Entrepreneurship and innovation in development finance institutions for promoting the clean development mechanism in Africa

Abstract

This article demonstrates how entrepreneurship and innovation can help promote the clean development mechanism in Africa through development finance institutions. If DFIs do not have sufficient knowledge of how to enhance entrepreneurship and innovation they will have only a limited impact in promoting innovative financial instruments for achieving environmental benefits. Supporting innovation and entrepreneurship will enable DFIs to create opportunities for adaptive learning and creativity, to adjust to emerging CDM innovative financial instruments and to play a key role in promoting CDM in Africa. It will make DFIs more knowledge based and enhance their ability to provide monetary incentives through their project financing activities, to encourage and facilitate partnerships to support the CDM, and to provide technical advice and support to clients for project design, planning and implementation.

1. INTRODUCTION

Development finance institutions (DFIs) can play a key role in promoting the implementation of the clean development mechanism (CDM) in Africa. This article describes entrepreneurship and innovation by a DFI in this regard. CDM is perceived as a new, market-oriented, innovative and flexible financing instrument articulated by the 1997 Kyoto Protocol that came into force in February 2005 (UNFCCC, 1997). The entrepreneurship and innovation required by CDM is embedded in DFIs as institutions with the ability to codify the ideas necessary for change. Drucker (1985) describes and analyses such entrepreneurship and innovativeness as the basis for modern development instruments. CDM, as one of these, aims to enhance the implementation of investment strategies that have capabilities for adapting to or mitigating the adverse effects of climate change and promoting sustainable development.

CDM is one of the flexible mechanisms established by the Kyoto Protocol to promote the reduction of greenhouse gas emissions in a cost-effective manner. In addition to the other flexible mechanisms, Emissions Trading and Joint Implementation, rules and modalities for the CDM have been discussed at a variety of meetings, including the 1997 Kyoto Protocol, the 1998 Buenos Aires Plan of Action and the 2001 Marrakesh Accord in Morocco (UNFCCC, 2005). At these meetings, participants agreed to promote the CDM in the context of sustainable development that would include small-scale project activities and land use, land use change and forestry (LULUCF) projects in addition to energy, waste management and industrial projects. These projects will contribute towards mitigating climate change.

Climate changes that result in temperature increases with possibilities for global warming may cause drought, thus affecting agricultural productivity and constraining development (UNFCCC, 1992, 1997). These climate changes are thought to be the result of emissions of greenhouse gases (GHG), in particular carbon dioxide (CO₂), which has an average life span of 100 years in the atmosphere as compared to methane (CH₄), which has a high warming potential but a life span of 24 years (IPCC, 1992). The measurement of greenhouse gases has been standardised against the CO₂ equivalent.

The process of valuing the CO₂ equivalent into monetary units is complex for both DFIs and policy makers (Gowdy & O'Hara, 1995). If DFIs are innovative and entrepreneurial, particularly in promoting the CDM, which will finance projects with the potential to generate opportunities for reducing greenhouse gases, this creates an enabling environment. As a market based innovative instrument CDM requires entrepreneurship to deal with market forces of supply and demand. According to Drucker (1985), entrepreneurship and innovation are the best proof of institutional abilities and capabilities to cope with market forces that address development challenges and adapt to emerging innovative financial instruments such as CDM.

2. ENTREPRENEURSHIP AND THE CDM

Drucker's view of entrepreneurship and innovation can be seen as a challenge to put knowledge to work through DFIs – to apply entrepreneurship and innovation as knowledge based approaches that can promote CDM in Africa. This perspective allows for institutional flexibility in accordance with the basic characteristics of a project's life cycle or time span, the preparation for the project, the predictability of risks, and the anticipated market challenges. If well articulated, as knowledge products entrepreneurship and innovation can enhance institutional abilities to effectively manage projects necessary for addressing development.

Despite the complex process, Africa has become the region of focus for CDM projects through DFIs. Africa's industrial growth requires the consumption of more energy at an affordable cost (World Bank, 2006). On the basis of the economic cost effectiveness principle, the cost of doing a CDM project in Africa is much lower than that of doing a similar project in a developed region, which provides an opportunity for investment in clean energy sources by using CDM investments to offset emissions from high carbon based energy sources (Karani, 2002). Other potential projects would be from land-use initiatives that contribute to sequestration of carbon by forestry, soil conservation and better agricultural practices (Seo et al., 2005). In emerging mega-cities, other projects could be sourced from waste management to reduce emissions from methane.

