa s a dap d ............................................32

5.1: g s a Pe/vc ...................................................................41

5.2: l c a Pe/vc ................................................................................42

ii


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BoxesB 2.1: sa lap: A i A Pe/vc a epa .........7

B 2.2: e ef B m ..................................................................9

B 2.3 t r Pa e a ga Pj .....................12

B 3.1: o Ba i ..........................................................................18

B 4.1: t ic ep i t ......................................27

B 4.2: n l capa gpca s i .................28

B 4.3: A ma haza ....................................................................................29

B 4.4: t yza : A s waa s ......................................31

B 4.5: Pb capa waa s:

l iaa ep..........................................................33

B 4.6: e+c spp B2wa la i

ea t s Aa ................................35

B 4.7: eap Appa spp P i ...................36

B 5.1: t d B db a e .....................................................41

ii


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PuBlic PrivAtequity PArtnershiPs: AccelerAting the growth o climAte relAted PrivAte equity investment

iv

ADB Asian Development Bank

CCG Combined-Cycle Gas urbine

CDM Clean Development MechanismCER Certied Emission Reduction

COP15 15th Conerence o the Parties

CSR Corporate Social Responsibility

CW Carbon Warehouse

Dera Te Department o Environment, Food, and Rural Aairs

DFID Department or International Development

EE Energy Eciency

EBRD European Bank or Reconstruction and Development

EU-ES European Union Emissions rading Scheme

ERPA Emissions Reduction Purchase AgreementERUs Emission Reduction Units

ESCO Energy Service Company

GHG Green House Gasses

FIs Financial Institutions

GP General Partner

IFC International Finance Corporation

IFI International Financial Institution

LP Limited Partner

IPO Initial Public Oering

KFW Kreditanstalt r WiederaubauMAC Marginal Abatement Cost

MACC Marginal Abatement Cost Curve

MCCF Multilateral Carbon Credit Fund

PE Private Equity

PE/VC Private Equity and Venture Capital

NASDAQ National Association o Securities Dealers Automated Quotation System

PEF Private Equity Funds

PSPEF Publicly Supported Private Equity Fund

PPP Public Private Partnerships

SPC Shadow Price or CarbonUK United Kingdom o Great Britain and Northern Ireland

UNFCCC United Nations Framework Convention on Climate Change

US United States o America

US$ United States Dollar

VC Venture Capital

VCF Venture Capital Funds

WACC Weighted Average Cost o Capital

aconym nd abbviion


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Mitigating climate change by reducing greenhousegas emissions in developing countries will require

considerable investmentsestimated by the World

Banks 2010 World Development Report to be as much as $4.6

trillion to keep global average temperature rise within 2 degrees

Celsius by the end o the century. Most o this investment will need

to come rom private businesses. Many o the investments will

require risk taking and innovation, involving new technologies

and new business models. Many investments will be small and

ace uncertain cash ows. Climate riendly projects with just these

characteristicssmall size, risky and requiring innovationwill

need sources o capital able to deal with the level and types o

risk involved. Tey also need investors able to add value through

improved governance and mentoring o management.

Not all sources o capital are able to respond to this challenge.

Far rom being ungible, capital tends to all into specic

categories. Equitythe at risk capital which claims prots rom

the businessis clearly dierent rom debt, which comes with

a much lower risk appetite and an expectation o xed returns.

Among the various types o capital, Private Equity/Venture

Capital (PE/VC) is uniquely suited to nancing climate riendly

investments that are risky, innovative, and relatively small. PE/

VC unds will certainly not provide more than a raction o the

$4.6 trillion investment neededbut they ll a key niche.

Pe/vC Funds FIll An IMPortAnt nICHe

PE/VC unds:

Make risky investments: PE/VC unds provide rms

and projects with a orm o nancing that is more pa-

tient and exible than debt. PE/VC unds are among the

only investors willing to provide cash to medium sized

companies to burn while they develop into protability

Provide cornerstone nance: PE/VC unds are able toprovide equity nance to earlier stage companies that can-

not access debt nancing (cash ows too risky and too ew

tangible assets) and are too small to access securities mar-

kets, but too large to rely on riends and amily. Te equity

nancing provided by PE/VC unds allows the companies

to invest and access other orms o nancing such as debt

Help companies do business better: PE/VC unds

help the companies in which they invest to build

up their governance, managerial and technical

capacity. Tis provides much needed support, especially indeveloping countries where such capacity is oten lacking

Identiy and develop business opportunities: PE/VC unds

take an active role in developing the pipeline o projects

and companies in which they can invest. Tis oten means

helping companies in which they wish to invest to build

up the systems (such as governance, accounting and per-

sonnel) needed to absorb outside nancing, systems which

are oten lacking in companies in developing countries.

Te ability o PE/VC unds to provide both expertise and

capital means that they are uniquely positioned to initiate

investments in nascent climate industries.

tHe Pe/vC MArket FACes bArrIers tHAt sloW

InvestIng In ClIMAte FrIendly ProjeCts In

eMergIng MArkets

Tere are both capital market and carbon market barriers

that hinder the development o the PE/VC market or climate

riendly investing in emerging markets:

Fund manager ormation: New investment areas need

new und managers. However, putting together a new

und is risky, costly, and time-consuming. Few pro-essionals with the right skills have the appetite to do

it. Unortunately, a shortage o good und managers

slows the rate at which the entire market can develop.

Raising capital: Mitigating climate change requires invest-

ments in new sectors, technologies and business models.

Tese investment types oten have no track record o his-

toric returns. Te und management teams who have the

skills to tackle these areas are oten new too, with no track

record. Yet typical investors in PE/VC unds rely on track

records o teams and sectors in deciding where to place their

capital. Tis leads to a chicken and egg problem. A und

or sector needs a track record o returns to attract capital,but without a track record o returns it is unable to raise

nancing and so cannot invest and build a track record.

Deploying capital: Small, innovative climate riendly

projects may impose high management expenses on PE/

VC unds, which are uneconomic within the industry-

standard two percent management ees. Such pioneer-

ing investing can benet the development o a whole in-

dustry, since it produces models or others to ollow, but it

is oten hard or the pioneers to capture this aspect o the

excuiv summy


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benets they produce. Further, PE/VC undslike any

other investor in climate riendly projectssuer rom di-culties in capturing the positive externalities rom carbon

emissions reductions in a orm that can attract nance.

role oF tHe PublIC seCtor

Te public sectorparticularly the International Financial

Institutions (IFIs) and bilateral donorscan help to overcome

the barriers holding back the PE/VC market. o assist with the

ormation o unds and raising capital, public sector nancial

institutions can:

Anchor new unds: IFIs can identiy promising new und

management teams and commit capital to them. Anchoring

includes letting teams with potential know where they

need to strengthen their oering (or example, by bring-

ing additional skills), helping the und with structuring

and documentation, and introducing the und to other

potential investors. Te advice and introductions are

made credible by the IFI committing capital to the und.

Anchoring has successul ly kick-star ted PE/VC invest-

ing in areas as diverse as early stage climate riendly inra-

structure in Asia, plantation orestry in Arica, and clean

technology in China. Anchoring can be a commercially

successul strategy. IFCs return on rst time private eq-uity und teams between 2000 and 2010 was higher than

the top quartile benchmark o emerging market unds.

Finance new und development: Public institutions can

provide capital to new management teams to help them -

nance the costs o setting up a new und and getting com-

mitments to the und rom investors. Firms currently do

this on a commercial basis but largely in developed PE/

VC markets. IFIs and donors could do this in emerging

markets. Te capital provided could be a quasi-equity in-

vestment in the und manager, which would return capi-

tal to donors rom returns on the und i it is successul.

IFC does not do this now, but its experience with rsttime unds suggests that this approach could be com-

mercially successul, as well developmentally positive.

