1. Introduction

2. Sources of Capital for SNGs

2.1. Public Sources of Funding

Several national and international public sources are potentially available for SNGs to finance their climate action projects and they include:

2.1.1. SNG’s Own Resources

For most SNGs, budgets are the primary source of finance for climate action, funded through intergovernmental transfers, subsidies, tax revenues, user fees, and property income. SNG4 budgets vary but typically account for about 9% of GDP and 23.9% of public spending on average.

An effective approach is ‘climate smart’ budgeting, integrating climate action into broader SNG activities. Despite its complexity and the need for cross-departmental collaboration, only a few cities like Kampala (Uganda), Arusha and Dar es Salaam (Tanzania), Durban/eThekwini (South Africa), Mumbai (India), and Rio de Janeiro have attempted it.

As tools and techniques for climate smart budgeting become more available and affordable, more SNGs are likely to adopt this approach. However, SNGs in developing countries often lack the capacity or financial resources, making implementation challenging.

2.1.2. National Government Transfer

In most developing countries, national government funding comprises over 50% of revenue for SNGs. Since 2008, with World Bank support, the Government of Ethiopia has been using performance-based fiscal transfers to 117 SNGs to improve institutional performance and achieve climate and sustainable urban development objectives. This program incentivizes SNGs to enhance their capacity and efforts in these areas in exchange for additional funds and resources. A similar program in Kenya, supporting the Kenya Devolution Support Program, is co-funded by the Kenyan Government and the World Bank.

2.1.3. DFIs

A Development Finance Institution (DFI) is a specialized financial organization set up to develop the private sector. They are often owned and funded by national and international governments. DFIs are increasingly supporting SNGs in developing countries by providing concessional loans, credit enhancements, and assistance in structuring investments, with a growing focus on climate-smart and sustainable infrastructure.

In 2023, the UK's DFI, British International Investment (BII), invested 20 million EUR in The Urban Resilience Fund (TURF) in partnership with the private sector infrastructure investor Meridiam for decarbonization projects in SNGs in sub-Saharan Africa.

DFIs5 play a critical role in financing climate action initiatives for SNGs, focusing primarily on private sector development as a catalyst for economic development and sustainability. While DFIs do seek projects with commercial viability, their investment criteria extend beyond financial returns, aiming for broader developmental impacts, such as social, environmental, and economic benefits. They often channel their support to projects associated with SNGs rather than directly funding the SNGs, to ensure effective utilization of funds and achievement of developmental outcomes.

However, SNG projects frequently face challenges in attracting DFI financing due to issues like underdevelopment and lack of investment readiness, which can overshadow their potential to meet stringent investment criteria. Despite these challenges, DFIs invest in projects that may not yield direct commercial returns but are essential for economic development, such as infrastructure projects critical for private sector growth. This approach underscores the DFIs’ commitment to balancing financial viability with broader developmental goals, effectively contributing to climate action and sustainable growth initiatives.

2.1.4. Aid Agencies

Aid agencies, such as the United States Agency for International Development (USAID), play a role in supporting SNGs through technical assistance, capital facilitation (grants and other viability gap funding), and credit guarantees. These agencies primarily offer technical support to SNGs, helping them build capacity and improve project readiness. In certain cases, aid agencies also make investments in projects that align with their goals or mandate.

Aid agencies typically require detailed project proposals and may prioritize projects based on their alignment with the agency’s objectives. While the support from aid agencies is valuable, it often comes with conditions and requirements that SNGs must meet. This can include demonstrating the project’s potential impact, sustainability, and alignment with broader development goals. The availability of funds and the specific criteria for support can vary, making it essential for SNGs to carefully navigate the application process.

2.2. Private Sources of Funding

In addition, SNGs also have access to private sources to meet their investment needs, fostering economic development. These sources include:

2.2.1. Commercial Banks

Commercial banks continue to be major investors in SNGs, particularly in infrastructure, and have access to considerable capital, with an increasing focus on sustainable development

For many SNGs, commercial banks are the first-choice option for securing loans and investments. However, commercial banks are driven by business considerations, so their willingness to lend depends on several factors:

• The SNG's creditworthiness and track record of managing and repaying loans.
• The commercial viability of the project, including its risk profile and return on investment.
• The SNG's ability to take on additional debt.
• Adequate financial management of the SNG, including budgeting, financial controls, and reporting mechanisms.

2.2.2. Institutional Investors

An institutional investor is an entity that invests funds on behalf of others, seeking long-term investments with minimal risk and stable returns. Examples include pension funds, insurance companies, and mutual funds. Municipal bonds are a common method for SNGs to secure financing from institutional investors for their projects due to their long tenor, stable returns, and minimal risk profile. While the largest municipal bond markets are currently in the USA, China, and Japan, municipal bonds are becoming increasingly utilized in developing countries.