However, current opportunities for CDM in Africa indicate very small volumes of carbon offsets. Thus far, only a few CDM initiatives are associated with development projects in Africa (Lecocq & Capoor, 2003). For example, in a Moroccan CDM energy efficiency project portfolio of 25 projects, only seven projects can generate 85 000 tons of Certified Emission Reductions (CERs) per year (Senhaji, 2004). In contrast, the first South African CDM project on Low-Income Housing Energy Upgrade to be registered by the CDM Executive Board on 29 August 2005 can generate only 2.85 CO₂ equivalent tons per household per year over 21 years (UNFCCC, 2005). Similarly, the CDM projects identified by UNIDO (United Nations Industrial Development Organization) in Senegal, Nigeria, Zimbabwe, Kenya and Zambia can generate only 1.17 million tons of CO₂ equivalent (Pembleton, 2002). These total emission reductions from Africa are just barely the equivalent of one CDM project in Brazil, Mexico, India or China.

Clearly, although emission reduction opportunities in South Africa, Nigeria and Egypt are seemingly higher, Africa is still behind the rest of the world in participating effectively in the CDM market (Knudsen, 2005). This is unfortunate, considering that CDM has potential opportunities for fuelling Africa's economy. Africa needs additional resources to attract investments in clean energy, better agricultural practices, forestry and soil conservation techniques, all of which would enhance productivity (World Bank, 2006).

However, the CDM process has not in itself made it possible for Africa to move fast enough in attracting foreign investment. This is partly because the process itself has been extremely slow and constrained by institutional bureaucratic obstacles (Karani, 2002). Thus far, by March 2006 only 16 CDM projects have been registered globally by the CDM Executive Board, of which one is located in Africa – at Kuyasa, Khayelitsha, on the south-eastern side of Cape Town, South Africa. Since the project objectives include development impacts through the installation of solar water heaters, insulated ceilings and compact fluorescent lighting bulbs in 2300 poor low-income community households, the project has strong social and environmental components that will add value to socio-economic development.

The project's components will eliminate indoor burning of coal and hence reduce indoor air pollution, thus improving human health. Reducing respiratory health problems will in the long run reduce social costs as a result of lower medical bills. In addition, the lifestyle of the local communities will be improved by spillover effects from the provision of jobs for the vendors needed to maintain a continuous supply of such necessary equipment as solar heaters and fluorescent bulbs. This entrepreneurial and innovative process calls for additional support from DFIs, and a passionate approach. The effect of this support will be long term: in the long run, the CDM project will generate environmental and climate change benefits by reducing dependence on high pollutant fossil based energy consumption, leading to the reduction of 2.85 CO₂ equivalent tons per household per year (UNFCCC, 2005).

3. ENTREPRENEURSHIP AND INNOVATION IN CDM

Entrepreneurship and innovation are emerging as key factors of institutional excellence in confronting development challenges and promoting sustainability. Drucker (1999) emphasises that the success of a core business is based on entrepreneurship and innovation that engage management in confronting challenges and addressing market needs. The DFI market is complex and driven by forces of theories and practices. This calls for putting knowledge to work; knowledge that will analyse development challenges, interpret statistical data, contextualise field surveys and draw the best-informed conclusions in support of sustainable development.

The global institutional transformations and policy changes between 1980 and 1990 are largely referred to as the outcomes of entrepreneurship and innovation. During this period a number of global institutions cut down on their production costs as part of the structuring process while others innovatively created numerous job opportunities, especially in ‘Silicon Valley’, and others undertook ‘merger and acquisition’ processes in order to remain in business. The question remains why some institutions perform better than others at creating new products and services. DFI products and services tend to be generic, with development as the core objective. Similarities create challenges and competition among DFIs through products and market segmentation. Peters and Waterman (1982), in an attempt to differentiate products and market segmentation, argue that institutions can create ‘intrapreneurship’ through renewal of corporate strategy, innovation and entrepreneurship that will make the institution distinct from others in developing unique products and services.

DFIs' products and services broadly include development banking and development assistance (Musasike et al., 2004). They include lending and investment, guarantees, grants and technical assistance, advisory services, and research and policy. This classification does not detail the new and innovative products based on carbon measured in CO₂ equivalent units as articulated in the CDM (Karani, 2002).