Invest in a new und on a concessional basis through a wa-

terall structure: In a classic und structure, a ll investors, in-

cluding any public institutions, participatepari passuthat

is, they share equally in prots and losses. Public institu-

tions have an opportunity to oer a waterall structure,which subordinates their returns to the returns o private

investors in certain circumstances. Te waterall can be de-

signed to attract private investors by dampening their losses

i the und does badly or leveraging upside i the und suc-

ceeds. Tis approach contributed to the development o the

Venture Capital (VC) sector in Israel. In Israel, the Yozma

und deployed US$100 million o government capital in

1993 into select VC unds using a waterall structure. Tis

helped catalyze the development o an industry which had

US$9.6 billion under management by 2001. In other words

or every dollar invested by the Israeli government in 1993

by 2001 US$96 had been invested by the private sector.

o help overcome the barriers to deploying capital protably,

public sector institutions can:

Support pioneer investments: Grants can be provided or

pioneering activities such as easibility studies and regulatory

approvals or new types o investment. Given the scale o the

pioneering needed, there is potential or governments to in-

crease the level o support provided and to proactively route

it through the PE/VC unds. In order to mitigate potential

moral hazards and to increase the alignment o interest be-

tween public and private capital, support could be provided

through a loan acility that is repaid out o the und man-agers uture earnings. Tis acility could help cover the up-

ront costs enabling PE unds to provide business and mar-

ket development services as part o their investment strategy.

Provide improved carbon payments: Public sector institu-

tions have an opportunity to create a new kind o carbon

payment mechanism that will provide revenue certainty or

carbon emissions reducing projects. While this mechanism

could in the long term provide an additional revenue stream

in the short term it can be used as collateral against which

projects can raise more debt. Such a new carbon payment

mechanism would be particularly helpul in catalyzing

urther private equity investment as the increased lever-age would help to shit the equity returns on many climate

riendly projects rom marginal to commercially attractive.

Trough a combination o the above ve interventions, public

sector institutions could greatly accelerate the development o the

PE/VC market in climate riendly investing in emerging markets.


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Public sector institutions around the world are working on waysto bring more private nance into investments in emerging

markets that mitigate climate change. Tis paper argues that

there is an important role or Private Equity and Venture

Capital (PE/VC) unds. IFC has been actively investing

in climate riendly private equity unds and is interested in

understanding how public private partnerships could be

developed to scale the market. o that end, IFC contracted

Castalia Ltd (www.castalia-advisors.com), to prepare this

report. Tis paper suggests that:

PE/VC unds have unique role to play acilitating climate

riendly investments (Chapter 2)

Tese unds ace important barriers that limit the ow o

PE/VC into climate riendly investments (Chapter 3)

Public sector institutions have arange o interventions theycan use to overcome those barriers and so increase PE/VC

nance o climate riendly investments in emerging markets

(Chapter 4).

Te audience or this report is policy makers and others

interested in the role that public support or PE/VC unds can

play in supporting climate riendly investments. It is intended

to help shape conversations about how public capital can

eectively be deployed to leverage private nance to stimulate

the growth o climate riendly private equity investment in

emerging markets.

1 Inoducion


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interventions across all asset classes. Among the various types

o capital, Private Equity/Venture Capital (PE/VC) is uniquely

suited to nancing climate riendly investments that are risky,

innovative, and relatively small and thus likely to have themost transormational impact. PE/VC unds will certainly not

provide more than a raction o the $4.6 trillion investment

neededbut they ll a key niche.

Indeed over the last decade there has been a signicant growth

in climate riendly investment by PE and VC rms. From very

ew deals in 2000 the market has grown to US$ 20 billion per

year in 2010.

While the market has grown there is

considerable opportunity to accelerate

the deployment o PE/VC capital in

emerging markets. As can be seen in

Figure 2.1, most deals are occurring in

developed countries, with more than

50 percent o activity in the United

States and United Kingdom. Less than

10 percent o climate riendly deals are

in emerging economies, and o these

more than 80 percent have occurred in

India and China. As a result, less than

2 percent o PE/VC und activity is

spread across all the emerging markets

outside o India and China, despite

these countries making up 20 percent

o the worlds economy. Further most

investment in emerging markets has

been made by international rms

investing rom overseas. Tere is still a

very limited number o locally developed

climate riendly private equity unds in

emerging markets.

Investments have to date also targeted

a common niche with 3,334 deals, or

80% o the total number o climate

riendly deals ocusing on technology

development, particularly in energygeneration, as shown in Figure 2.2.

Mitigating climate change requires vast investment. Te

World Bank estimates the volume o nancing needed to

meet the additional costs by the international community or

climate change-related development at between $180 billionand $250 billion per year. However, this sum represents

only the additional or incremental costs: it would need to

leverage nearly 20 times that amountor up to as much as

$4.6 trillionrom underlying investment nance rom other

public or private sources.1

Tese investment needs are diverse, and catalyzing the necessary

nance to address the challenge o climate change wil l require

2 t Diinciv Combinion o piv equiynd Vnu Cil o Miiging Clim Cng

1 Tis investment is required to keep global average temperature rise within 2 degrees Celsius. Page 2 World Bank, 2010 Beyond the sum o its parts, combining nancialinstruments to support low-carbon development Te International Bank or Reconstruction and Development.

2.1: nb ca da c b Pe/vc

b 2000 a 2010 b gap

Source: ICF International and the Payne Firm.

2.2: da h ca i

ma, b Pa i

0

500

1000

1500

2000

2500

Other

Materials

Water&

Wastewater

Agriculture

Manufacturing

/Industrial

Air&

Environment

Transportation

Energy

Infrastructure

Recycling

&Waste

Energy

Storage

Energy

Efficiency

Energy

Generation

0

10,000

20,000

30,000

40,000

50,000

60,000

70,000

NumberofDeals

DealValue(Millions$)

Deal Value

Number of Deals

Source: ICF International and the Payne Firm.


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2.1 the role or Pe/vc inemerging mArket climAte inAnce

As shown in Figure 2.3 in emerging markets there is an

untapped potential or private equity and venture capital

to support technology deployment and business growth in

Clean Energy and in other sectors including energy eciency,land use and orestry, and climate-riendly transportation.

Opportunities also exist along the supply chains in these

industries, both upstream and downstream.

2 Tese percentages are dierent or countries other than Mexico. For instance in Indonesia there is substantial potential to reduce emissions rom changing land use. InIndonesia the two largest sources o GHG emissions are peatlands (which makes up 38 percent o GHG emissions in 2005) and the degradation o natural orests (whichcontribute around 40 percent o emissions). Dewan Nasional Perubahan Iklim, 2010 Indonesias greenhouse gas abatement cost curve August 2010

2.3 eap s a ma ca ca

Source: odd Johnson, Claudio Alatorre, Zayra Romo, and Feng Liu, 2009 Low-Carbon Development or Mexico, Te International Ban k or Reconstruction and Development, TeWorld Bank.

Percentages reer to the share o investments expected in Mexico. 2

Areas where investmentis needed and the relativesize o investment needed

Sectors in which PE/VC unds invest thatmitigate climate change

Companies that needPE/VC fnancing

(i) Independent

developers notafliated with largerutilities or large listed

companies, investingin small scale projects,typically less than

35MW, and (ii) start-ups introducingand/or manuacturing

new technologies

Independentcompanies, not

afliated with a utility

Companies whosebusiness model is basedon saving clients energy

ESCOs

Converting agriculturalwasted into electricityBiogas

Start-ups not linked toestablished electronics

companies

These devices replacecarbon emittingkerosene lamps

Solar lamps

Heat rom undergroundis used to generateelectricity

Geothermal

Small to medium size,

domestic companies

These devices reducecarbon emissions romcookingCookstoves

Wind energy is used togenerate powerWind arms

Unlisted plantationcompanies

Plantations sequestercarbonAgriculture

investments

Land use(orestry andagriculture), 10%

Energy efcientdevices andprocesses, 43%

Clean powerinrastructure, 33%

Biological waste romactories is used toproduce energy

Biowastecogeneration

PPPsMass transit systemsreduce carbon-emmittingpersonal transportation

Masstransit

Inrastructure investmentsthat reduces the need orenergy, 14%

Solar radiation is con-verted into electricitySolar

Photovoltaic


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tHe dIstInCtIve CoMbInAtIon oF PrIvAte equIty And venture CAPItAl to MItIgAtIng ClIMAte CHAnge

2.1.1 CleAn teCHnology develoPMent

Mitigating climate change requires that consumers and companies

use energy more eciently, and that energy is generated romnew, renewable resources. Tis requires innovative new devices

and processes.

