Financial flows and Asia's power sector

This is a summary of Simmons & Simmons’ presentation at the "Spring Sustainability Session: An overview for Investors and Financiers in Asia’s Power Sector" co-hosted by Simmons & Simmons and ERM in Hong Kong on 07 February 2017 and in Singapore on 14 February 2017.

The following topics were discussed:

• Paris Agreement and party commitments
• Asian Infrastructure Investment Bank (AIIB) and its Energy Sector Strategy that will inform the AIIB’s investment in the region
• Sector Understanding for Coal-Fired Electricity Generation Projects  to the OECD Arrangement on Officially Supported Export Credits (New Sector Understanding)
• standardisation initiatives for the large-scale and cost efficient deployment of solar PV
• green bonds,

and, in particular, how the above will increasingly direct and facilitate “finance flows consistent with a pathway towards low greenhouse gas emissions and climate resilient development” as targeted by the Paris Agreement. 

Paris Agreement

The conclusion of the Paris Agreement (the Agreement) at COP21 in late 2015 marked a breakthrough in discussions on climate change action by the global community. Consensus was obtained to limit temperature increases to well below 2°C above pre-industrial levels on the basis of a “bottom-up” agreement with parties setting their own intended contributions to respond to the threat of climate change. 

Actions and NDCs

Parties’ contributions include:

• limiting national emissions of greenhouse gases to successive nationally determined contributions (NDCs)
• enhancing adaptive capacity and climate resilience
• developed countries providing and leading mobilization of financial resources for both mitigation and adaption
• strengthening cooperative action on technology development and transfer, and
• enhancing the capacity and ability of developing country parties to take effective climate change action.

As a rule, countries are to update their NDCs on a five yearly basis with successive NDCs representing a progression beyond their current NDCs (and reflect their “highest possible ambition”). The current NDCs of a number of Asian country parties to the Agreement are set out in the table. If countries align domestic policy to achieve their NDCs and meet the challenges of climate change adaptation, this will provide increasing opportunities for investment in low carbon projects and climate resilient infrastructure.

While we have seen a number of Asian countries, including India and China, make impressive progress in wide scale deployment of renewable energy generation capacity, policies in other countries in the region have vacillated between support for low carbon projects and continued reliance of fossil fuel in a bid to keep costs low, maintain stability of supply, and in some cases, support their indigenous fossil fuel industries. The Indonesian Minister of Energy and Mineral Resources recent release of Regulation No. 12/2017 on the Utilization of Renewable Energy Resources for Electricity Supply, requiring tariffs for electricity from renewables compete with base load power tariffs, and the Vietnamese Government’s plan to build approximately 30 new coal fired projects by 2030 (to plug the gap that will be left by the Government’s decision not to proceed with the development of nuclear power capacity), are cases in point. Meanwhile President Trump wants to “destroy” the Paris Agreement, so we are left wondering how successful the Agreement is likely to be?

Table 1 – Asian Country Parties’ Nationally Determined Contributions; where one figure is stated it is unconditional; where two figures are stated the second figure is conditional upon receiving financial and other support.

“moral agreement”

The Agreement has been described as a “moral agreement”, not imposing anything more than binding procedural obligations on parties. The Agreement refers to NDCs as something a party only “intends” to achieve. The Agreement’s implementation mechanism is further expressly described in Article 15(2) as “non-adversarial and non-punitive”. It is against this backdrop observers have queried the value of the US formally withdrawing from the Agreement. 

Carbon markets and sustainable development mechanism

A noteworthy feature of the Agreement that may create additional opportunities for investors is found under Article 6 of the Agreement. This Article recognises that parties may cooperate on a voluntary basis in the implementation of the nationally determined contributions (both in relation to mitigation and adaption actions). Carbon trading and a sustainable development mechanism are contemplated, akin to the flexible mechanisms under the Kyoto Protocol (which included emissions trading, the Clean Development Mechanism and Joint Implementation).

The rules and modalities for the sustainable development mechanism are yet to be determined. However a share of the proceeds of activities under the mechanism will be used to assist vulnerable countries meet the costs of adaptation. We will provide an update on the mechanisms as more information becomes available.   