Within the CDM framework an example of a DFI project with CDM potential is the Bethlehem Hydroelectric Power Project. This project has been prepared with the support of the DBSA (Development Bank of Southern Africa) in partnership with the World Bank and is considered suitable for carbon financing. With an installation capacity of four megawatts, the project is in the process of being registered by the CDM Executive Board, after which it will be officially recognised for carbon monetary exchange (personal communication, Project Manager, DBSA Agencies Unit, February 2006). DFI products associated with this project are investments worth US$5 million, technical assistance and advisory services. The project will generate 200 000 CERs over a period of five years and will be purchased by the World Bank at a price ranging between US$4 and US$5 per CER, generating additional monetary returns of US$800 000 to US$1 000 000.

Since 2000, the evolving CDM with carbon financing has been seen as a product that can be offered within the framework of development banking and development assistance. The World Bank Prototype Carbon Fund (2005) has generated lessons and good practices on the application of the CDM within the development framework. However, the World Bank continually faces criticism – from outside, saying that this Fund is crowding out the private sector, and from inside, saying it is insufficiently integrated with the rest of the Bank's development efforts and operations that aim at promoting development effectiveness. Other DFIs therefore need to extrapolate from these lessons and practices and develop replication strategies in line with their particular strategic thrusts towards sustainable development.

DBSA has made good progress towards realising its strategic development vision for South Africa. This has resulted in strong partnerships with municipalities, provincial government and regional institutions, such as the New Partnerships for African Development (NEPAD), as well as the private sector. It has extended basic services to millions of un-served and under-served people, and continually builds further momentum towards achieving the millennium development and NEPAD goals – and fundamentally towards meeting goals for poverty reduction (DBSA, 2005).

As part of its achievement, DBSA has increased the number of households with access to safe water from 7.2 million to 10 million – that is, from 79.8 per cent of the total in 2001 to 85.0 per cent in 2004. The number of households with access to electricity has increased from 5.2 million to 8.3 million – equivalent to a percentage increase from 57.5 per cent to 70.4 per cent (DBSA, 2004–2005). DBSA provided the financial support and technical assistance necessary for preparing and implementing the projects. It aspires to reach the remainder of the households in partnership with the government of South Africa and other development institutions.

This is necessary because the overwhelming majority of the remaining service backlogs are in rural areas where settlement densities are low and the costs of electricity and water connections are high. To offset some of these costs, it is necessary to mobilise additional resources to complement development initiatives. The CDM provides an opportunity to offset these high costs and promote cost effective sustainable development. But political instability, civil unrest, conflict, immigration and high levels of corruption have emerged as major obstacles to better economic performance in Africa and constraints on entrepreneurship and innovation.

The institutional challenges to economic growth in African countries contribute to the slow pace of capital formation or investment that is a major reason for Africa's tardy economic growth. The current rate of capital formation, about 16 per cent of GDP, is low compared to that of fast-growing developing countries. Since the mid-1970s, the rate of capital formation in rapidly emerging economies such as those of the Asian Tigers has been consistently above 25 per cent of GDP. Clearly, to achieve the Millennium Development Goals by 2014 African countries must target capital formation of 25 per cent. This target creates room for entrepreneurial and innovative financing that blends CDM flexibility with investment opportunities. DFIs' efforts in bridging financing gaps can use CDM opportunities to enhance investment flows, technology transfer and additional financing and thus boost development in Africa.

The task of DBSA is to identify risks and maximise opportunities for development through a high quality portfolio of investments. With the emergence of the CDM, DBSA has the potential to mitigate adverse effects (on human health, water quality, soil fertility, climate change, and so on), to enhance efficiency and cost-effectiveness in both the mobilisation and use of resources and to protect the environment, hence adding value to sustainable socio-economic development.

DBSA's products and services give some indication of how the CDM could be leveraged and promoted through lending and investment products. Investors in infrastructure in Africa recognise their environmental and social responsibilities and obligations. This recognition creates room for promoting the CDM through DFIs' market based products and services. For a long time DFIs' financing and project design were not market based in approach and thus suffered from market exploitation.