Innovations in energy eciency and renewable energy

technology are likely to come disproportionately rom smaller

companies that are supported by, or need support rom, PE/VC

unds. Large investments have already been made by Venture

Capital (VC) unds in this space. In the United States alone,

VC unds invested more than $1 billion on clean technology in

the rst three months o 20113 Kortum and Lerner4 nd that

companies supported by Venture Capital Funds produce ve

3 iany Hsu, 2011 Clean-tech venture capita l jumps 54% in rst quarter 2011 LA imes, May 2, 2011 (http://latimesblogs.lat imes.com/greenspace/2011/05/cleantech-venture-capital-jumps-54-q1.html).4 Samuel Kortum and Josh Lerner, 2000 Assessing the contribution o venture capital to innovation RAND Journal o Economics, Vol. 31, No. 4, Winter 2000, pp.674692.

times as many patents per dollar o R&D expenditure than

other rms spending on R&D. Smaller rms oten need PE/

VC unds to provide them with capital because they cannotaccess nance rom banks or security markets. Tey are also

able to earn the returns that PE/VC unds expect rom their

ability to achieve ast top line growth.

Te disruptive and innovative role o start-up companies can

be seen in the climate mitigation investment area. Box 2.1

shows how VC unds have contributed to the development

o solar lantern technologies. Solar lanterns replace kerosene

lamps which emit carbon dioxide. Castalias research suggests

that 100 million households who rely on kerosene lamps could

aord to buy a solar lamp. I solar lantern companies achieve

Box 2.1: Solar Lamps: an Industry Accesses PE/VC Fund Financing to Expand

Large, well established, electronics companies were slow to supply solar lamps to poorer consumers. Te market was not thought

to be particularly large, and designing solar lamps or consumers at the bottom o the pyramid was dicult or multinational

companies used to selling products to wealthier consumers. A number o start-up companies lled the gap, introducing innovative

products and business models. Te table below shows that leading solar lamp companies relied on PE/VC und nancing to

expand (d.light and Duron), or are actively seeking PE/VC und investors to grow (Bareoot Power and Greenlight Planet).

BarefootPower(Australia)

d.light(United States)

GreenlightPlanet (India)

Duron

EquityandloansupportfromOikocredit 1milliongrantfromEIB Seeking$5millionfromothernanceprovidersincludingPE/VCfunds.

Raisedstart-upcapitalbywinningbusinessplancompetitions $6millionSeriesAnancingfromPE/VCfundinvestors $5.5millionSeriesBnancingbytheinitialinvestorsandOmidyarNet-

work.

Grantfunding Initialfundingfromanangelinvestor

Currentlylookingtosocialimpactfundstogrowitsbusiness.

Raisedstart-upcapitalthroughgrants SeedCapitalfromAngelInvestors(Idealab,QuercusTrust,Solgenix).

Example o device Name Investment and Financing


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8

Tese segments have growth characteristics that oer

opportunities or smaller applications. Additionally, many

o the clean power technologies are new, or instance wind

and biomass generation use rapidly developing technology.Innovative geothermal plants are being developed as well.

Given the scale and the relative novelty o the technologies,

smaller developers can be expected to play an important role.

Innovation will be crucial to supporting the development

o the industry as it helps to lower the costs o technology

enabling scale up by larger utilities. Innovation will also be

required to develop new business models or the deployment

o clean energy solutions. Small scale enterprises will need to

be backed with capital and expertise i they are to get through

their start up phases and into ull production.

Tere is already considerable investment in clean energy by

private equity unds.9 For instance, Berkeley Capital has raised

$74.12 million or its Renewable Energy Asia Fund (REAF).

Te und will ocus on investing in small hydro, wind, solar

power, and biomass in India and other developing countries

in Asia.10

Still, the investment need is greater than the current private

equity activity. Project developers report that an absence o

third party nancing is holding back investment. An example

is asiaBIOGAS, a developer with experience developing a

range o biogas technologies in South East Asia. Despite its

experience and technical credentials, it has ound that anabsence o third party equity nancing has constrained its

ability to develop projects. Opportunities also exist to utilize

telecom towers, which are not connected to the grid, as

oundation customers providing power to them with a high

renewable energy content. While there is a very signicant

market and demand or such an approach, the key aspect o

it is that the power company needs to have the appropriate

balance sheet in order to assume the risk that comes rom the

demand o the mobile operators or tower companies. Private

equity unds could supply the crucial cornerstone equity or

such ventures.

their objective to serve all these consumers, annual carbon

dioxide emissions rom kerosene lamps would all by 8 million

tons.5 Yet companies in this space typically have almost no

assets, and negative cash ow, so banks will not lend to them.

ake d.light as an example. d.light is pioneering the sale o

solar lamps to poor consumers in India, Arica, and the Pacic

Islands. Te rm was initially unable to obtain debt nance.

It had ew tangible assets because its business model required

substantial investment in the development and marketing

o innovative products. In its early years d.light relied on

nancing rom PE/VC unds such as the Acumen Fund,

Gray Matters Capital, Nexus Venture Partners, Draper Fisher

Jurveston, and Garage. Tis nancing enabled d.light to sell

more than 250,000 lamps by 2010 and the company hopes to

provide lighting to 50 million people by 2015.6

PE/VC unds are also supporting better place, a company

that is pioneering the roll out o battery service stations where

electric vehicles can swap drained batteries or a recharged

battery in much the same way that a car lls up with gasoline.

Tis inrastructure allows electric vehicles to achieve the

same range and convenience as conventional ossil uel

powered vehicles.7 Another beneciary o PE/VC nancing is

Changelight, a Chinese company that researches and produces

LED chips and high eciency solar cells.8 Investment is

thereore happening but it is still at a very nascent stage with a

limited number o investors actively looking or opportunities.

2.1.2 CleAn PoWer InFrAstruCture

o meet GHG emissions reductions targets, substantial

investment is needed in biogas, geothermal, wind arms, and

other renewable energy generation. Investment will be needed

in grid connected installations, mini grids and in devices such

as solar lamps. In many cases these technologies oten use

relatively small, decentralized power plants. Tese plants are

oten developed by smaller companies with limited resources

which need cornerstone investors such as PE/VC unds.

5 Castalia research on the potential market or products and services that extend access to energy6 David Wolman, 2010 Want to Help Developing Countries? Sell Tem Good Stu Cheap Wired October 2010

(http://www.wired.com/magazine/2010/09/st_essay_pennies/).7 Israeli Cleantech Partners supported better place, better place is described on its website ((http://www.betterplace.com) and Israeli Cleantech Partners is described here:

(http://www.israelcleantech.com).8 Changelig ht received nancing rom Sequoia Capital (http://www.http://www.sequoiacap.com/china/changelight).9 Asieh Monsour, Stella Yun Xu and Mark Fulton, 2009 Inrast ructure Investments in Renewable Energy RREEF (http://www.dbadvisors.com/content/_media/1175_

InrastructureInvestmentsInRenewableEnergy.pd).10 VCC, 2009 Berkeley Energy Ra ises $74M Cleantech Fund o Invest In India, Asia VCCIRCLE

(http://www.vccircle.com/500/news/berkeley-energy-raises-74m-cleantech-und-to-invest-in-india-asia).


