Innovative finance for cities tackling the net-zero carbon transition
BwB has been working as one of a number of “Design Partners” with EIT Climate-KIC, the EU’s main climate innovation initiative, in a deep demonstration programme called Healthy, Clean Cities. We are partnered with 15 cities across Europe working collaboratively to create strategic experiments to test new ways of achieving climate change mitigation and adaptation and scaling these initiatives to drive the required level of change. This involves combining technical innovation, policy, regulation, governance, engagement and finance to create new ways to tackle the transition to net zero carbon in the urban environment.
This note updates on our thinking so far in this process on Innovative Finance when it comes to the challenge of making cities netzero carbon. In terms of agenda, we will introduce who the design partners are, the scale of the challenge we face, three pieces of good news and then talk about the three evolving components that we think make up Innovative Climate Change Finance for cities and then finally the governance challenge that goes along with the funding challenge.
By way of introduction, BwB is a not-for-profit financial advisory firm that works on projects with an environmental and/or social impact, typically for foundations or public sector bodies ranging from individual local authorities up to global development institutions. We are made up of former investment bankers who have left the city to help solve the netzero challenge and make a positive contribution towards sustainability.
This note represents our thinking but also the collective thinking of the other Design Partners. While BwB brings finance to the table, we work with Dark Matter Labs, who are a strategic discovery, design and development lab working to transition society in response to technological revolution and climate breakdown, The Democratic Society a non-profit organisation working for greater participation and dialogue in democracy who bring expertise in citizen engagement, Material Economics, who are a sustainable economics and consultancy firm looking at the value case for climate adaptation/mitigation and the Global Covenant of Mayors for Climate & Energy, the largest global alliance for city climate leadership.
Scale of the problem
First for context we need to consider the financial scale of the issue of becoming net zero carbon. If we take just the existing built environment which typically contributes about 40% of a city’s CO2 emissions, then to take that towards net zero carbon means both reducing demand by making the built environment much more thermally efficient but also maximising energy generation potential in that built environment to impact the overall net energy system. To do that in an ambitious way is a costly problem. If we use the City of Edinburgh as an example (c. 500k population and slightly more than 200,000 dwellings) then this is around a £10–15bn problem for a city with a £1bn annual revenue budget.
There is also an urgency to this that requires an aggressive ramp up of spend and capability now, all in an environment when most city revenues are down 20–30% due to the impact of COVID-19. We then need to add in costs for mobility transition, green infrastructure investment, circular economy stimulation etc. The point is that in totality this is a problem way bigger than a normal annual civic revenue budget.
There are three pieces of good news
Not just a cost problem
The first is that we shouldn’t just think of this as a cost problem. As work from our colleagues at Material Economics shows there is a strong long term economic case for moving to net zero carbon when we consider the economic value of the wide range of benefits that flow from this work for example in terms of lower physical and mental healthcare costs, higher productivity, lower energy costs etc etc. There are returns here which means these aren’t simply costs that are required to be funded, they are investments with returns that can be used to bring in the funding. That is important and we will come back to it.
Not just a carbon problem
The second piece of good news is that we shouldn’t just think of this as a carbon problem. We have the opportunity to focus on creating liveable, equitable, healthy urban environments where people thrive and where netzero carbon is a natural by-product of that transition — this challenge can be a catalyst for a significantly positive transition in the urban lived experience, all the more important in a world impacted by covid. Doing this in a way with clear civic legitimacy is critical, which is where full and deep citizen engagement is so important. Bringing communities on the journey of redesigning where and how they live.
We know there is demand from private finance
The third piece of good news is that there is a huge shift moving through the financial sector emanating from Europe and now starting to spread into the US. Investment banks and asset managers in general have traditionally only focused on returns for their customers. Now the individual investors, pension fund holders, insurance policy holders etc who provide those assets are increasingly demanding that these funds are not just invested for a return but also for positive impact. Almost $50 trillion of assets have signed up to the Principles of Responsible Investing to date. While there is inevitably some posturing within that, the challenge those asset managers have now is how to demonstrably invest with impact. some more progressive asset managers realise that that is not just about optimising listed/unlisted equity and debt portfolios, it is about how to engage with the public sector which is where the real work needs to occur to counter climate change. The point is that there is demand to be able to invest where there is real impact in decarbonisation if these projects can be made investible.
These three points are principally what BwB works on. How do we generate the pipeline of investible projects, which means designing projects with an investment and return mindset, aggregating for scale and standardising plus working on the reporting from those projects so that impact money can demonstrate to the underlying investors that it has indeed had impact.
What is “Innovative Finance”
So what do we think of by the phrase Innovative Finance? The most obvious component is new ways to raise finance, however it is much more than just that. As a simplification we think of three areas.
1 — Raising Money
The first as stated is the ability to go out and raise money for existing spend requirements — we have a project with a funding gap — how can we “innovatively” raise money to pay for it? The US for example has a pretty well developed municipal bond market and corporates are increasingly finding that painting their bond issuance in greenwash is driving investor demand and creating very attractive lending rates for the borrower. So we are talking with a number of cities in Europe about the potential to directly raise municipal green bonds, with the proceeds ringfenced to specific climate adaptation and mitigation projects. We believe there is demand for these from the investment community.
