Finance and the Cost-Benefit Analysis of Climate-Resilient Projects

The views expressed are those of the author and do not necessarily reflect the views of ASPA as an organization.

By Byron Ramirez
February 19, 2016

Climate change has become a prevalent concept amongst scholars, policymakers and government administrators.

According to reports from the United Nations and NASA, nations face grave environmental challenges. Climate change, along with food insecurity, poverty and inequality, threatens citizens’ well-being.

This article suggests that climate finance can be utilized by government officials and public administrators to help mitigate pressing environmental issues. The article also discusses general concepts associated with the cost-benefit analysis of climate-resilient projects.

Investment in Climate-Resilient Projects 

In 2005, Hurricane Katrina displaced hundreds of thousands of people and caused around $125 billion in damage. Hurricane Sandy in 2012 destroyed housing, infrastructure and transit systems, and left billions in damage. In 2013, the White House issued an executive order, Preparing the United States for the Impacts of Climate Change. It calls for investment in several activities and policies designed to mitigate the effects of climate change.

Meanwhile, the European Commission has implemented a set of policies as part of a larger environmental sustainability strategy aimed at reducing greenhouse gas emissions progressively. Investing in low carbon technologies, protecting the ozone layer and adapting to climate change are some of the European Commission’s main priorities. In consequence, the European Union has invested significant financial resources in financing these types of initiatives.

These are two examples of the large investments been made in climate-resilient projects. 

Climate Finance

According to a 2011 report from the Climate Policy Initiative, climate finance is defined as:

• “Financial support for mitigation and adaptation activities, including capacity building and R&D, as well as broader efforts to enable the transition toward low-carbon, climate-resilient development.”
• “Capital flows that target low-carbon and climate-resilient development.”

Climate finance may incorporate either public or private financing flows, or a combination of the two. Given the budgetary challenges that public officials face, climate finance can be especially useful in helping to support capacity building and financing technical assistance. Climate finance can assist government officials in financing projects related to mitigation and adaptation interventions.

Public officials can benefit from understanding the different types of climate finance available, the utility of performing a cost-benefit analysis and the risks that must be considered.

Sources of Funding and Financial Instruments

Climate finance funds can derive from:

• Public sources (e.g., government agencies and ministries)
• Private sources (e.g., project developers and corporate actors)
• Public intermediaries (e.g., national development banks)
• Private intermediaries (e.g., financial institutions, foundations, private equity and venture capital)

Crowdfunding—raising and pooling monetary contributions from a large number of people—has become an alternative method for funding a project. In recent years, there has been an emergence of climate funds, which blend grants and funds and help to finance large-scale projects.

Private and public investors funnel investments to climate-resilient projects via a range of policy and financial instruments. The principal instruments used are:

• Grants
• Low-cost project debt
• Capital instruments
• Risk management instruments
• Policy incentives

Grants cover the incremental costs that are associated with climate-resilient activities. Grants can include in-kind support and cash transfers. Low-cost project debt involves offering preferable terms to borrowers including lower interest rates and longer loan tenor. Capital instruments include equity investments (direct equity and quasi-equity funds). Risk management instruments consist of loan guarantees and insurance policies. Policy incentives encompass clean energy subsidies and tax incentives.

Instruments help align public and private interests, address investor-specific needs and support scaled-up investments in climate-resilient projects.

Cost-Benefit Analysis of Climate-Resilient Projects

Before pursuing financing, public administrators should perform a cost-benefit analysis (CBA) of the proposed climate-resilient project. Such an analysis will help determine the welfare derived from the project as a function of the costs associated with it. Hence, it is important to understand the project’s cost structure as well as the principal variables that drive cost. Benefits can include direct cost savings and estimated indirect cost savings from preventing a costly event from occurring.

The CBA ought to consider the following costs:

• Recurring
• Non-recurring (e.g., capital investment)
• Incremental investments
• Opportunity cost
• Project failure cost
• Cost of not doing the project
• Costs through externalities

Administrators are encouraged to estimate future cost functions by collecting information and data, analyzing data using statistical methods and exploring cost variations given a range of plausible scenarios.

Accounting for Risk

Projects inherently differ in terms of their riskiness, so it is important that benefits and costs be discounted at a rate that accounts for risk. Risk can raise the cost of capital and limit private-sector financing for the project.

It is recommended that capital and upfront costs are carefully considered. One must consider whether the financial instrument correctly priced risk and evaluate whether there is sufficient access to recurring financing. How much leverage (amount of private financing that can be mobilized per dollar of public or quasi-public support) is there?

Other risks that must be considered are:

• Technical and physical risks (e.g., uncertainty over the cost and timing of design, construction and operations, environmental impact)
• Market risk (e.g., uncertainty about the demand for the project output)
• Financing risks (e.g., uncertainty about access to capital for financing and refinancing)

Public officials can certainly benefit from using climate finance. Before engaging in such efforts, it is crucial to examine carefully the benefits, costs and risks associated with the climate-resilient project. 

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Author: Byron Ramirez is a researcher, analyst and consultant. He completed his Ph.D. in Economics and Political Science at Claremont Graduate University and his Master of Science degree in management at the Drucker School of Management. His areas of expertise include strategic management, finance, sustainability and performance management. Email: [email protected].

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