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2.1.4 lAnd use And Forestry

PE/VC unds also have an important role to play investing in

plantation orestry. Expansion in plantation orestry has the

potential to sequester large amounts o carbon dioxide. ake

East Arica or example. Te World Agroorestry Centre13

estimates that in Kenya, Zambia, and Uganda there is potential

or 30 million hectares o plantations. In a scenario where this

land would otherwise be grassland, these plantations would

sequester enough carbon emissions to oset the emissions that

eighty 500MW coal powered stations make over 20 years.

Reaching even a raction o this potential will be dicult

without access to private equity. Large scale expansion in

greeneld plantations are dicult to nance using debt

because plantations can take more than seven years to start

2.1.3 energy eFFICIenCy

As much as hal o the tota l abatement in Green House Gases

(GHG) needed globally is expected to come rom increasedenergy eciency.11 Analysis o abatement costs consistently

show energy eciency investments as among the lowest cost

approaches, oten generating nancial and economic returns

that should more than justiy the investment, even beore

the benets o GHG abatement are taken into account. Yet

the potential or energy eciency gains in private companies

and government acilities remains largely unexploited. Tis is

oten because the managers o those companies and acilities

do not have the expertise, ocus, or incentive to pursue energy

eciency. Other barriers include agency problems, in which

energy ecient investment would be a cost to the landlord, but

the benet would go to the tenant in lower utility bills. People

buying buildings and equipment oten cannot easily assess the

dierence in lietime energy costs between dierent options,

and so may choose not to pay more or more ecient options,

even when doing so would be in their own interest.

Energy Service Companies (ESCOs) are a solution to some

o these problems. As described in Box 2.2, ESCOs are

companies that specialize in increasing energy eciency or

large energy users in the private and public sectors. Tey install

devices, and implement processes, which reduce companies

and governments energy usage. Te ESCO provides the

capital, ocus, and expertise needed to make energy eciency

happen, and typically is rewarded with a share o the savings

in energy costs.

Because ESCOs invest in energy ecient equipment and its

installation, and then are paid rom a share o the energy savings,

they need capital. Without signicant collateral ESCOs can

nd raising debt challenging and are generally able to leverage

their assets less that other companies. ESCOs thereore need

substantial quantities o equitymore than can be provided

rom riends and amily and retained earnings. However, they

are generally too small to raise equity on a stock exchange.

As a result, a lack o private equity constrains their ability to

grow. An example is Gestin Integral Energtica SA (GIE), a

Columbian ESCO. GIE provides services to smaller clientsthat the ESCOs associated with large utilities in Columbia

dont consider worth serving. However, GIE and other similar

ESCOs struggle to access equity nancing. Tey report that

there are many companies that they could protably serve i

they had access to additional equity nancing.

11 IEA, 2009 World Energy Outlook 2009 Fact Sheet, Why is our current energy pathway unsustainable?(http://www.iea.org/weo/docs/weo2009/act_sheets_WEO_2009.pd)

12. Bullock, Car y, and George Caragha iur. 2001 Guide to Energy Services Companies Te Fairmont P, Inc., 2001. 10 Mar. 200813. Figures or Kenya, Uganda and Zambia are taken rom Jonathan Hasket, Potential or Land Use Carbon in Aric a: Forest and Agroorestry Carbon World

Agroorestr y Centre (www.aricacl imatesolution.org/.../Potential_or_Land_Use_Carbon_in_ Arica _06042009.pps).

Box 2.2: Energy Eciency Business Models

Tere are two major business models based on improving

energy eciency (EE). Te rst is to prot rom producingmore energy ecient equipment. Tis includes sellers o

industrial equipment as well as consumer appliances such

as washing machines and light bulbs.

Te second is the Energy Service Company (ESCO)

model. Tese companies install equipment, or redesign

buildings and industrial systems and processes, to reduce

their customers energy usage. Te customer does not pay

or this service. Rather, the ESCO bears the up-ront cost

and then makes back its investment by receiving a share

o the resulting energy savings. In this way the ESCO

provides service (reduced energy consumption) and

nance by bearing the up-ront cost and only receivingits return over time.

One o the earliest examples o an ESCO was ime

Energy rom exas. In the 1970s it started selling a

device to automate the switching o and on o lights and

other equipment to save on energy costs. Many potential

users doubted that signicant savings would result rom

instal ling the devices, and so sales were slow. o overcome

these doubts the company decided to install the devices

up-ront and ask or a percentage o any savings that

resulted. Tis approach led to a large increase in sales.

Tis model has been widely adopted since then.12


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10

2.2 how Pe/vc investingAdds vAlue

Many climate-riendly projects and companies are small,innovative, and ace unamiliar risks. Tese projects and

companies need capital that is able to deal with the risk and

uncertainty involved and as a result securing debt nance can

be problematic without sucient collateral. Equally smaller

businesses are oten caught between having the necessary

scale to access the public markets but requiring too much

capital to be unded through riends and amily. Climate

related businesses in new sectors also in many cases require

investors who can provide additional support and services

helping to improve governance, management capacity and

business processes, as they undergo rapid expansion. As Figure

2.4 illustrates Private Equity and Venture Capital Investors

provide a mix o capital and expertise that can support ast

growing climate riendly businesses in some o the key growth

sectors that were identied above.

However private equity is among the most expensive sources o

capital. wenty percent plus returns on capital are a common

target. In addition, the costs o the und managerthe

management ee and the carrymust ultimately come out o

the returns on the investment. Clearly then, PE/VC unding

or a company only makes sense when other types o unding

are not suitable or available, or when the und manager is able

to add signicant value to the investment.

PE/VC unds use our main techniques to achieve their desired

returns:

Revenue growth: Higher sales, coupled with constant or

declining unit costs, increase the total value o prots and

thus the value o the company. For example, a supplier o

energy ecient appliances could expand its distribution

network, increasing sales and prots proportionately

Margin expansion: Prices can be raised or costs cut thus

increasing the rms protability and thus the price at

which it can be sold. For example, a solar PV company could

improve its procurement o solar panels, thus pushing downinput prices

generating revenue, meaning that the investment cannot cover

debt payments rom cash ows or seven years or more. It is

dicult to raise nance or plantations through public equity

oerings because integrated orestry companies (o the kindtypical in East Arica) have had diculties achieving air

value in public equity marketswhich makes listed orestry

companies wary o investing in plantation assets.14

As a result, PE/VC unds are behind a number o the

companies pioneering investment in plantations in East

Arica. For instance, Green Resources, one o the continents

largest plantation companies, received nancing rom Phaunos

imber Fund.15 Another leading player in the region is New

Forests Company which received nancing rom HSBCs

Principal Investments und.16 Tese companies, and others,

have nanced large increases o the land under plantation in

the region using PE/VC und investment.

2.1.5 trAnsPort InFrAstruCture

Since around 20 percent o anthropogenic GHG emissions come

rom transport, ecient transportation inrastructure is clearly

important in abating emissions.17 Tis will mean new investment

in ecient urban transit systems such as metro rail and bus rapid

transit, as well as multi-modal reight terminals and ecient ports

and rail networks or the transport o heavy cargo. Ecient toll

roads can also reduce emissions i they provide more direct routes,

less stop-start driving, and cut time idling in trac.

PE/VC unds are an important source o nance or ports, rail,

and or Public Private Partnerships (PPPs) which enable many

public transportation projects. Te rehabilitation o Londons

underground was nanced by private equity, as was Sydneys

airport rail link. Private equity is also investing in port assets

globally. In India or example, private equity is backing

the expansion o Karaikal Port in amil Nadu.18 A PE rm

managed by Warburg Pincus has invested in the development

o Gangavaram Port in Andrha Pradeshthe deepest port

in the country.19 Inrastructure unds have made large scale

investments in public transport inrastructure in developing

countries. IDFC Private Equity has invested in public

inrastructure in India and 3i Inrastructure has ra ised a $1.2billion und to invest in transport inrastructure in India.20

14. Neilson suggest s that integrated plantation orest companies are not able to reali ze the true value o their planted and managed native orest holdings in the companies

share prices and so these companies have a large incentive to disinvest rom plantation holdings and a corresponding absence o incentive to invest in plantations.D Neilson, 2007 Corporate Private Sector dimensions in planted orest investments. Food and Agriculture Organizations o the United Nations.