Notable examples of municipal bonds include:

• Mexico City Green Bond issued for $50 million in 2016
• In India, from 2016-2017 to 2020-2021, nine municipal bodies raised 38.4 billion rupees through bonds.

Institutional investors tend to finance projects directly, with public entities (such as DFIs or government agencies) stepping in to ‘de-risk’ the projects to a suitable level. As a result, they do not tend to finance SNGs directly, except through bonds.

SNGs will require:

• Suitable investment projects with low-risk profiles and stable anticipated returns.
• An investment-grade credit rating.
• However, many SNGs are forbidden from issuing debt by their central governments due to the risk of default and in many cases do not have the capacity or creditworthiness to do so anyway.

2.2.3. Corporate Buyers

Many companies worldwide are increasingly purchasing carbon credits to fulfil their corporate climate targets and commitments through global carbon markets, estimated at 865 billion EURs in 2022.6 Ho Chi Minh City (HCMC) in Vietnam has initiated a pilot Carbon Credit Exchange & Clearing House to sell carbon credits generated from local projects like rooftop solar in domestic and international markets. The revenue generated is intended to fund additional climate-related initiatives. Carbon credits can serve as a valuable revenue source for SNGs, but projects must be sufficiently large or pooled to cover transaction costs.

The revenue generated from selling these credits on voluntary carbon markets (VCMs) can offset investment costs for projects such as urban reforestation or rooftop solar, making these initiatives more economically viable. However, carbon credits have drawn criticism for potentially allowing affluent entities to continue emissions by offsetting rather than transitioning to sustainable practices, which could undermine emission reduction goals.

2.2.4. Private Companies

Private companies play a significant role in financing projects for SNGs through mechanisms such as project finance and balance sheet financing. Although these companies may not have the licensing to provide loans directly, they can partner with SNGs on various projects. This collaboration often takes the form of PPPs7 and contributions through CSR8 initiatives. Such partnerships and initiatives support the financial and developmental needs of SNGs, providing essential resources and expertise. The risk appetite of private companies in these ventures typically ranges from low to medium, depending on the project’s nature and potential returns.

2.2.5. Households

In addition, households/citizens also contribute to the financing landscape through direct investments, such as consumer loans, and crowd-based financing. This type of financing is particularly relevant for smaller projects, typically requiring funding between $1-3 million. While households and citizens may not have the capacity to raise funds for larger projects, their contributions can be significant for smaller-scale initiatives. The risk appetite in this context can vary widely, ranging from low to high, depending on the specific circumstances and the perceived risks and benefits of the investment.

3. Sources of Funding in Developed Countries

3.1. United States

3.1.1. Green Banks

Green banks are public or quasi-public financial institutions dedicated to financing clean energy and sustainable projects. They provide low-cost financing, incentives, and technical assistance to accelerate the adoption of renewable energy, energy efficiency improvements, and green infrastructure.9

3.1.1.1. Connecticut Green Bank

The Connecticut Green Bank, established in 2011, is the first green bank in the United States. It was capitalized through a combination of public funds and private investments. Initially, the bank leveraged $362.7 million in public funds to attract $2.06 billion in private investment, achieving a leverage ratio of $6.70 for every $1 of public funds.

Notably, Connecticut Green Bank financed the Solar for All program, which aims to make solar energy accessible to low- and moderate-income households.

3.1.1.2. New York Green Bank

The New York Green Bank, launched in 2014, was initially capitalized with $1 billion from the state of New York. It has since reinvested its initial capitalization to result in over $2 billion of capital commitments.

The New York Green Bank provided funding for the Community Solar NY initiative, which supports the development of community solar projects across the state.

The bank has placed a strong emphasis on ensuring that all New Yorkers, including those in historically marginalized communities, benefit from the clean energy transition. This focus on inclusivity not only addresses social and economic disparities but also supports sustainable growth by enhancing community resilience and engagement in the green economy.

4. Financial Instruments

4.1. CONCESSIONARY loans

Concessional finance, provided by institutions like development banks and multilateral funds, offers below-market rate loans to developing countries to support economic development goals. While typically available to sovereign governments, some SNGs are now also eligible.

The primary benefit of concessional loans is their affordability, enabled by public funding from Development Finance Institutions (DFIs). Although concessional loans alone do not attract private investment, blended finance facilities that use public funding to reduce the cost of private finance can.

Concessional finance is increasingly being used to drive climate action at the sub-national level, but there are often barriers to SNGs accessing it:

• Need for fiscal autonomy and strong financial management systems.
• Permission and guarantee provided by sovereign government.
• Eligibility and restrictions set by provider e.g. creditworthiness of borrower.
• The fiscal capacity of the SNG, whether it has reached its debt ceiling, which can limit its ability to take on additional debt.