The lending and investment activities offer a challenge to DFIs such as DBSA to ensure the efficient delivery of products and services. One way of meeting this challenge is to combine CDM projects with normal DBSA operations. The comparative advantage of doing so is to integrate all project preparation costs and all the work being done on environmental impact assessment, social impact assessments and safeguards that are included in a market based approach. This approach will reduce transactions costs and diversify risks that are likely to affect the CDM projects and limit development in Africa. In this context CDM resources will leverage normal DFIs' funds for investment.

Environmentally sound infrastructure is strategic for the DBSA's involvement in socio-economic development through investment, advisory services and partnership. As DBSA's primary focus is on financing infrastructure and sustainable development (its mandate), its basic point of departure is that the environment is the source of development and that its protection and conservation require full support. The market for clean design, clean production, sustainable and appropriate packaging, community based resource recovery, and adding value to existing safe water streams, survives numerous challenges. Valuing CO₂ and measuring development impacts at household levels are not only monetary in approach but challenged by emerging environmental markets and policy responses.

Environmentally friendly infrastructure requires investment in products, processes and services that are not polluting or harmful to human health. Investment by DBSA in pollution prevention technologies through CDM initiatives will result in minimising costs that, in the long run, would be greater than the initial investment. Clearly, DBSA must help clients and partners to plan, design and construct environmentally friendly infrastructure that is cost-effective, efficient and sustainable. What is important for environmentally friendly infrastructure is the quality of services and products offered by DBSA. Consequently, it is important to identify and assess potential natural and human induced environmental hazards and risks within the context of CDM investments (Meyer, 2004).

4. DFIs AND THE CDM

The development of carbon credits can be complex and requires exchanging information and sharing knowledge and experiences. Based on DFIs' long history and experience of providing finance and technical assistance for effective development, practical opportunities and solutions to promote the CDM through DFIs cannot take place without entrepreneurship. Whether in process or product innovation, entrepreneurship must be viewed in the context of:

• factors that promote the CDM through mitigating technology, innovation, deployment and diffusion, including national, regional and international cooperative efforts and the removal of barriers to sustainable development; and

• the socio-economic aspects of mitigating climate change, such as costs and benefits, co-benefits, poverty reduction and economic impacts, including spillover effects.

Entrepreneurship is a key factor in promoting the CDM through DFIs and will facilitate positive thinking about the mechanism in the context of sustainable development in Africa. Entrepreneurship and innovation enacted through economic sectors with DFIs can generate carbon credits. The carbon credits calculated in CO₂ equivalents can be generated by sectors through accelerated technologies and efficient and cost effective practices that are entrepreneurial in nature. Key economic sectors with potential for generating carbon credits in South Africa are presented in Table 1, which contains information from the government on the types and quantities of greenhouse gases produced by various sectors in the period between 1990 and 1994.

Table 1. Greenhouse gas emissions in million tons of CO₂, CH₄ and N₂O in South Africa in 1990 and 1994

Greenhouse gases	Carbon dioxide (CO2)		Methane (CH4)		Nitrous oxide (N2O)
Year	1990	1994	1990	1994	1990	1994
Energy	252 019.05	287 850.96	346.96	375.70	5.10	5.88
Energy industries	159 114.62	167 816.64	0.52	0.47	2.76	2.61
Industry	47 026.25	53 186.34	5.64	6.15	0.74	0.78
Transport	30 941.18	42 716.69	8.63	10.58	1.36	1.88
Commercial	5 043.78	780.26	0.54	0.07	0.08	0.01
Residential	6 683.79	7 397.49	7.35	0.60	0.08	0.08
Agricultural/forestry/fishing	3 209.42	15 953.54	0.48	30.70	0.09	0.53
Fugitive emissions			323.81	327.12
Industrial processes	28 912.74	28 106.26	3.27	1.25	5.84	7.27
Mineral products	5 478.19	5 330.91
Chemical industry	1 658.81	1 952.10	3.27	1.25	5.84	7.27
Metal production	21 775.73	20 823.26
Agriculture			1014.45	937.41	61.84	50.89
Enteric fermentation			916.55	844.01
Manure management			83.42	78.47	1.40	0.07
Agricultural soils					59.71	50.05
Savanna burning			12.63	12.63	0.61	0.61
Agricultural residues			1.85	2.31	0.12	0.14
Land use change and forestry	− 16 982.37	18 615.97
Changes in biomass stocks	− 13 640.99	− 10 885.81
Soil removals	− 3 341.38	− 7 730.15
Waste			688.40	743.07	2.38	2.66
Solid waste on land			669.27	721.74
Wastewater handling			19.13	21.33	2.38	2.66
Source: Department of Minerals and Energy, 2000.

