Why green credit risk guarantee schemes are important for MSMEs

by Najwa Mouhaouri (Chair of the IGFWG), Laura Ramos (Policy Manager of the IGFWG), Nik Kamarun (Senior Policy Manager of the SMEFWG)

In developing and emerging economies, green segments are still considered a new frontier for most financial institutions. There are many challenges to financing green projects – from the risk appetite of lenders to the lack of awareness of borrowers. Further, it is challenged by a lack of policy and regulatory guidance, as well as economic efficiency (i.e. projects which produce social returns but insufficient private returns, given the perceived risks).

However, the combination of financial inclusion approaches with sustainability objectives, is quickly gaining traction across AFI member jurisdictions. Several AFI members have successfully implemented micro-, small, and medium enterprise (MSME) credit risk guarantee schemes (CGSs) in varying design approaches and experiences. As such, adapting these schemes to meet future green finance policy goals is being widely considered.

CGSs is one of the financial enablers to mitigate credit risk thus facilitate financing for MSMEs

CGSs should allow lenders to build capacity particularly by challenging new green sectors, while improving their financial and business understanding of MSME borrowers. CGSs can function as a catalyst in lending to early-stage green markets by serving as a bridge in the initial phase of uncertainty where financial institutions may perceive target groups as too risky.

What are the pre-conditions to provide green credit guarantees to support MSME financing?

• Existence of a sustainable or green framework: The provision of associated credit guarantees will be challenged, if not impossible without a clear pathway to financial system integrity and materiality that will support the financial sector’s ability to finance green and inclusive segments.
• Existence of a green finance agenda: Jurisdictions which have formalized a financial inclusion agenda and a sustainable finance or green finance agenda will be best-positioned to implement a green CGS for MSMEs that can measurably address financial sector development expectations.
• Alignment of the National Financial Inclusion Roadmap and the National Green Finance Strategy: Ensuring alignment of a green CGS design with both the national roadmap for financial inclusion and the national sustainable or green finance strategy will be key to defining the success of the scheme, in terms of addressing the desired economic additionality.
• Existence of a green taxonomy: The development of national green or sustainable taxonomies is critical to ensure that financing activities are aligned with policy goals. A green taxonomy will support lenders developing green financing frameworks to standardize categories of green economic activity.

What are the barriers to green financing for MSMEs?

Barriers exist on both the supply side (lender) and demand side (borrower). Although the precise financing challenges will vary depending on the jurisdiction and the level of sophistication of the business entities or projects involved, the following are some common challenges faced by borrowers in inclusive green segments and identifies which can and cannot be addressed by implementing a green credit guarantee scheme (CGS).

Challenges that can be addressed by Green CGS:

1. Collateral eligibility: MSMEs often do not have traditionally eligible collateral such as land and building assets to pledge, instead they may have minor moveable assets.
2. Borrower information asymmetries: more typical for micro and small enterprises which often do not have any or poor formal relationships with lenders
3. Longer payback periods: green projects covering energy efficiency and agriculture often have longer payback periods than typical working capital type loans.
4. Lack of technical know-how: knowledge of green financial technical and management approaches is often new for lenders and borrowers. Human capacities may need substantial shifts in skills, leading to a lack of qualified personnel on both the demand and supply sides.

Challenges that cannot be addressed by Green CGS:

1. Uncertainties on green policies and the regulatory environments: both lenders and borrowers often lack guidance on defining what constitutes “green”.
2. Lack of borrower awareness: MSMEs lack awareness about the environmental impact of their activities, the effect of environmental regulations on the industry and the growing need for green skills.
3. Legal framework issues: the lack of favorable legal environments guaranteeing energy prices or land rights are often obstacles to the stability of future business conditions.
4. High monitoring costs: evaluation and validation of successfully achieved green benefits are often complex and require an increase in monitoring resources.

A green CGS can address two unique characteristics of financing: supporting access to finance and targeting green economic outcomes. These two seemingly mutually exclusive goals can be combined to efficiently address national policy goals without constraining one or the other. However, in application, these policy goals may be contradictory. On the one hand, a CGS can support access to finance while on the other, they can restrict the market by requiring specific “green” criteria.

What are main recommendations to policymakers to implement a green CGS?

• Policymakers should be more explicitly considering the role of MSMEs in contributing to national targets both with regards to climate change mitigation and adaptation.
• Building-up the technical expertise of both regulators and commercial banks to assess the inherent risks in green transactions.
• Ensure the scheme’s green standards and definitions are well-aligned with national guidance.
• Create demand by raising awareness of climate change risks and mitigation and adaptation strategies with MSMEs.
• Promote the scheme and provide training and workshops to support the interactions between borrower and lenders.
• Create KPIs for both financial performance and policy progress.
• Be aware of being overly ambitious at the outset, start small and learn.
• Allow policymakers and regulators to develop their own manuals and processes and give some flexibility to the local operating environment.
• Manage the scheme’s operational costs very carefully (ensure good governance), beware of overly burdensome bureaucratic procedures that may lead to underutilization.
• Try to build the capital base of the scheme over time so that operations are not totally dependent on fees.

Globally, MSMEs employ a large proportion of the working population and make a significant contribution to GDP. As such, they can play a potentially significant role in strengthening a country’s resilience to climate change.

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AFI’s inclusive green finance workstream, is part of the International Climate Initiative (IKI), which is supported by the German Federal Ministry of the Environment, Nature Conservation and Nuclear Safety (BMU), based on a decision of the German Bundestag.