We are also looking at a variation of this, performance based green bonds, where the return to the investor is directly correlated to the impact that the city achieves through spending the funds raised. The cost of debt falls as targets are met creating a clear financial incentive for successful execution on plans.
Then we also work with cities on how to finance specific projects, for example how to finance the electrification of a bus system. Essentially this usually boils down to structuring a project in such a way that a large upfront capex bill is turned into opex over the life of the project making it fit better into the annual civic budget cycle and matching the capital outflow to the benefits that accrue such as reduced fuel & maintenance costs.
Finally while maybe a smaller component in terms of potential to raise money there is growing interest in community investment structures where citizens themselves can invest in the transition of their neighbourhoods. This can be valuable in terms of engagement and helping drive some of the behavioural changes that will be required.
There are however two other areas that we think fall into innovative finance.
2 — Creating an innovation led community
The second area that we do a lot of work on, is more broadly how to use financial tools to enable a community led culture of innovation around the green economy. We know that we don’t have all the answers today to fix the issues that need fixing. Entrepreneurialism will have to play its part in finding the answers. We are working with cities to set up city run Green Angel Investment funds, seeded by public money but also looking to partner with the private sector. Giving grants out to early stage local projects and ideas to turn them into investible start ups and then providing that all important early seed funding through angel equity stakes. Building incubation capability to help that start up sector not just with money but in other ways to improve chances of success. By doing so, over the medium term, the city can participate in the upside of successful start up businesses and align them with the city’s own climate missions as well as generating a return so that the capital can be recycled and help further businesses. We are also working with other cities to set up funds specifically to drive the circular economy sector again targeting specific areas of the economy that will enable the city’s broader goals.
Both of these two areas — city fundraising and a city innovation and investment framework have tangible outputs — Monies raised through specific financial instruments, fund structures established.
3 — Switching to an investment mindset in project design
But the third area is perhaps the least explicitly tangible, but in our view the most important and is what we will concentrate on in the remainder of this note. It comes back to how we create projects in the public sector that are fit to be invested in by the private sector given the huge amount of money required to do everything that we need to do.
This is about designing the responses of cities to climate change in a way that maximises their potential to be funded. We will illustrate with some specific examples. How we can work directly in a collaborative way with teams of city staff on the problems that they are trying to address, across built environment retrofit, large scale development, green infrastructure, mobility transition, behavioural change etc. Based on our experience over the last nine months this is where the Climate KIC programme comes into its own. By bringing together a range of smart individuals from multiple disciplines and then working together with engaged and ambitious city staff across different often siloed departments plus other actors within the city like academic institutions, industry leaders etc there is a collaborative effort combining best practice from around the world with deep local knowledge. This is building relevant, ambitious and innovative projects, initially through tests of change, that can show us what will and won’t work — learning by doing and learning at times by failing. This isn’t about acting as consultants to cities with a menu of off the shelf solutions, but acting as collaborators, co-creators to drive change in a specific environment.
From a finance perspective this is most often about timeline. Business As Usual in a city tends to be 12 months forward planning and lends itself to an incrementalist annual budget mindset — which is totally appropriate to the normal business of running a city. Prioritising between competing projects with a limited annual budget to nudge as many things forward as possible year by year. The challenge posed by decarbonisation is of a totally different timescale. We are talking about decade+ long investment programmes. We are talking in many cases about transitions to completely different systems of operation. And programmes that are of a completely different financial scale (e.g the retrofit example given earlier) but often with some very clear direct returns over a long payback period, potentially a nice fit for pension type investment profiles. This requires thought about how to internalise some of those benefits.
Green Infrastructure
As an example let’s consider green infrastructure: Milan, a city of 1.9 million people, is in the process of planning to plant and then maintain 3m trees across the city centre at considerable cost. But there are also considerable benefits. Mental and physical health of inhabitants improves with a positive impact on healthcare requirements. Water runoff and flood mitigation is abated with impact on water company capital budgets. Real Estate prices go up. Propensity to spend in commercial districts improves. Air conditioning costs are reduced through anti-heat island effects. How can we think of a tree planting program as a utility and an investment programme rather than a green vanity project. How can we leverage real-time data technologies to track and measure co-benefits? How can we co-opt other budgets in, to share in costs as preventative measures? How can we engage with communities to ensure maximum impact? How can we turn some of those benefits into direct monetary return for the tree planting agency so that up front costs can be financed?
This is what we refer to as the investment mindset.