15. Capitaleritrea, 2009 Phaunos imber Fund Raises Stake in East Arican Forester Green Resources(http://www.capitaleritrea.com/region/phaunos-timber-und-raises-stake-in-east-arican-orester-green-resources/).

16. HSBC, Principal Investments, Arica (http://www.hsbcnet.com/pi/arica).17. Roger Gorham, 2002 Air Pollution rom ground transport an assessment o causes, strategie s and tactics, and proposed actions or the international community Te

Global Initiative on ransport Emissions, A Partnership o the United Nations and the World Bank, Division or Sustainable Development, Department o Economicand Social Aairs, United Nations (http://www.un.org/esa/gite/csd/gorham.pd).

18. http://www.avcj.com/avcj/news/2103237/ascent-capital-commits-usd45m-kara ikal-port-expansion.19. http://www.gangavaram.com ; http://www.business-standard.com/india/news/gangavaram-port-hopes-to-break-even-in-3-yrs/447560/.20. http://www.3i-inrastructure.com/3i-india-inrastructure-und.html.


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In emerging markets, these techniques can be less easy to

deploy and PE/VC unds must ocus largely on revenue

growth and margin expansion. While debt is harder to raise

PE/VC unds do still provide a crucial source o capital against

which urther nance can be leveraged. For climate related

investments PE and VC unds look to achieve returns by:

Funding risky new technologies and business modelswhich

creates value by allowing the rm to achieve revenue growth

Identifying and developing promising companies, through

signicant due diligence and pipeline development PE unds

actively seek and create new investment opportunities andwill oten spend considerable time supporting businesses

prior to an investment.

Helping companies do business better through improved

governance, strategies (including a shit to lower carbon

operations), and systems which acilitate equity investments

and helps rms to achieve higher revenue growth and

margins. Tis approach can also expand multiples, since with

better management and governance systems, risk is reduced.

Multiple expansion: Te Price to Earnings ratio (or similar

valuation metric) at which investors value a company

increases. In essence, a new buyer is willing to pay a higher

price per dollar o expected uture earnings than the PE/

VC und paid or it. Tis is generally achieved by decreasing

risk levels (or example, taking a renewable energy project

rom permitting to operations). It can also be achieved by

increasing the prospects or growth, or example, pioneering

the entry o the investee company into a new market

Increased leverage: Te amount o debt taken on can be

increased thus reducing the rms cost o capital and thus

increasing its value. For example, a biogas company can takeon more debt as it becomes more established. Tis would

allow equity to be taken out o the company, and increase

the return on the equity that remained.

In developed country markets, leverage and multiple expansion

are the techniques commonly associated with PE unds.21 Tese

techniquesbuying a company, loading it with debt, and then

selling it at a higher price to someone elsecan be controversial.

2.4: s ca- i a n Pe/vc

Type ocompany

Indepenentdevelopers

Small-scale projects

Companies notaliated with

a utility

Start-up companies

Independentdevelopers

PPPs

Ability toprovidecollateral

Developers haveew tangible

assets until projectis nanced

Same as above

Banks sometimes dontaccept contracts with

clients as collateral

Companies have

ew tangible assets

Plantations are asource o collateral

Collateral dependson the nature

o the PPP

Volatility andRisk o CashFlow

In early to latestages projects

have highlikelihoodo ailure

Equity needed innancing to absorb

any volatility incash fow, even

though cash fowrelatively stable

Risk o non-paymentby rms

High risk and volatility

in start up phase

Plantations producelittle on-going cash

fows to service debt

Risk o non-paymentby government

Ability toaccesssecuritiesmarket

Developers aretoo small to accesssecurities markets

Projects are too smallto access securites

markets

Too small

Too small

Limited

Only particularlylarge PPPs can

access securitiesmarkets

Beneft rommanagerialadvice

Advice oncontractural risks,

structuringcontractural

arrangements,regulatory risks

and riskmanagement

techniques

Potenital toacilitate transer o

technology andpratices

Strategic andmanagerial advice

have increasedvalue

Value rom bringingin the best practice

management o

plantations

PPPs do not benetrom management

advice

Need orprivate equityfnancing

3

3

3

3

3

Clean power inrastructure

Biogas

Geothermal

Solar Photovoltaic

Wind arms

Biowastecongeneration

Energy eciency

ESCOs

Clean technologydevelopment

Solar lamps

Cook stoves

Land use and orestry

Plantations

Transport Inrastructure

PPPs

21 VC Funds in contrast ocus more on Growth. Tey are looking or rms with low sales but great potential, such as new technology companies.


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12

Being the cornerstone investorin a growing company, and

so bringing in other, lower-cost debt capital that would not

otherwise be available thus increasing the rms leverage

Te ollowing section lays out in greater detail how private

equity unds have the potential to support the growth and

development o climate related businesses by providing

a combination o growth capital and expertise. A uller

description o the basics o how Private Equity and Venture

Capital investing works can be ound in Appendix A.

2.2.1 FundIng rIsky neW teCHnologIes And

busIness Models

VC investors in particular oten seek to nance highly risky

technology companies, knowing that many will ail, but

counting on those that succeed to do so well that they more

than oset the losses. For this approach to make sucient

returns to warrant the risks, the rms that succeed need to

achieve dramatic revenue growth.

Tis ability to take risk is in complete contrast to banks.

ypically, banks demand that borrowers have steady positive

cash ows that can pay interest on the debt, and tangibleassets that can be used as collateral. Tese requirements work

or companies investing in real estate or machinery, but rms

investing in intellectual property or new business models

struggle to get bank nance.

Geothermal energy is a renewable technology that absolutely

requires risk capital. Geothermal energy is one o the ew

renewable resources that provides reliable power 24 hours a day,

365 days o the year, at prices which can be competitive with

ossil uels. Unortunately, early stage geothermal development

is much riskier than conventional power plant development.

Te only way to tell i the geothermal resource will generate

power is to drill a well. But drilling the well costs millions o

dollarsoten a substantial portion o the total geothermal

development cost. Few investors are ready to put up millions

o dollars, knowing that it could all be lost i the well is not

successul. Box 2.3 describes how private equity investors have

been willing to take on this risk.

Box 2.3: Te Role o Private Equity in Financing Geothermal Projects

Broadly speaking, the development o a geothermal plant as

shown below occurs in two stages, (i) nding the geothermal

source and drilling wells to establish the sources potentialand (ii), construction o the plant.22 Te rst stage is

completed with the drilling o production wells. Tis is a

risky exercise, as dril ling does not always lead to a productive

well. Each well, productive or not, is very expensive at US$3

millionUS$6 million each, depending on various actors.

Te high risk o ailure precludes debt nancing and the

large amount needed to drill each hole makes it dicult to

raise nancing rom riends and amily. Early wells thereore

are oten nanced through third party equity, with PrivateEquity unds such as ArcLight, USRGs, and Denham Capital

providing the needed nancing. Tis nancing allows the

projects geothermal potential to be demonstrated. Once

the well has been proved, the remainder o the development

costs, consisting o negotiating contracts and constructing

the plant, can largely be nanced using debt nancing.

Source: Adapted rom odd Bright, 2010 Geothermal PowerPrivate Equity Perspectives Denham Capital.

0%

20%

40%

60%

80%

100%

DebtPrivate EquityInternal Equity

Project Timeline

Percentageo

fCapitalCosts

Drilling Build and operate

22 Tis discussion relies on two reports (a) John McIlveen, 2011 A Geothermal Incentive Design GRC AGM San Diego and (b), John McIlveen, Mark Vernest andKhurram Malik, 2008 A Geothermal Primer Jacob Securities. Te numbers reerred to in the text do not necessarily map directly to the numbers implied by the graph.


19/52 13


o the companies that they provide nance to. Trough their

carried equity interests in the companies in which they invest,

the und managers benet rom any increase in the companies

value rom increased growth, improved eciency, multipleexpansion or leverage.

