The current energy crisis underscores the urgency to scale up green infrastructure investment.
Government support aimed at limiting the global economic fallout from the current energy crisis, risks delaying critical climate action due to diminishing fiscal space. Now more than ever, it is important to boost and drive infrastructure investment towards sustainable, inclusive, and resilient economic outcomes. Well-planned green infrastructure projects raise potential output with a greater focus on climate change that improves countries’ socio-economic resilience to extreme weather conditions caused by progressive warming, and helps reduce the carbon intensity of economic progress.
However, current public investment plans alone will not be sufficient to close the estimated green investment gap. Budgeted infrastructure spending in most G7 economies has been declining for years, and the implications of the decades-long underinvestment in infrastructure are now painfully felt (Figure 1). We need more strategic rebalancing toward green infrastructure investments. In our recent analysis we estimated that the largest investment gap for the green transition in public infrastructure is in the US, at about 1.7% of GDP per year. In Europe, the largest investment gaps are in Spain and France (1.6% and 1.3%, respectively), with more moderate numbers in Italy (0.6%) and Germany (0.4%).
Figure 1: Public infrastructure investment (% of GDP). Note: The calculation only accounts for gross fixed capital formation in 'other buildings and structures'. Sources: OECD; Refinitiv; and Allianz Research.
A strong case for more private participation in green infrastructure investment
Greater private sector participation in the planning, construction, and operation of infrastructure can help mitigate current constraints on public budgets and investment capacity. The green investment gap far exceeds the current public investment trends. The innovative potential of the private sector is critical to enhance efficiency and affordability of climate-friendly infrastructure. For instance, Allianz Global Investors recently launched the Emerging Market Climate Action Strategy (EMCA) in a public-private partnership with the European Investment Bank. The recently published Global Infrastructure Hub (GI Hub) report, Infrastructure Monitor 2022, found that private investment in wind and solar energy projects grew rapidly once their financial performance reached the average returns. Still, today’s energy capacity from wind and solar energy needs to quadruple to achieve the emission reduction required under current net-zero targets. Thus, achieving the global climate targets will become exceedingly challenging without more private sector participation in infrastructure investment as a key element of climate action.
However, the flow of private capital into infrastructure has stagnated for eight years running. As the financing conditions sharply tightened in 2022 with rising interest rates, it is more costly for the private sector to finance infrastructure projects, especially regulated financial institutions. Most prudential standards for banks, insurance companies, and pension funds do not consider the actual credit performance of infrastructure in specifying capital requirements for solvency purposes. Capital requirements for infrastructure investments tend to be based on the credit performance of the broader corporate sector.
A more differentiated regulatory treatment of infrastructure investment
Creating an enabling regulatory environment for infrastructure investment can help mobilise more private capital. For instance, under the international Basel III/IV regulatory framework, banks that invest in infrastructure debt, especially unrated transactions, need to hold much more capital than would be warranted on account of the debts strong credit risk performance. Infrastructure assets, being long-term and less liquid in nature, already face higher liquidity risk premium. Recognition of the lower credit risk of infrastructure investments can enhance their attractiveness for investors and boost private sector participation.
So far, the lack of data on the credit performance of infrastructure projects has hindered greater comparability to corporate exposures and a more differentiated regulatory treatment. Improving the availability of performance data on infrastructure projects for governments, regulators, and investors would help to create a more favorable regulatory treatment.
Figure 2. The historical credit performance of infrastructure project loans. Sources: Jobst (2018), Jobst and Pazarbasioglu (2019). Note: The definition of 'ultimate recovery rate' closely matches the definition of recovery rate in the Basel Accord framework for banks and Solvency II for European insurance companies; 'green' denotes project finance in industry sectors that meet the use-of-proceeds eligibility criteria of the ICMA Green Bond Principles; 'brown' is short for 'brown infrastructure'; the sub-samples refer to (i) all European Economic Area (EEA) and OECD member countries and (ii) all emerging markets and developing economies over a study time period between 1995 and 2020 based on project loan data from Moody’s Investor Services and S&P Global.
Our recent findings based on seminal work at the World Bank suggest sufficient scope for lower capital charges to be applied to infrastructure investment - through project loans - without altering the current (or planned) calibration methods. During the initial years, the default rate on infrastructure loans exceeds the investment-grade level (threshold for low default risk). After about five years, the default rate reaches investment-grade level and then continues to decline to very low default rates over time, to exhibit high credit quality similar to A-rated loans over a decade. The recovery rates for defaulted loans are significantly higher than corporate loans. A detailed analysis on the performance of infrastructure as an asset class is presented in the GI Hub’s Infrastructure Monitor report.
Banks should only half the regulatory capital if they invest in green infrastructure project loans
The favorable credit performance of infrastructure investment is even more pronounced for projects in sectors that would fall within the scope of the eligibility requirements for green bonds. In fact, on a global basis, green infrastructure projects seem to default only half as often over a 10-year period as ‘brown’ projects. Our estimates suggest that green infrastructure project loans should attract less than half the regulatory capital banks are required to hold under the Basel Accord (Table 1). While the current treatment of project loans in the Basel framework provides capital relief for operating infrastructure projects, there is still scope for amending current capital rules to better reflect the special features of infrastructure to reduce the regulatory cost to banks.
The G20-GI Hub Framework on How to Best Leverage Private Sector Participation to Scale Up Sustainable Infrastructure Investment calls for the establishment of a collaborative forum including regulators, global standard-setters, and the banking and insurance sectors to discuss the supervisory and regulatory treatment of infrastructure as an asset class and its climate-related risks. In addition to this framework, the GI Hub is forming a coalition of leading global banks in the infrastructure space to enhance evidence for a prudent but conducive treatment of infrastructure exposures in the Basel III framework.
Table 1. Infrastructure project loans - comparison of current regulatory treatment (capital charges) for banks and fair value economic capital cost. Note: The sub-samples refer to (i) all EEA and OECD member countries and (ii) all emerging markets and developing economies over a study time period between 1995 and 2020 based on project loan data from Moody’s Investor Services and S&P Global; we assume a capital adequacy ratio of 12.5%; 1/ risk weights of 130/100 percent are assigned to (unrated) project finance exposures during the pre-operational/operational phases; 2/ banks that do not meet the requirements for estimating the probability of default under the foundation internal ratings-based (F-IRB) approach need to map their internal risk grades to five supervisory categories, each of which is associated with a specific credit risk weight ('slotting criteria approach'): 70/90/115/250 percent for credit quality score (CQS)=0-2/3/4/5 – for illustration, we assume the credit quality of unrated project loans reflects CQS=4, resulting in a risk weight of 90 percent; 3/ capital charge under the F-IRB approach using actual credit risk parameters of (unrated) project loans (with fixed LGD of 45 percent but without PD floor); 4/ capital charge under the advanced internal ratings-based (A-IRB) approach using actual credit risk parameters of (unrated) project loans (without floors to PD and LGD); 5/ based on the conditional tail expectation (CTE) of a generalized extreme value (GEV) distribution. Sources: Basel Committee on Banking Supervision, Jobst (2018); Jobst and Pazarbasioglu (2019); and Jobst and others (2022).
Regulatory treatment of infrastructure as an asset class