New Urban Development
Another example common to many cities are large scale urban redevelopment plans, where a neglected area, perhaps post industrial, is put forward for regeneration. When we look at these kinds of projects they tend to be thought of in fairly traditional terms as a typical public urban redevelopment project. Residual Land Value methodology to bring private developers in to take away risk and some of the cost. There is often a lot of talk about how to turn these new communities into examples for a new way to build a community and a built environment. To demonstrate net zero build techniques and renewable energy generation but all too often that comes up against the hard economics of the traditional development model which is overwhelmingly focused on how much is it going to cost and how can we defray as much of that cost as possible from the public purse. Almost inevitably this ends up with a huge value transfer to the private sector based on land value uplift with all the unwanted consequences of that model — developers who are incentivised to minimise cost (and therefore standards) and push up sale price in order to maximise their profit in the near term. This drives the cycle of gentrification and unaffordable living while retarding the development of innovative building methodologies or land economy models such as Design for Manufacture and Assembly, offsite construction, Fairhold Leases, and community investment.
But there are wonderful opportunities to change this dynamic to achieve the real ambitions of cities. Plans often lead to large blocks of housing with ground floor commercial spaces which are the most efficient output of traditional onsite construction techniques to yield sufficient densification in an economic way. This often leads to cities recouping little value for their land while developers gain the ability to create significant profit. Does this approach yield fantastic places to live which will support thriving communities? How can we reimagine projects looking at the incredibly diverse assets that plots of land often represent and thinking about the direct value that could be created there in terms of renewable energy generation, eco-tourism, residential rents, commercial rents etc and how those value streams could be used to finance parts of the upfront capital requirement. How communities could be engaged to invest in and build village-like communities of low carbon buildings. Thinking of the whole project in effect as a long term business opportunity rather than a short term cost problem to be financed will help bridge the gap between budgets and the genuine ambitions of city councils. Collectively we are very excited about the potential of council-led new developments with ambition to build new netzero carbon communities, but these will require risk appetite from cities to try new models — the same old input will yield the same old output.
Deep Community Retrofit
A third example is going back to the thorny problem of existing building retrofit with the hefty price tag that we have talked about previously. The current model globally for achieving deep building retrofit is to encourage individual building owners to undertake the work. And everywhere you look the net result of that is essentially zero take up. We are asking building owners to take on significant debt, make incredibly complex decisions on which set of interventions to choose to minimise heat/energy demand and maximise generation for their building and then manage the various contractors in the project. All to yield long term savings that are not actually all that attractive if going beyond superficial decarbonisation.
We are working with several cities on an alternative model to set up city owned renovation funds. These funds would carry out deep community retrofit as a public service for all segments of the built environment regardless of ownership. And in return the fund will contract with residents to provide long term heat and cooling comfort with resident payments indexed from historic spending patterns (but linked to the property so they remain over time with whoever lives there not who was living there when the contract was signed). Though it is important to say that the costs could also be adjusted in certain areas as a lever against energy poverty.
With this structure the energy savings are turned into a revenue stream for the fund and this can be used to service the debt taken on to carry out the work in the first place. By centralising procurement, significant economies of scale are generated improving the overall economics.
And the fund can work district by district. We believe this creates an opportunity not just to improve thermal efficiency and the net energy system of buildings but also while in situ invest in these communities at a lower marginal cost than would otherwise be the case. For example to add in green infrastructure or add in community assets like community centres or co-working spaces to provide a third option beyond working at home in cramped shared apartments or commuting to the city centre office, driving up resilience. So that this programme makes communities not just more energy efficient but makes them safer, more liveable places and creates incentive for communities to sign up and co-design this regeneration.
Our financial modelling in a number of European cities suggests that while some public funding will absolutely be necessary it can be blended with long term impact investment from the private sector yielding reasonable returns over a long investment horizon with fantastic positive impact credentials.
This third area is the most critical — it is about having a new set of tools within councils to think about how to tackle these issues and how to use the long term benefits as a mechanism to raise the up front capital. Our goal is to work with cities to come up with good ideas but in doing so also change the way cities approach these issues in the first place making us increasingly not required. The old adage of “Give a person a fish, they will feed themselves for a day, teach a person to fish and they will feed themselves for a lifetime”.
Governance and Stewardship
The final thing to say is that the timeline of the work that needs to be done to move cities to netzero carbon is such that it also requires thinking about stewardship and governance. This is ten to twenty years work which doesn’t fit neatly with our typical political cycle. Setting up governance structures in a way that avoids these programmes being derailed by politics every 3 to 4 years is critical to their chances of success. And those structures will also create the bandwidth, capacity and long-termism to drive this work forwards, mobilising stakeholders (including citizens themselves) and building shared legitimacy in the transition pursued. Other new institutional arrangements that enable regulatory and policy innovation as well as the deployment of new technology and data capabilities will be necessary to steward these complex programmes of work. These kinds of institutional shifts are where Dark Matter Labs in particular have done a lot of work.
Climate change adaptation and mitigation are unfortunately not things that can be done as an extra for already stretched staff. A strong team is required to drive the change, working in different ways with different tools and frameworks, across a city’s council departments, institutions and communities.
Conclusions
Inevitably as these projects are designed and created there will still be funding requirements and we can come back to the fundraising part, but if we design the work and governance structures well these will be significantly reduced, we will have built a partnership with private sector investors to provide that funding and the initiatives funded will have a much greater chance of long lasting and positive change, not just to carbon emissions but to the way in which we live in the cities of tomorrow.
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