4.2. Market Rate Loans

Market rate loans, provided by the private sector, are crucial for financing climate projects with clear financial returns, such as renewable energy and building retrofits. Though more expensive than concessional loans, they are more readily available, with commercial lenders increasingly interested in climate-focused investments due to rising investor commitments to climate goals.

Many SNGs struggle to attract private finance due to inadequate risk-reward profiles and creditworthiness.

Market rate loans are pivotal for climate finance, especially for larger, creditworthy SNGs, especially in developed countries, frequently use these loans, but smaller SNGs in developing countries face barriers such as:

• Lack of creditworthiness, fiscal autonomy, and fiscal capacity.
• Need for sovereign debt guarantees.
• Requirement for revenue-generating projects to service debt.
• Risk of default due to underdeveloped projects and other factors, such as lack of political championing, corruption, etc.
• Insufficiently large ticket sizes, due to small projects, which are unattractive to investors.

4.3. Carbon Credit

Carbon credits are generated by certified mitigation projects like renewable energy or tree planting, which can be sold in international carbon markets. These credits can offset project costs and provide future revenue streams, though upfront investment is required. By providing a steady revenue stream for decarbonization projects, carbon credits not only help to offset their costs but also contribute to economic development by fostering innovation, and attracting investment in sustainable infrastructure. However, they require large enough projects to offset transaction costs, certified third-party monitoring and verification, and upfront investment.

In 2021, compliance carbon markets reached $850 billion, and voluntary markets $2 billion, with rapid growth expected. These markets could be a significant revenue source for local governments developing credit-generating projects.15

5. Municipal Bonds

Figure 1. Municipal bond issuance and utilization process.

Figure 1. Municipal bond issuance and utilization process.

5.1. Constitutional Issues

Constitutional issues influencing SNG’s issuance of municipal bonds include:

Table 1. Legal framework governing SNG bond issuance.

Table 1. Legal framework governing SNG bond issuance.

Legal authority	SNGs derive their power to issue bonds from laws and statutes, which must be strictly followed to ensure the bonds’ legality. This authority is often outlined in state constitutions or legislative acts, providing a clear mandate for bond issuance and the specific purposes for which these funds can be raised
Adherence to debt limits	Constitutional debt limits are set to prevent excessive borrowing that could jeopardize the financial stability of the SNG. Bonds issued in contravention of these limits face legal challenges and may be deemed invalid, leading to disputes that can undermine the credibility of the SNG and its future endeavours to raise capital
Ultra vires doctrine	The principle of ‘ultra vires’ acts as a safeguard against SNGs exceeding their authority. If bonds are issued beyond the scope of the legal power granted to the SNG, they can be declared void. This doctrine emphasizes the importance of operating within the legal confines to maintain the enforceability of bond obligations

6. Green Municipal Bonds (GMBs)

6.1. Comparative Analysis Between Traditional Municipal Bonds and GMBs

As opposed to traditional municipal bonds, GMBs finance eco-friendly projects with added transparency and impact reporting.

However, across different attributes, they share much in common, as seen in the table below:

Table 2. Comparison of vanilla and Green Municipal Bonds.

Table 2. Comparison of vanilla and Green Municipal Bonds.

Attribute	Vanilla municipal bonds	Green municipal bonds
Purpose	Finances a broad spectrum of municipal projects, including some with environmental benefits	Exclusively earmarked for projects with environmental benefits, like renewable energy or efficient waste management
Investor base	Attracts a diverse range of investors, including institutional and individual bondholders	Draws a similar investor base, with a notable appeal to those prioritizing environmental, social, and governance (ESG) criteria
Risk	Credit risk is tied to the financial health of the issuing SNG	Shares a similar credit risk profile, with additional scrutiny related to ESG risk. The risk profile, however, is not inherently higher or lower than traditional municipal bonds
Return profile	Offers returns based on market conditions and the issuer’s creditworthiness	May offer slightly lower yields, reflecting premium investors are willing to pay for contributing to environmental sustainability
Certification & standards	Standard municipal bonds without specific environmental certifications	Often come with green certifications, ensuring the funds are utilized for qualifying environmental projects
Tax treatment	Generally, enjoy tax-exempt status, making them attractive to tax-sensitive investors	Typically share the same tax benefits, aligning with the tax treatment of traditional municipal bonds
Bond structure	Can be general obligation or revenue bonds, with terms and repayment structured according to the project’s needs and the issuer’s capabilities	Structured similarly to vanilla bonds, but with the stipulation that funded projects must meet environmental criteria, which may influence terms and repayment options

6.2. Eligibility on GMBs

Eligibility is determined by their use of proceeds, reporting standards, and impact measurement:

Table 3. Key requirements for GMBs.

Table 3. Key requirements for GMBs.