Asian Infrastructure Investment Bank

Spearheaded by China with 57 founding members and capital of USD100 billion, the AIIB is a new multilateral financial institution that was founded to address the daunting infrastructure needs across Asia, with Asia being defined broadly to include the Middle East. Indeed two of the nine projects already approved by the AIIB are in Oman.

Energy sector strategy

The AIIB is in the final phase of its consultation on its Energy Sector Strategy (Strategy) that will “provide the framework, principles and operational modalities to guide the [AIIB]’s future energy sector engagement, including the development of its pipeline and future sub-sectoral lines of business”.

The draft Strategy, to be finalised in June 2017, is summarised in the diagram below.

The Strategy (and subsequently the AIIB’s investments) is to align with the AIIB’s core values: “Lean, Clean and Green” and be informed by the principles underpinning the Paris Agreement, Sustainability for All and the 2030 Agenda for Sustainability.

Notwithstanding the push towards lowing CO2 intensity in the energy mix, as stated on the launch of the AIIB, the AIIB is not seeking to impose a policy agenda on client countries. In applying its principles the AIIB will take into account a country’s “constraints and uniqueness” and its support will “be aligned with [a country’s] national energy investment plans”. If a country has made significant commitments to decrease emissions under the Paris Agreement, the AIIB will support it to meet its goals. Conversely support won’t be denied solely on the basis that a country wants to continue its reliance on fossil fuels in its energy mix.

Somewhat controversially, the AIIB made clear at its launch that it will support coal fired power generation (and large scale hydro) contrary to the position of other multilateral agencies and international agreements (including the New Sector Understanding). The overarching message that comes through from the draft Strategy is however that funding and other support will be directed to a lower CO2 future. While there were initial fears over the role of AIIB, in particular as a vehicle to finance Chinese construction of “dirty” infrastructure projects across the region, China’s leadership on Climate Change following President Trump’s election suggests otherwise. 

Strategy implementation

Key areas where the AIIB will provide support to the public and private sectors are as follows:

• Power transmission and distribution infrastructure – seen as lower risk investments for the AIIB as it builds its project pipeline in its early years and an essential component of the AIIB’s strategy to promote connectivity and regional cooperation; specifically the bank will support (i) new transmission and distribution (T&D)  projects for climate resilience, leapfrogging to smarter more efficient systems, and (ii) rehabilitation and  reinforcement of existing networks for climate resilience, reduction of technical losses, stability and integration of intermittent renewable energy. 
• Energy Efficiency investments – there is significant untapped potential for energy efficiency projects in Asia but capturing efficiencies is challenging due to fossil fuel subsidies and the fact that energy efficiency projects tend to be smaller and fragmented; the AIIB will look to cooperate with multilateral, bilateral and other partners to provide technical assistance for capacity building in this area. 
• Renewable Energy investments –  to limit CO2 emissions the AIIB will support:
  1. hydropower including financing existing facility upgrades and direct loans for greenfield projects in a manner consistent with the AIIB’s Environmental and Social Framework
  2. solar PV and wind, partnering with other multilateral and bilateral agencies to seek grants from global funds and partners to improve financial viability, share risks, and promote distributed generation
  3. innovative and transformative projects such as solar with adequate storage and concentrated solar power, but only in selected and likely high income countries with high penetration of intermittent renewables to help create a market of scale for these technologies, and
  4. geothermal alone or in partnership with other multilateral development banks (MDB) to develop new approaches to reduce resource risk; may provide sovereign loans to governments or state owned entities to confirm resources prior to private sector involvement.
• Local and regional pollution management – proposes to assist client countries reduce local and regional pollution in partnership with MDBs and bilateral agencies; will consider multi-sectorial approaches to cleaning up Asia’s highly polluted regions and cities (could include initiatives to address acid rain, PM2.5 and smog etc).
• Adaptation projects – emerging as an MDB business line with grants from the Green Climate Fund, Global Environment Facility and others, the AIIB proposes to partner with MDBs and bilateral partners to support adaption efforts in Asian countries most vulnerable to climate change. 

