Instrument Overview
Climate Adaptation Notes is a structured funding mechanism aimed at increasing private, institutional investment in water and wastewater sector infrastructure projects. The instrument combines short-term project financing for construction from commercial banks with long-term asset-based infrastructure funding provided by institutional investors [1]. In some EU markets (e.g. Germany), the structure is similar to a Schuldschein.
Why it matters for cities
- Unlocks new capital: Mobilizes institutional and private investment for adaptation projects that cities often can’t fund with public budgets alone.
- Cuts costs & delays: Streamlines construction and refinancing into one instrument, lowering financing costs and speeding up delivery.
- Expands resilience services: Increases access to safe water, sanitation, and wastewater treatment, which are core to urban livability and public health.
- Builds investor confidence: Leverages banks’ project expertise to reduce risks, making adaptation projects more attractive to long-term investors.
- Bridges the finance gap: Helps address the large shortfall in climate adaptation funding for cities, where most climate risks are concentrated.
Key features
- The instrument is structured to unlock the liquidity of the local debt capital markets for climate adaptation projects
- Combining construction and refinancing phases into a single instrument mitigates uncertainties and reduces financing costs for projects, thereby improving the projects’ likelihood of success and profitability
How It Works
Climate Adaptation Notes works through a three-stage process, implemented through an independently managed and regulated Debt Capital Markets platform [2].
In Stage 1, the manager of the Platform works predominantly with local commercial banks to identify and screen suitable projects. Criteria for selection include commercial viability as well as adaptation criteria, to ensure projects reduce climate-related risk. Once selected, these projects are marketed to institutional investors and DFIs. No funding takes place at this point. Instead, the Notes represent a commitment to refinance the commercial bank construction loans after each project’s commercial operation date [2].
In Stage 2, commercial banks provide short-term construction loans. The commitment of the Notes allows the banks to provide more competitive loan pricing, as they have a commitment of refinancing and are therefore not subject to the capital costs imposed on commercial banks under Basel III for longer-term funding [2].
In Stage 3, after projects reach commercial operation, the Notes are funded. The proceeds are used to repay the short-term construction loans. The long-term investors assume the credit risk, and the projects benefit from the more favorable terms of the Notes [2].
Benefits & Challenges for Cities
Benefits
- Combining short-term construction financing from commercial banks with long-term post-construction refinancing allows long-term funders to leverage the commercial banks’ construction project expertise, mitigating project performance risk and enabling investment in sectors previously seen as too risky by institutional investors [3].
- This new approach also reduces the time and cost involved in financing such projects [3].
- Approach enables climate adaptation projects to tap into institutional savings pools [4].
Challenges [3]
- Project pipeline risk: lack of investment worthy-projects, licensing barriers, and lengthy project development cycle could reduce pool of financeable projects
- Instrument structure: the dual phase structure and note commitment pre-funding are new and require socialization and vetting
- Monitoring and measurement: climate criteria can add a burden for lenders
- Increased demand for capital: COVID may increase demand for capital and limit public budgets
Use Cases
Climate Adaptation Notes (CAN) in Southern Africa [3]
Southern Africa is one of the globe’s most water stressed regions. Approximately 39% of the regions’ population does not have access to safe drinking water and 61% of the population does not have access to adequate sanitation facilities (SADC). Climate change is leading to more erratic rainfall and a resulting increase in the risk of droughts and floods. Significant investment in the water and wastewater sectors is critical to ensure the livability of the region for generations to come. However, there is a substantial funding gap due to limited availability of government funding and low private sector investment due to risk perceptions, challenges with project profitability, and the complexity of the due diligence process. The current funding gap has been exacerbated by increasing demands on public budgets given the COVID-19 crisis.
Climate Adaptation Notes is the first instrument to address water scarcity in Southern Africa by streamlining adaptation project financing into a single instrument through a partnership between commercial banks and institutional investors.
Climate Adaptation Notes aims to increase the flow of commercial, institutional and DFI funding into water and wastewater sector adaptation projects in Southern Africa by combining construction financing and post-construction refinancing phases into a single instrument, reducing the time and cost involved in carrying out two financings. The instrument employs a type of asset-backed bond (the “notes”) administered through a debt capital markets (DCM) platform. The platform is managed by a partnership between GFA Climate and Infrastructure and Renewable by Nature with the capacity to serve as trustee and manage the screening and performance monitoring of project climate adaptation metrics. The instrument leverages commercial banks’ construction project expertise to mitigate technical risk, thereby broadening the appeal of such investments to long-term funders, who currently view the sector as too risky. This new approach enables climate adaptation projects to tap into the nearly USD 550 billion in capital in the domestic institutional savings pool in the Southern Africa region.
Based on a pilot issuance of USD 125 million targeting projects in Botswana, Eswatini, Lesotho, Namibia and South Africa, Climate Adaptation Notes could increase water and wastewater treatment capacity by approximately 90 megaliters per day, reaching an additional 90,000 or more municipal residents. At scale, Climate Adaptation Notes could generate tens of millions of additional cubic meters of safely treated water and wastewater and could benefit hundreds of thousands of households facing water shortages and sanitation challenges.
Lessons learned from CAN [5]
While CAN’s potential in financing a number of suitable adaptation projects in Southern Africa is clear, many of the listed projects for CAN could not be materialized. This is due to various reasons, primarily political, as a concrete infrastructure project to tailor CAN to could not be found.
This experience highlights a crucial lesson: the importance of robustness in the project pipeline. CAN’s success hinges on securing a suitable project for implementation. This requires critical evaluation during the initial project pipeline. Relying on a government infrastructure list turned out to be insufficient. Ideally, a more thorough due diligence on each project should have been conducted rather than assuming its validity.
Another crucial lesson is early engagement with potential funders. Once a promising structure is developed, testing it with funders is essential. While potentially discouraging, negative feedback allows for early adjustments before significant resources have been invested.
When to Use It
CAN could be applied in middle-income country markets that share the following characteristics [5]:
- Well-developed domestic capital markets
- Large domestic savings pools
- Established banking infrastructure
References
[1] https://www.climatefinancelab.org/wp-content/uploads/2020/01/CAN-Instrument-Analysis.pdf
[2] Climate Adaptation Notes | The Global Innovation Lab for Climate Finance
[3] https://www.climatefinancelab.org/wp-content/uploads/2020/01/CAN_2pager-FINAL-1.pdf
[4] Cities Climate Finance Leadership Alliance