Raising Private Capital for Climate Change Adaptation Projects in Africa
A benefit of being a USC Professor is that I have the opportunity to meet with many interesting people who visit Los Angeles. A few months ago, I had a great meeting with Olufunso Somorin. In this entry, I discuss his recent OP-ED published in Business Daily.
Every nation faces specific challenges posed by climate change. Africa’s nations face their own challenges and many of these nations are poor. Poor people and poor nations face the greatest challenges posed by climate change. This creates the economic growth imperative. People and nations must grow richer in order to adapt to the serious climate change challenges that each of us face.
PHD Economists will remember the famous Robert Lucas paper;
Lucas, Robert E. "Why doesn't capital flow from rich to poor countries?." The American economic review 80, no. 2 (1990): 92-96.
This Nobel Laureate’s ideas take on a new importance in the face of rising climate change risk.
Let’s recall the core argument. Capital should flow to the area and the projects offering the highest rate of return. If a capital intensive project in Kenya offers an 11% rate of return per $ invested while a capital intensive project in Detroit offers a 2% rate of return then a puzzle arises if Wall Street invests in Detroit rather than Kenya. A standard economic argument for explaining how it could be the case that the marginal product of capital could be huge in Africa but $ doesn’t flow there is to focus on political risk and uncertainty. If Wall Street fears political instability and exchange rate instability in a nation seeking capital imports, then a huge risk premium could emerge such that $ doesn’t flow to Africa. If climate change raises the need for access to capital, then this old Lucas issue takes on even greater importance.
This discussion suggests that those African nations that can credibly commit to exchange rate stability and good governance will be able to borrow at a lower international interest rate and have greater access to foreign private capital.
This international capital market discipline provides an incentive for foreign governments to invest in “good governance”. Why? Those nations that fail to develop a good reputation will pay through having to pay a high risk premium and this will result in higher domestic interest rate and this will mean that fewer adaptation lumpy capital intensive projects will be financed.
NEW POINT
Every poor nation seeks to attract more international capital. The leaders of each of these nations are smart and anticipate that if they say; “The $ will be used to shrink our economy’s carbon footprint (think of solar panels and electric vehicles) and to invest in climate resilience” —- this marketing campaign helps to attract Western capital flows. Economists teach our students about fungibility. A smart developing country can attract this $ intended for green capital and reroute it to the set of projects they actually want to invest in. How will the capital investors verify that the $ they send to poor nations actually leads to “additionality” so that the recipient nation doesn’t engage in fungibility?
One solution here would be if the international capital owners own physical assets in the developing countries. For example, an international investor could own a percentage of hotels in a given area in different African cities. In this case, the international investor would have an incentive to invest in local public goods such as sea walls to protect the physical asset (the hotel) from sea level rise. Yes, this would be in the self interest of the international investor AND it would benefit the local area close to the hotel and the workers who work at the hotel. This is a simple example of complementarities. I will build on this point in the future.
For economists who read my entries; here is an important and under-appreciated paper that speaks to this issue.
Kousky, Carolyn, Erzo FP Luttmer, and Richard J. Zeckhauser. "Private investment and government protection." Journal of Risk and uncertainty 33, no. 1 (2006): 73-100.
Final Point
I would like to see more cities in the developing world issuing municipal bonds for achieving climate change adaptation bonds. If these cities could commit to verifiable performance criteria for what are the intended consequences of the bonds, then social impact bonds could be sold so that the city pays a lower interest rate if the city achieves the stated performance targets (for example deaths per year from extreme weather). This free markets approach would allow Western “do-gooders” to invest in projects that actually align with incentives to enhance adaptation.