Sovereign wealth could fund the SDGs

By Matt Dallisson, 05/12/2019

The striking fact is that funding is available, but it is not flowing to where it is needed. The total investment available is approximately $98 trillion, including commercial banks, investment banks, insurance and public pensions, sovereign wealth funds, equity funds and public global funds, such as donors, foundations and endowments.

This mounting finance gap is especially profound in cities. Urban areas are already home to 50% of the world’s population, generate around 80% of global economic output and account for 70% of greenhouse gases.

Increasing urbanization leaves more and more people dependent on urban infrastructure systems. With the lack of enough finance for investment in infrastructure, especially during the Fourth Industrial Revolution, urban populations are prevented from reaching their full potential of productivity, which increases the overall costs of municipalities.

One example is the city of Hangzhou, China, which uses an artificial intelligence transportation management system called the “City Brain” to gather traffic information through videos and GPS data. It then uses artificial intelligence to analyze the data and coordinate more than 1,000 key traffic lights and road signals to guide real-time traffic flow. Hangzhou, a megacity of 7 million people, once ranked fifth among China’s most congested cities, is 57th on the list as of 2019.

However, the world cannot rely solely on productivity gains to fix the severe financing gap for infrastructure, SDGs and climate resilience. There is an urgent need to find new financing tools for countries and cities, and one crucial source will be sovereign wealth funds.

While there is no single definition of a sovereign investment fund (SIF), it can be thought of simply as a government-affiliated investment vehicle that manages a substantial pool of assets. This new group of sovereign investors – which includes some of the world’s largest government pension funds (federal and state), traditional sovereign wealth funds, central bank reserve funds, state-owned enterprises and various policy-driven investment funds backed by government-affiliated capital – have become the most influential capital markets players and investment asset owners.

SIFs are commonly funded by anything: from foreign-exchange reserves or fiscal surpluses owned by central banks; to pension savings or natural resources such as oil. Lately, both the size and number of sovereign investment funds have increased – meaning they are becoming increasingly powerful players on the global financial scene.

One common characteristic of sovereign wealth funds is maximization of long-term returns, which results in a higher risk tolerance than traditional foreign exchange reserves. This means that investment in, for example, climate-resilient infrastructure should not only be seen as an equitable investment choice for the funds but also suitable investment projects with the fitting risk-reward profile.

There are two main methods that local governments usually rely on for financing infrastructure: pay-as-you-go (pay-go) and pay-as-you-use (pay-use). Pay-go capital financing refers to using cash or other current assets rather than debt issuance to fund capital projects. It usually depends on local taxes and user charges and is most commonly used in cases when capital project sizes are small, project sponsors have limited access to debt, local governments are approaching their debt limits, or there are prohibitions on the use of debt.

Pay-use capital financing means issuing long-term debt in the form of general obligation bonds or revenue bonds to fund capital projects. Infrastructure often involves large or lumpy investments and benefit both current taxpayers and future generations. Local infrastructure projects also rely on national government transfers, as they often have cross-municipal benefits.

Cities, however, use a range of public finance instruments and leverage tools to support sustainable infrastructure. An important one is public-private partnerships for capital-intensive sustainable infrastructure. The risk-reward profile of infrastructure projects largely determines the “investability” potential and thus the attractiveness to private finance investors. A pipeline of investable projects usually allows large investors to commit a greater share of their resources to infrastructure.

In this context, mobilized private capital, from domestic and international sources (such as foreign SIF funds), will need to complement an efficient allocation of public finance. It will also require a steady pipeline of projects that help countries meet their sustainable development objectives.

Countries remain limited in their ability to move from funding to a financing approach due to capacity constraints and incomplete deployment of tools or support mechanisms. They are not fully able to field a pipeline of projects that both contribute to a country’s sustainable development objectives and are suitable for private financing.

Meanwhile, emerging markets need to understand the perspective of investors, who assess infrastructure projects against a multitude of options in other asset classes and countries. In this context, countries with more effective regulatory environments and credible project pipelines will attract more investment at a lower cost. Recommended actions can be categorized in three aspects:

Linking sovereign investment capital and smart city infrastructure needs may require a lengthy process of building consensus among stakeholders. But the rewards are high: developing countries’ governments can do much to attract quality long-term financing and set the foundation for future prosperity, while sovereign investors reap the attractive returns of long-term investment projects.

This content was originally published here.