IFC has ound that providing advice and support also helps

saeguard the investments PE/VC unds make. PE/VC unds

typically buy minority stakes in the companies in which they

invest. In emerging markets the legal protections or minority

shareholders are oten quite weak. Providing advice and

support helps the PE/VC unds to be seen as real partners to

the majority shareholders and so increases the likelihood that

the majority shareholders will respect their legal rights.25

An example o a PE/VC und providing advice that helped a

company improve its perormance is singhau Venture Capital

(HVC) whose Clean Energy Fund purchased a 37 percent

stake in PowerU, an energy services company in China.

HVC acted as a sounding board or PowerUs management

and helped the company appoint a nancial ocer.26 Beore

HVC invested in PowerU, the und manager helped the

company improve its nancial and accountings systems and

skills, paving the way or HVCs equity investment. Similarly,

GEFs Arica Sustainable Forestry Fund has been able to

increase the value o its investments in orestry companies

by acilitating the introduction o modern management

techniques, increasing the productivity and thus the value o

the companies in which it has invested.

27

Inrastructure unds investing in early-to-late stage renewable

energy projects oten provide developers with substantial advice

and support. PE/VC unds help to mitigate development and

contractual risks; or instance, by structuring and securing

appropriate contractual arrangements and terms with suppliers,

development and operating partners. Tey also apply risk

management techniques such as risk transer to subcontractors

and suppliers through perormance bonds, guarantees, and

warranties.

E+Cos support or Bio2Watt illustrates the value an experienced

investor can bring to an entrepreneur. Bio2Watt is a SouthArican company introducing animal waste to energy plants in

South Arica. Tese plants reduce methane emissions,28 produce

electricity, and improve the management and disposal o animal

waste. Trough its capital, expertise and networks E+Co assisted

2.2.2 IdentIFyIng And develoPIng

InvestMent oPPortunItIes

PE/VC unds invest heavily in nding companies that are inneed o their capital and assistance. Fund managers then work

with promising companies to rene their strategies, business

plans, and management teams to turn diamonds in the rough

into true gems. PE/VC is almost unique in this regard. Banks

and stock exchanges tend to be more passive, waiting or rms in

need o capital to come to them, and expecting the companies to

develop sound plans on their own beore they will invest.

A typica l inrastructure PE und, or example, will need to

identiy a pipeline o potential investments rom the und

raising stage. A renewable generation und thereore will seek

out developers with promising projects, and oer to provide

them with capital. Troughout the investing phase o a unds

lie the management team is using industry networks to seek

out new opportunities.

Many times, PE/VC unds come into contact with companies

and entrepreneurs who have part o what they need to be

successul, but not the complete package. Te strategy to

commercialize a technology might need to be rethought, or

the rms management team strengthened. Te und will work

with the company to gure out how to turn its idea into an

investable business proposition.

Aloe Capital did this when it worked with Indian entrepreneurs

Arul Chalamalasetty and Mahesh Koli to create Greenko.

Greenko buys, builds, and runs clean technology power

plants in India. Te company began by purchasing distressed

biomass plants across the country and rehabilitating them. It

then began to build its own biomass power plants and its own

run-o-the-river hydro plants. oday Greenko directly employs

600 people (1,300 including contractors) and reduces carbon

emissions by 1,448,909 tons a year.23

2.2.3 HelP CoMPAnIes do busIness better

PE/VC unds increase the value o the companies in which they

invest in a number o ways. Besides providing needed capital,they replace and recruit senior management, provide technical

advice, contribute to strategic decisions, and acilitate access

to debt and equity nancing rom other nance providers.24

PE/VC unds have a particular incentive to increase the value

23 Venture Intelligence, 2010 Private Equity Pu lse on Cleantech July 2010 (http://www.ventureintelligence.in/pepulse-c t-2010.pd).24 Hannu Jungman, 2003 Te Value Adding Role o V2C - Searching Evidence rom the value-added provided by Private Equity i nvestors Frontiers o E-Business

Research 2003.25 Udayan Gupta, 2011 Institutional Investor International Finance Corps Private Equity Gamble Pays O September 23, 201126 David Blanchard, 2005 Equity capital investment in Chinas Energy Eciency Sector http://3countryee.org/public/EquityInvestmentEEChina.pd.27 Castalia market intelligence.28 Methane is a powerul greenhouse gas


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14

the value o the companies they invest in by increasing the

leverage o investee companies. Teir connections with

lenders allows the companies they invest in to take on more

debt thus increasing their leverage and the return PE/VCunds make on their investments

PE/VC funds strengthen businesses, and so improve

access to capital. By making businesses better at what they

door example, by strengthening the senior management

team, and making sure management inormation and

accounting systems are in place, PE/VC rms naturally

make their portolio companies more attractive to other

investors. Tis process culminates when the PE/VC und

exits. A unds exit rom an investment generally involves

sale to a larger company, or listing on a stock exchange. Te

new owners are generally much more able to raise capital

than the entrepreneurs originally were, assuring a supply o

capital or continued investment. Because the new owners

can more easily raise capital they are able to pay a higher

price or the earnings the rm generates (as measured by

the ratio between the price per share and the earnings per

share). Tis allows the PE/VC und to earn a return on their

investment rom the resulting multiple growth as they pay

a lower price or the rms earnings and sell their investment

or a higher price.

Te crucial role PE unds can play as cornerstone investors

is apparent in the development cycle o renewable power

projects. Many innovative renewable projects are developed

by independent project developersindividuals and small

rms who specialize in spotting new project opportunities. As

Figure 2.5 illustrates, these independent developers are able to

nance the early stage o projects, but struggle to nance mid-

stage to late-stage project development.

Lenders (both mezzanine and senior debt providers) are

generally willing to nance much o the construction costs,

once all permits and contracts have been nalized. However,

it can cost millions o dollars to get through the late stage

development process o getting all the approvals to use the

site and the renewable resources, and negotiating a long term

contract to sell the power.

Some PE undssuch as InraCo Asiaare willing to take

on this risk, and thus get the renewable projects across the

line and into the stage where more conventional capital will

ow to nance the project.31 Tereore, they play a key role

in developing a pipeline o new energy inrastructure projects.

Bio2Watt to develop its pioneering projects in South Arica.

E+Co helped the entrepreneur select the right technology,

develop environmental impact assessments and negotiate

Power Purchase Agreements (PPAs). E+Co used its extensiveinternational network to acilitate investments in the company

by international investors and assisted Bio2Watt to secure grant

unding (see Box 4.6 or more details on the investment).

2.2.4 beIng tHe Cornerstone Investor

Te unique characteristics o PE/VC unds enable them to

become cornerstone investors. A cornerstone investor helps to

attract the rest o the capital that a company needs to grow.

PE/VC provides a risk-bearing cushion that allows banks

to lend. For example, Global Green Power, a bio-energy

company in the Philippines, needed $60 million to establish

biomass power plants. Banks were willing to lend $44

million. However, banks would only lend i the company

could raise $16 million in equity.29 Until Global Green

Power attracts this outside equity investment, its innovative,

carbon-mitigating plan cannot be implemented. Tis risk

bearing cushion is particularly important in developing

countries. For example, in developed markets, banks are

oten willing to nance wind arms with a debt-equity

ratio o 90:10 (nine parts debt nance to one part equity).

In developing countries the comparable gure is oten ar

lower. For example, in Vietnam banks typically will only

nance on a debt-equity ratio o 50:50 (one part debtnance to one part equity), and in some other countries a

debt-equity ratio o 70:30 is the norm30

PE/VC rms have strong connections with other

nanciers, facilitating information ow and trust.