The AIIB will take a more limited approach with its support in the following areas:

• Fossil fuel power generation investments – will finance investments that are “demonstrably compatible with a country’s transition toward sustainable, low-carbon energy and internationally agreed targets” with an expectation to support commercially available least carbon technology and anticipation that gas-fired power generation will form part of the lower CO2 transition; in specific circumstances the AIIB will finance coal and oil-fired power plants.
• Oil and natural gas processing, transportation and distribution – while an area with greater private sector involvement, the AIIB will support investments that improve energy security or promote regional integration and trade, including the development, rehabilitation and upgrade of natural gas transportation, storage, distribution networks, and controlling leakages, recognising the need “to foster greater penetration” of gas in Asia during the lower CO2 transition.
• Nuclear power generation – the AIIB will not finance nuclear power plants but in special cases will consider engagement for safety enhancement and upgrading.

The below table sets out the AIIB’s approved and proposed projects. 

Table 2 – AIIB approved and proposed projects

New sector understanding

Ahead of COP21 in Paris in 2015, OECD country parties to the Arrangement on Officially Supported Export Credits (the Arrangement) agreed on the New Sector Understanding to limit export credit agencies financing new coal projects from 01 January 2017. Refer here for more details.

OECD countries reportedly provided 50% of the financing for coal fired projects between 2007 and 2014, making the New Sector Understanding a significant diplomatic feat. In a similar vein to the Paris Agreement however, the Arrangement is non-legally binding and relies on moral pressure for enforcement.

Country parties had concerns entering into the New Sector Understanding as to whether it would actually encourage governments to alter their energy policies/plans and increase the share of renewables and more energy efficient technologies in the energy mix, or whether it would simply provide the exporters and investors of non-participant countries to the Arrangement (notably China) a competitive advantage.

A review will be undertaken in 2019 that will take into account (among other things) developments in the export credit policies and practices of non-OECD countries. These developments will likely impact any agreement to strengthen the terms of the Sector Understanding in a second phase to commence from 01 January 2021.

Encouragingly however and spurred on by the New Sector Understanding, public perception and potential future regulation (such as the recently announced carbon tax for Singapore), many international commercial banks have firmed up their stance on coal and publicly committed to not funding further coal fired power projects, regardless of the technology, scale or location of the project. With other investors and corporates adopting a similar stance, there are significant funds available to support low carbon infrastructure development where policy conditions are right. This presents a great window of opportunity for governments in the Asian region if they deliver the policy certainty investors require. 

Solar standardization initiatives

Recognising the need to “de-risk” projects to lower the cost of funding as well as associated transaction costs (including commercial, legal and technical consultancy fees) for the cost competitive large scale deployment of renewables, there are several initiatives around the world directed at just this. This includes the World Bank’s self-described “One-Stop Shop for Fast, Affordable Solar” Scaling Solar Programme and the IRENA-TWI solar standardization initiative. Both programmes provide for the use of standardized suites of bankable documentation to keep costs low. The World Bank further makes competitive finance and insurance available to all bidders for Scaling Solar tenders as well as providing risk management and credit enhancement. While Scaling Solar is designed for government led procurement, the IRENA-TWI document suite is intended for use in either public or private sector led procurement/transactions and in particular targets pension funds and other institutional investors for funding at the greenfield stage.

While work continues on the IRENA-TWI solar standardization initiative prior to market launch, the World Bank’s Scaling Solar Programme has already delivered the lowest cost solar tariff in Africa in Zambia at US 6.02 cents kWh fixed for 25 years with no indexation (equating to an average price of US 4.7 cents kWh). Senegal has now also launched tendering as part of the Scaling Solar Programme and the World Bank has engagement with Madagascar and Ethiopia. While the Scaling Solar programme provides support at the sovereign level, the IRENA-TWI solar standardization initiative targets private sector transactions as well.

These initiatives could play a significant role in enabling the roll out of price competitive solar in Asia (beyond India and China) without the need for feed-in tariffs (FITs) for project viability. Subsidies have been contentious with consumers in Asian countries and increase the risk to investors of subsequent policy changes retrospectively adjusting FITs, or in the case of the Philippines, commercial viability issues where FIT is awarded to the first projects commissioned.

Green bonds

For a commentary on green bonds and the significant opportunity they present in funnelling funds to climate aligned investments in Asia, please refer to our recent update.