SPLITTING FOR GREEN
Methods to Finance
Image: Muhuri Irrigation Project, Bangladesh
Source: Flickr Creative Commons
By Samuel Hausner-Levine
Samuel Hausner-Levine is a student in his final year of the Master of City Planning program. Before becoming a planner, Sam earned a bachelor’s in history and worked in education. His interests include climate adaptation finance, urban redevelopment and green infrastructure. Because he did not get to travel for studio due to COVID-19, Sam has doubled down on his commitment to visit Japan by the end of 2022.
In order to meet the United Nation’s Sustainable Development Goals (UN SDGs) of climate resilience, cities across the globe will need to rapidly update their infrastructure and transportation systems to reduce emissions. While in the long-term projects will pay for themselves with future returns estimated at nearly USD $30 trillion, upfront costs are high. It is expected that through 2030, USD $4.5 to 5.2 will be needed annually to meet global urban infrastructure needs.  Yet in a global credit market that almost exclusively interacts with sovereign states, few cities have access to the capital needed to implement such projects.
Both commercial and mission-driven financial institutions generally view the extension of credit to cities, particularly in the Global South, as carrying greater risks than returns. Cities often have limited capacities to generate the resources necessary to pay off debt and often lack the technical capacity to effectively implement complicated infrastructure projects. Yet, by excluding cities from credit markets, financial institutions prevent them from building the technical and financial capacities that might allow them to become creditworthy and effective partners in achieving global sustainable development.
To solve this issue, nations that have committed to achieving the SDGs should establish domestic municipal development banks to enable direct financing. Working exclusively with municipal and local governments, these banks would serve as intermediaries between cities and global financial markets and create opportunities for cities to access capital and invest in their own development. In doing so, central governments can expedite their progress to reaching the SDGs and make cities engines for national economic growth.
THE NEED FOR MUNICIPAL DEVELOPMENT BANKS
In recent years, a growing consensus has emerged within the international community on the critical role cities play in helping the world reach the UN SDGs. Urban areas currently contain half the world’s total population and are responsible for 80% of gross domestic product. They also consume 60-80% of all energy and are responsible for 70% of greenhouse gas emissions.  Analysis of the SDGs found that achieving 103 of 169 targets will require the participation of local or municipal governments. 
However, cities lack the financial resources required to invest in green infrastructure and other climate risk mitigation and adaptation projects. Subnational public spending comprises nearly 30% of total public expenditures for developed nations, but only 20% for lower-middle income countries and 7% for low-income countries. Cities and subnational governments in developing countries rely disproportionately on intergovernmental transfers from their countries’ central governments, which account for 72% of all local spending. While transfers are an essential lifeline for cities without the capacity to generate the necessary revenue, tying municipal finance systems to central government policies can create a range of problems. In particular, it limits municipal autonomy and politicizes flows of capital, leading to investments motivated by political gain rather than project viability.
A major reason for cities’ dependencies on transfers and grants is their inability to access credit markets. Domestically, the ability to assume debt is limited by national laws. In certain countries, such as Cambodia, this may even be expressly forbidden. However, the greater hurdle for cities wishing to access capital is their exclusion from the international credit market. Cities are seen as high-risk investment partners by both commercial and mission-driven financial institutions, and as a result, are not deemed creditworthy.
National Development Banks (NDBs) are a financial mechanism which many nations have established as a way of extending capital for local infrastructure projects. Although varied in structure, NDBs are generally nation-wide financial institutions that have access to government funds as well as international credit markets, and can provide grants, loans, and technical assistance to regional and local governments for development purposes. Today, NDBs hold USD$5 trillion in assets, compared to only USD$1 trillion held by multilateral development banks. 
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NDBs have been effective in creating pathways for local governments to access capital and build creditworthiness, but also have limitations. First, like transfers, NDBs consolidate financial decision-making in the hands of the central government, tying programs to national political agendas. Politically expedient and high-profile projects are often prioritized for investment, with credit being extended to non-creditworthy local governments and non-feasible projects. Second, working on a national scale, NDBs also lack familiarity with local contexts and specific regional conditions and needs. Because the scope of their work is so wide, they lack sufficient familiarity with local actors and contacts familiar with the political landscape. As a result, it is harder for NDBs to fully assess viability and identify potential projects for funding.  Lastly, few NDBs have explicit mandates in their charters to invest in urban infrastructure, and therefore cannot be relied on to prioritize the needs of cities.
In order to finance the infrastructure needs of cities, development financial institutions and national governments should consider the establishment of subnational municipal development banks. This entails the creation of banks similar in structure to NDBs, but with a mandate limited to specific subnational territories. Municipal Development Banks (MDBs) have been established in a range of countries, particularly within federal systems such as Brazil and India where political power is diffuse. While not a replacement for NDBs, MDBs have several advantages as local financing mechanisms, and can be used in conjunction with “last mile banks” to cover gaps in the national framework. 
The advantages of MDBs range from locally contextualizing projects to greater options for credit access. Working on a localized scale, MDBs acquire a greater knowledge of on-ground dynamics and needs, which reduces the asymmetry of information that typically makes financial institutions leery of investing at the local level. This knowledge of local actors helps MDBs take a bottom-up approach to financing and allow them to pool local projects to qualify for financing. They are also effective at making sure that second-tier cities and localities without national profiles are able to access credit. By focusing on specific areas and a narrower range of activities, MDBs provide start-to-finish technical support and guidance for local stakeholders to make sure that projects functioning with allocated funds are effectively implemented.
They do, however, come with their own set of risks, most notably the issue of debt-repayment. They have been associated with relatively high rates of non-performing loans and defaults from borrowers.  With limited ability to penalize cities for defaulting on loans, there is often no accountability for irresponsible spending or poorly executed projects, and municipalities may still receive other sources of financial support from central governments. Additionally, differences of political interest between local and central governments, and between successive administrations, increases risk for lenders and deters the issuance of debt.
Successful MDBs have mitigated these risks through various measures and an overall strategy of risk-sharing among stakeholders. The Tamil Nadu Urban Development Fund (TNUDF) is a notable case that helped finance extensive road, sanitation, and other infrastructure projects in Southern India with a loan recovery rate of 100%. The TNUDF achieved this degree of success and establish itself as a creditworthy actor in the international credit market by following a few key strategies.
Projects were pooled to ensure revenue sufficient to cover debt service. Debt obligations were shared between the state of Tamil Nadu and the Indian government, which remained entitled to intercept state transfers to service debt in the case of non-payment. The Fund operates as a public-private partnership with private investors and foreign FDIs to ensure that projects are managed to remain profitable. It also provides consistent technical support to municipalities to ensure successful project implementation.
This brief recommends that financial development institutions with an interest in developing sustainable urban infrastructure should work with national governments to establish domestic MDBs, with the strict mandate of supporting cities to assume debt and improve creditworthiness to finance green infrastructure projects. In countries where this role is currently filled by NDBs, MDBs should be implemented as a “last mile bank” to cover gaps in the existing system. In countries in which NDBs do not exist, FDIs should work with national governments to open the regulatory environment for subnational borrowing.