Entrepreneurs oten do not know what banks need to see

to persuade them to lend. Entrepreneurs also may not know

which nanciers are interested in their type o company. PE/

VC rms are in touch with other nanciers because the PE/

VC unds are repeatedly seeking capital or their portolio

companies. Tis means the PE/VC rms know what banks

and other nanciers are looking or, and so can provide an

ecient bridge between their investee companies and othernanciers. Just as importantly, because PE/VC rms are

playing a repeated game, they have an incentive to only seek

loans or companies that will be able to repay. Tis reduces

the risk the lenders ace in evaluating the investment, and

so make it more likely that a company backed by a PE/

VC und will be able to raise debt nance. Tis provides a

channel through which PE/VC unds are able to increase

29 Tis equity would essentially absorb the rst $16 million losses i the business plan did not work as expected.30 Interviews with market participants.31 Inraco Asia is supported by the PIDG group o donors. Additional inormation on Inraco Asia can be ound at http://www.inracoasia.com/.


21/52 15


2.5: Pe/vc a Pj b ip dp

Source: SDCL and UNEPNote: Sustainable Development Capital (http://www.sdcapital.co.uk/) and Duncan Ritchie and Eric Usher, 2011 Mind the Gap, Addressing the lack o earlystage nancing or low-carbon inrastructure in developing countries UNEP.

Approx. 1%oTotal Project Cost

Early Stage ProjectDevelopment Activity

Early-stage Mid-stage Late-stage

EstablishFeasibility

FinancialClose

CASHFLOW


Late Stage ProjectDevelopment Activity


ConstructionFinance

Financial Close

Private Equity and Inrastructure Funds

Mezzanine CapitalSponsor/ Developer

Debt Finance (Project Finance)

PE/VC und fnanceneeded to raise debt

and mezzanine fnancePE/VC necessary todevelop projects

Development Financing Construction Operation


22/52


23/52 17

Inormation asymmetries32 and agency problems33 plague

capital markets generally. Investors are looking or returns at

least commensurate with the risks involved. Firms seeking

investment generally have better inormation about their likelyuture perormance and risk than the investors. But rms also

have incentives to overstate likely perormance, and understate

risks. Te investor is let in the unortunate position o

knowing that the rm has the best inormation (an inormation

asymmetry), but also not eeling ully able to trust what the

rm says (an agency problem).

Te problems are worse or LPs placing unds with a und

manager. Te LP wants a und manager with the expertise to

make high returns. Many would-be und managers will say

they are experts and can generate high returns. Te LP nds it

dicult to validate the would-be managers claims o expertise

(an inormation asymmetry), but is not able to simply take the

claims at ace value (because o the agency problem).

Te previous chapter has noted that PE/VC can play an important

role in nancing and supporting the growth o new dynamic low

carbon enterprises. It has also highlighted that while PE and VC

unds are active in the market there are signicant opportunitiesto scale up and accelerate climate riendly investment. However

a number o barriers stand in the way o PE/VC being available

to climate riendly projects in the desired quantities. Figure 3.1

illustrates the development dynamics o the PE/VC market. New

und management teams will have to orm. Te new managers

need to raise unds rom limited partners. Te unds need to be

deployed into protable investments. As und managers deploy

capital protably, they can raise more capital rom the limited

partner community, in a virtuous circle. Tis should be a virtuous

circle o market development.

Unortunately, the virtuous circle is slowed by our underlying

actors: inormation asymmetries, agency problems, newness,

and coordination problems (these are shown in brown in

Figure 3.1).

3 Bi o Dvlomn o pe/VC Mk inClim Findly Inving

32 Inormation asymmetries arise rom asymmetric inormation, which is dened as a situation where economic agents do not all have the same inormation, this

concept is closely related to the issue o agency problems discussed in ootnote 33 ( John Black, 2003 A Dictionary o Economics Oxord University Press, USA.September 18, 2003).

33 Agency problems a rise rom the principal agent problem which is dened as Te problem o how person A can motivate person B to act or As benet rather thanollowing sel-interest. Te principal, A, may be an employer and the agent, B, an employee, or the principal may be a shareholder and the agent a director o acompany. Te problem is how to devise incentives which lead agents to report truthully to the principal on the acts they ace and the actions they take, and to actor the principals benet. Incentives include rewards such as bonuses or promotion or success, and penalties such as demotion or dismissal or ailure to act in theprincipals interests.(John Black, 2003 A Dictionary o Economics Oxord University Press, USA. September 18, 2003).

3.1: dp a Pe/vc a

Long und-raising periodsdeter new teams

Potential managementteams lack capital

Pioneering a market hashigh costs

Fund managers lack trackrecords

Difcult to capture allreturns rom pioneering

investments

New investment areaslack a history o returns

Benefts o CarbonAbatement not easily

monetized

InormationAsymmetries

Agency Problems Newness

ImpedeDevelopment o Cycle o Success

Co-ordinationProblems

New investments areperceived to be risky

Fund

management

team orms

Deploy

capital, then

exit

Raises capital

rom LPs

Fund

Formation

Repeats


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provide a guide as to how value can be divided between the

parties, reducing time-wasted in zero-sum negotiations. New

investment areas have none o these advantages. Te rst private

equity und investing in biomass generation in Bangladesh willnot nd lenders accustomed to nancing biomass plants. Te

legal precedents governing the respective rights o senior and

junior lenders in ESCOs in the Philippines do not yet exist.

Te underlying actors o inormation asymmetry, agency

problems, newness, and coordination problems give rise to at least

eight specic barriers (shown in blue in Figure 3.1). Tese barriers:

Slow the rate at which competent people coalesce into und

management teams

Slow the rate at which und managers can raise capital or

the und

Diminish the ability o the und to deploy capital protably.

Tese barriers interact. I deployment was easier, LPs would be

quicker to commit capital to unds. I und-raising was quicker,

o oset inormation asymmetries and agency problems,

investors use inormation on track records o managers.

Tey also look at past investment returns. Reputations or

competence and integrity are important. By denition, in anew area, track records and history are lacking. Reputations

and networks are being newly made. As a result, in a new area

like climate riendly investing in emerging markets, where

managers lacks track records, LPs can nd it almost impossible

to tell who to invest with. Rather than risk placing money with

someone who talks the talk but cannot walk the walk, LPs

may not invest in such a sector at all.

Coordination problems, too, put grit in the cogs o market

development. o get deals done, many actors need to come

together. Project developers need to bring in outside equity.

Debt nance needs to be orthcoming. Te equity investors,

the lenders, the project developer, and entrepreneurs all need to

know how to nd each other, and work together.

In well developed markets, each niche in the investment

eco-system is lled. Inormation and social networks allow

the players to nd each other. Precedents and competition

Box 3.1: Other Barriers to Investment

Tere are barriers which aect all climate riendly investing, whether carried out by PE/VCs or not. In addition, there are barriers which

aect all PE/VC investing, whether climate riendly or not. Tis box mentions some o the main barriers in each o these categories.

Barriers to all climate friendly investing

(whether PE/VC or not)

Lack o carbon payments, or other mechanism to

translate the environmental benet o greenhouse gas

emissions reductions into nancial rewards. Tis is a

particular obstacle or many green power inrastructure

and land use projects

Government actions, which may inadvertently make

economically viable investments unprotable, or simply

impossible. Tree important areas where government

imposes barriers are:

Ownership: government owns many o the entities

where investment is needed and so private sector

investment can only go ahead i government

establishes a Public Private Partnership

axes and subsidies: these oten distort

investments in avor o GHG producing processes.

For example, subsidies o ossil uels are common.

Regulation: in many cases government regulatory

regimes can deter investment (or example,

when power prices are held below cost) or ail

to provide the enabling environment needed (or

example, when there is no legal regime to acilitate

commercial orestry).

Barriers to all PE/VC investing

(whether climate riendly or not)

Inadequate rule o law: PE/VC unds tend to preer

investing in countries with ast judicial processes and

strong, air, and ecient enorcement o business law. A

lack o eectively enorced laws governing the rights and

obligations o limited and general partners deter PE/VC

investment

Tax regimes: Corporate tax levels, and in particular the

treatment o capital gains and the repatriation o prots

by oreign investors, are important or PE/VC unds.