Use of proceeds	The funds raised by green municipal bonds must be allocated to projects with clear environmental benefits, such as renewable energy, pollution prevention, sustainable water management, and climate change adaptation
Reporting standards	Issuers of green municipal bonds are required to adhere to internationally recognized reporting standards, such as the Green Bond Principles (GBP), which promote transparency and disclosure of how the bond proceeds are used
Impact measurement	The impact of the financed projects must be measured and reported to demonstrate the environmental benefits achieved. This often involves quantifying outcomes such as reduced carbon emissions or improved energy efficiency

6.4. Certification and Pricing Overview of GMBs

GMBs can be certified by independent bodies like the CBI20, which ensures they meet strict environmental standards and align with the Paris Climate Agreement goals. Certification increases investor confidence by preventing greenwashing and assuring the funds’ genuine environmental impact. Certified bonds typically have more favourable pricing, often yielding 24–36 basis points lower than uncertified bonds due to this added assurance.

Cape Town’s green bonds have received accreditation from the CBI, ensuring they meet stringent environmental standards. Africa’s first municipal green bond was issued by Cape Town in 2017. Initial guidance indicated a spread of 140-160 basis points over comparable local-currency government bonds.

Johannesburg’s green bonds lack formal certification by independent bodies like the CBI. However, Johannesburg also issued green bonds in 2014, contributing to South Africa’s total green bond issuances. Non-certified bonds may face different pricing dynamics due to investor confidence and certification status.

7. Case Studies

7.1. Case Study 1: Cape Town

7.1.1. Context

Cape Town’s issuance of green bonds was driven by its commitment to environmental sustainability and climate change mitigation. The city’s strategic climate action plans (Cape Town’s Climate Change Strategy and Resilience Strategy) aimed to align financial strategies with these environmental objectives, directing funds towards projects that enhance climate resilience and sustainable development. Prior to green bonds, Cape Town had a history of issuing traditional bonds for municipal projects. The shift to green bonds was motivated by the growing sustainable finance market and the city’s intent to attract environmentally conscious investors.

The funds from Cape Town’s green bonds were allocated to projects, such as water infrastructure enhancement and climate resilience measures, including water treatment facility upgrades and water supply security. Cape Town adhered to the Climate Bonds standard for impact reporting, providing transparency and accountability through annual reports detailing the environmental impact of funded projects. The city implemented a robust reporting framework to track the environmental benefits of the funded projects. This involved annual reporting on various metrics, including expected carbon reduction and improvements in water management. These reports were incorporated into the city’s financial statements, ensuring transparency and accountability in the use of green bond proceeds.

The market reception for Cape Town’s green bond was positive, with significant oversubscription indicating strong investor interest. However, it's important to note that the actual financial benefit of issuing the green bond was questioned, as the city did not observe a substantial difference in investor behaviour compared to traditional bonds. While competitively priced, the green bond’s issuance costs were higher due to the rigorous pre-issuance assessments and compliance with green bond standards. The city leveraged the expertise of firms like KPMG to ensure compliance with necessary certifications and criteria, which, although resource-intensive, helped secure a competitive rate for the bond.

7.1.2. Challenges

Table 4. Challenges faced in the green municipal bond issuance.

Table 4. Challenges faced in the green municipal bond issuance.

Challenge	Description
High costs	The issuance process incurred substantial costs for certifications and compliance with reporting standards, which, coupled with the lack of observed financial benefits, presented a challenge, particularly given the questionable financial benefits derived from the green bond compared to traditional bonds
Lack of financial incentive	Investors showed interest in the green bond for its propaganda (PR) value but were not willing to accept lower returns for the sake of environmental benefits. This lack of financial incentive made the green bond less attractive from a purely financial perspective, leading to scepticism about its overall benefit
No subsequent issuances	The absence of further bond issuances following the green bond suggests that the experience did not fully meet the city’s expectations, highlighting the need for careful evaluation of future issuances

7.1.3. Outcome: How Does the Future Look Like?

• Cape Town continues to explore sustainable finance options, but the experience with the green bond has led to a more cautious approach. The city is likely to weigh the benefits of green bonds against the practical considerations of cost and administrative burden. Future bond issuances will be evaluated on a case-by-case basis, with a focus on achieving the lowest cost of finance to support green projects.
• Investor sentiment towards green bonds remains generally positive, driven by the growing emphasis on ESG criteria in investment decisions. This shapes the city’s approach to future issuances, ensuring that any green bonds offered must also meet stringent financial criteria to attract investment.
• While the green bond issuance positioned the city as a leader in sustainable finance, it also highlighted the significant costs and questionable financial benefits associated with such instruments. As Cape Town navigates the evolving landscape of municipal finance, its commitment to economic sustainability and fiscal responsibility will guide its approach to future bond issuances, ensuring that the chosen financial strategies are both environmentally and economically sound.

8. Conclusions

Abbreviations

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