By Srinath Sridharan and Meiyappan Nagappan
India faces the dual challenge of achieving its climate goals while maintaining economic growth. To finance its green transition, India will need to allocate a significant budget, seek international funding and attract private investment.
Domestic finance has been crucial to India’s low-based climate spending so far. According to the Climate Policy Initiative’s 2022 report, domestic finance accounted for 87% and 83% of green finance in India in FY19 and FY20. Though international finance has increased from 13% in FY19 to 17% in FY20, it is still insufficient to achieve India’s net-zero target. Hence, greater participation of international finance is essential.
Energy transition powered by small and medium-sized enterprises is key to achieving net-zero by 2070. Access to financing for small and medium-sized enterprises requires a shift from traditional public grants, institutional loans, and philanthropy to blended finance. Social impact bonds provide a financing structure for small budget initiatives at the district, city, and state level that combines impact investing, public-private partnerships, and results-based finance. These financing structures enable investors to provide early risk financing for green projects, encouraging more investment by offering incentives such as clear performance parameters and guaranteed support for unknown risks.
Mobilizing capital requires innovation in debt and equity instruments and the development of risk mitigation tools such as insurance and guarantees. The first step to attracting capital is to mitigate systemic risks through clearly defined policies and regulatory clarity. Key instruments such as blended finance funds, carbon credits and climate insurance that can unlock additional pools of capital must be aggressively promoted.
Climate-related projects are high-risk and costly, making it impossible to raise climate finance without grant, preferential capital, or blended finance. Grant and preferential capital provide important seed capital and lower financial barriers to projects that may be too risky or expensive for private investors. Blended finance structures, which combine public and private funds, can help bridge the gap between high-risk climate-related investments and commercial capital. Effective regulatory frameworks can simplify the complex structures of blended finance, making it easier to assess its impact and efficiency.
Restrictions on preferred distribution models imposed by the Securities and Exchange Board of India to combat evergreening of loans complicate structuring of blended finance funds, especially those involving junior equity models. These restrictions significantly de-risk commercial capital as impact investors accept subordinate rights to returns compared to other commercial investors. Fund managers should be able to set up and operate funds with differentiated distribution models. For example, the Global Climate Fund (established under the United Nations Framework Convention on Climate Change) committed $200 million of first-loss capital to its India E-Mobility Finance Program and Green Growth Equity Fund (India’s first climate-focused fund), with the first-loss capital blended at the Singapore feeder level.
Another example where regulatory changes can help blended finance is the inability to pool grants and Corporate Social Responsibility (CSR) funds in Alternative Investment Funds (AIFs). Such pooling is not possible without the approval of the Foreign Contributions Regulation Act, which is not usually granted to private entities such as funds. Moreover, there are fears that the Ministry of Corporate Affairs may question the donation of CSR funds to AIFs and whether their purpose is to create impact or to help the interests of investors. Moreover, charities and CSRs would have to pay high taxes and risk losing their tax exempt status as the entire amount donated to such entities would not be recognized for tax purposes. These can be addressed with granular and structured reporting.
The recent announcement by the central government to introduce a carbon credit trading scheme by 2026 is a positive step and will include both voluntary trading and compliance-based elements. However, key aspects such as taxability of carbon credits, classification and applicable tax rates remain unclear. For example, taxes on the sale of carbon credits may range from 30% to 10% or may be exempt in some cases, depending on whether the carbon credits in question are UN-certified and whether the companies involved in the sale generated the carbon credits as part of their operations. For example, open issues remain regarding carbon credits generated using CSR funds through agroforestry initiatives. It is unclear whether they are a valid use of CSR funds and whether the sale of such carbon credits will be treated as generated as part of business.
Moreover, even though many companies have signed net-zero pledges as part of their core business principles, can they still take the position that generating carbon credits is not a business activity? On the regulatory front, multiple issues need to be streamlined. Exchange control regulations do not allow companies to receive advance payments for sales of goods for more than one year, beyond which it is treated as external commercial borrowing which is very restrictive and regulated. This is a sore point for Indian exporters of carbon credits. Permission would need to be obtained from the Reserve Bank of India for each such transaction, slowing down carbon financing.
The lack of a climate finance taxonomy was only marginally addressed in the Budget. An effective detailed taxonomy is essential to determine whether investments are aligned with the national climate objectives. Though a step in the right direction, it is still insufficient given the uncertainty of sector-specific benchmarks for achieving sustainability and development goals. However, given regional and sectoral differences, the transition path will vary significantly. With different regulators for different finance needs, India needs to ensure that a common taxonomy is used across the financial sector, corporate governance and tax frameworks.
The Indian insurance industry is under pressure to provide financial protection through climate risk policies as extreme weather events become more frequent and severe. There is an urgent need to develop metrics and identify risks related to climate change. Without adequate data, it may not be feasible to launch specialized climate insurance products at affordable premiums to mitigate financial and other risks associated with climate change, especially extreme weather events. Insurance can mitigate the impacts of climate change for various stakeholders including individuals, households, governments, local authorities and businesses.
Srinath Sridharan is a policy researcher and corporate advisor and Meyyappan Nagappan is a partner at Trilegal Law.
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