Where countries do not have investor PE/VC riendly

tax regimes, PE/VC investment will be slowed.


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HVC shows how good new teams can struggle to raise

unds. HVC was a rst time management team that wanted

to invest in clean technology in China in 2002. It would

be the rst und to do this. HVC was struggling to raiseunds in light o the limited history o returns that the und

managers (as well as the sector) had. Initially HVC raised a

relatively small und o around $25 million.37 Tis was only a

quarter o the minimum size needed or a sustainable und

the management team had to meet their expenses rom the

management ee, which by industry tradition is set at around

2 percent o assets under management. Tereore, with a small

und, the management ee was not enough to cover proper

und management expenses. Despite this, HVC pressed

ahead with investing the money that had been committed.

Tis allowed the rm to build up a history o returns. On the

back o this, HVC has now been able to raise $300 million

in unds, and has been a leading investor in a large number o

pioneering clean technology companies in China.

3.2.2 neW InvestMent AreAs lACk A HIstory oF

returns

Limited partners make choices about which sectors to invest

in. Clearly in making a judgment on where to allocate capital,

investors like to know the past history o returns in dierent

sectors.38

Tis creates another chicken and egg problem. Until private

equity has been investing in an area, there will be no historyo returns. But without a history o returns, limited partners

are reluctant to come ineven when underlying investments

in the area actua lly have the potential to earn good returns.

3.2.3 neW InvestMent AreAs Are PerCeIved to

be rIsky

A related problem to the lack o return history is high perceived

risk. Fear o the unknown is a commonly observed trait o

the human psyche. Studies suggest that this ear also operates

in investors minds.39 In other words, just because an area is

unknown, there is a human tendency to assume that risks in

that area are higher than they really are. As a result investorstend to invest in that which they nd amiliar.40

Aga in, this problem may be worse or climate-riendly PE/

VC investing in emerging markets than it is in many other

areas. ravel costs are higher when building unds that

link (typically developed country-based) investors withdeveloping country projects. Additionally, because the a rea is

nascent, there are ewer people in the sector who have already

earned the sort o wealth that allows them to strike out on

their own as und managers.

3.2 BArriers thAt slow cAPitAlrAising

Limited partners (LPs) investing in unds preer und managers

with a proven track record, investing in sectors that generate

prots more than commensurate with their risks. In a new area,

und managers do not have track records; return histories are

lacking, and risk perceptions high.

3.2.1 Fund MAnAgers lACk trACk reCords

Tose talented people who do persevere and orm und

management teams ace a chicken and egg problem. Almost all

limited partners want to invest with und management teams

with track records o having successul ly managed private

equity unds beore. Te traditional approach to selecting

managers places track record at the center o the investment

process. Indeed many institutional investors have written or

unwritten rules against placing unds with managers whohave not previously operated a und. Tere are a number o

explanations used to justiy this approach. One reason is

that investors need to conduct more careul due diligence

on a new und management team which is costly. Another

reason is that large investors such as pension unds outsource

decision making to investment agents who need to explain to

the pension unds why they have made the investments they

have. Reerence to the track record o a und manager provides

an easier (and seemingly more objective) justication than

deending a personal judgment o a new managers ability to

invest eectively. Clearly, without some way to break through,

progress o PE/VC nance in a new area, such as climate

change, will be slow.

37 According to Blanchard (2001) the HVCs und had at least US$25 million committed, its ollow on und aimed to raise US$30 million.38 Te need to demonstrate that investing will be protable in comparatively little known markets is thought to be an important inhibitor o Foreign Direct Investment

(FDI). For instance, see DeCoster, Gregory P. and William C. Strange (1993), Spurious Agglomeration, Journal of Urban Economics, Vol. 33, pp. 273-304.39 Note that this eect is dierent rom the simple lack o inormation problem o the previous heading. Lack o inormation removes the (apparently) objective basis on

which investors would like to justiy thei r capital allocation decisions. It does not suggest that the new area is worse than areas with returns history, just that there isno inormation to justiy a decision to invest. In contrast, ear o the unknown leads to the conclusion that an unknown area is actually a worse investment destinationthan a known area, because it is riskier.

40 Huberman, Gur, 2001, Familiarity breeds investment, Review o Financial Studies 14, 659-680; and Kalok Chan, Vicentiu Covrig, and Lilian NG, 2005 WhatDetermines the Domestic Bias and Foreign Bias? Evidence rom Mutual Fund Equity Allocations Worldwide. Te Journal o Finance, Vol. LX, No. 3, June 2005.


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bArrIers to develoPMent oF Pe/vC MArket In ClIMAte FrIendly InvestIng

investors. Te returns the company expects to achieve would

be high enough to attract PE/VC investment in a company

that already had a track record in the Philippines. However,due to the lack o an operating track record and the perceived

risk o investing in the Philippines investors are unwilling to

commit equity.

Investors report that once a single plant is up and running

protably, required returns would drop to a level that Global

Green Power projects can comortably achieve. Tus i Global

Green Power could successully nance the rst plant it could

attract nancing or the other three plants that are in the

advanced stages o planning. From the investors point o view

though, not knowing i a rm can deliver on its promises, or i

the eedstock can be secured, or how the regulatory regime will

evolve, is a genuine barrier to early investment.

Another example is the experience o commercial plantation

orestry in Arica. Te sector has strong prot potential, and

strong potential to mitigate climate change. Despite this,

it has been dicult to get investors to consider the market.

As a result, the CDC (the Fund o Funds owned by the UK

government), the IFC, and others supported the establishment

o the GEF Arica Sustainable Forestry Fund (GASFF) by the

Global Environment Fund. GASFF has achieved a rst close o

Tis tendency to ear the unknown creates yet another chicken

and egg problem, as Figure 3.2 illustrates.

In an unamiliar area like climate-riendly investing in

developing countries, perceived risk may be above what risk

perceptions would be in a more mature market. Underlying

investments in the sector may oer returns above what would

be required in a more mature private equity market. However,

i these underlying returns are below the return investors

require given the high risk perceptions in an immature market,

it may be that no investment takes place. I, however, some

initial investment does occur, then perceived risk and hence

required returns drop and, when they drop below the actual

levels being achieved, signicant amounts o investment can

ow. As investment increases, the best opportunities are taken

up rst, and so in time actual returns are orced down.

Biomass generation in the Philippines may be a sector trapped

at a stage where high perceived risks prevent investments being

made, i the story told by Global Green Power is anything to

go by. Global Green Power aims to develop, nance, build,

and operate biomass power plants in the Philippines. Tese

biomass plants work well elsewhere in the world, but are new

to the Philippines. Te company is seeking PE/VC investment

to build the plants. However, it has been unable to attract

3.2: w d a Pa e i n o a ma Pa ha r

Number o PE/VC investments made in the marketSource: Castalia

ROE

(actualandrequired)

Projects/Companiesactual ROE

Number o PEinvestments made ina mature market

Key:Required ROE ( )Actual ROE ( )

As a PE/VC und market matures required

returns all with a decrease in uncertainty

(as a track record is established) andtransaction costs all (as experience is

built up doing deals). As a result, the

market reaches a point where returns inthe market place are sucient to attract

unds into the market and the private

equity gap is closed.

ROE requiredor attracting

investors into PEunds in a new

investment area


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3.3.2 dIFFICultIes In CAPturIng All tHe returns

FroM PIoneerIng InvestMents

Worsening the high costs o pioneering a market are thediculties o capturing the benets. It might be argued that

the additional costs o pioneering a market should be more than

oset by additional returns. Indeed in some cases, early movers

can seize the best opportunities, or gain such a commanding

lead on the market, that their initial cost and risk bearing is more

than rewarded. In climate change markets this is not always true.

Sometimes the returns or rst movers are not much higher

than those or rms that ollow. For instance, in many markets

prices are oten xed (or instance through Power Purchase

Agreements) or the rst movers cost o production is no lower

than those that ollow. As a result, the markets de

Public Private Equity Partnerships and Climate Change

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