These figures may not be accurate, as the economic growth in South Africa was unstable in the years before 1994 and experienced substantial transformations after the 1994 political change (AfricaPractice, 2006).

The total emissions from the economic sectors indicated in the table above are the foundations for generating carbon credits when the emissions are reduced effectively through appropriate measures and clean technologies. To date, South Africa emits about 8.5 per cent of the total global emissions. As the economy of the country continues to expand, emissions increase on a progressive path. In the context of the CDM initiative, the expanding economy needs to integrate a CDM framework that will contribute to the generation of carbon credits.

Thinking about the CDM from a DFI point of view requires a strategic approach aimed at promoting sustainable development as mandated by CDM criteria. Development in most emerging economies is driven by low-cost options unattractive to investment as they are often linked to the consumption of low quality fuels deemed polluting. To mitigate such pollutants requires the rationalisation of development financing. This is in accordance with emerging environmental markets, particularly the carbon market that innovatively promotes additional financing for environmentally friendly initiatives aimed at reducing emissions of greenhouse gases such as CO₂ and CH₄.

The acceleration of environmental technologies such as solar panels or wind turbines or scrubbers that reduce carbon emissions from energy projects promoted through additional investments can generate carbon credits. At the time of writing, DBSA is operating in a high-risk market where investment for poverty reduction is driven by policy and business continues as usual. In this type of situation clients prefer low-cost options – hence the tendency towards using polluting technologies because of a perceived short-term cost advantage. At this level of operation, very small volumes of carbon credits can be generated. Since environmentally sound technologies are sometimes high-cost initially and carbon credits are market driven, the CDM and environmental financing provide additional resources to supplement investment for carbon credits. This approach encourages investment in low carbon economies – for example, investment in renewable energies that are non-polluting and enhancement of carbon sinks and sequestration projects. This level of operation has the potential to generate carbon credits at an additional cost that is outsourced above DBSA's investment baseline.

A number of environmental standards have been emphasised and legitimised by the Equator Principles. These Principles establish benchmarks for funding large projects with minimum level of investments of about US$50 million. The Principles subscribed to by some financial institutions, including ABN Amro, Standard Bank and Nedbank and led by the International Finance Corporation (IFC), are aimed at enhancing the environmental responsibilities of both the financier and borrower. To some extent the Principles enhance targets aimed at the institutional environmental performance standards of the World Bank and IFC. This includes the application of well-established environmental guidelines and safeguard measures and policies in development financing. DFIs needing to internalise the Equator Principles and safeguard measures on environmental and social issues to provide a potential opportunity for promoting the CDM. For instance, the Principles seek to ensure that projects are developed in a manner that is socially responsible and reflects sound environmental management practices. DFIs need to mainstream environmental matters if they are to comply with the Principles and the World Bank Group's environmental guidelines and safeguards.

The most obvious benefit of the Equator Principles to DFIs is that they will become more committed and responsible and ensure that projects are subject to greater scrutiny, which should result in their being more environmentally and socially sound. Beyond that, the Principles offer the consistency necessary for compliance and minimising institutional risk. They also provide for commonality in approach and terminology among all subscribing DFIs, which should provide certainty for both the DFIs in respect of project risk and the customers or borrowers who have a prescribed framework with which they must comply if they are to obtain funding.

In the context of emerging CDM markets that are environmentally based, Sterner (1999) argues that it is necessary to promote market based policy instruments for institutional transformation and the reform of the environmental agenda that will promote CDM initiatives. Policy reform and institutional transformation are critical to the effectiveness of the DFIs that will be competent to promote CDM in Africa with strategic targets for financing environmental infrastructure. The 2002 World Summit on Sustainable Development characterised the sectors associated with institutional arrangements in the South African context and identified specific areas of policy reforms in governance, economic growth, development and environment that are critical to sustainable development and which fully require the role of DFIs in mobilising resources and providing resources that will achieve sustainable development. It is within this framework that DFIs can promote CDM projects as implementation targets focusing on poverty reduction, capacity building and partnerships, economic growth, environmental management and adding value to socio-economic development.

5. CONCLUSIONS

Over the years, DFIs have gone through institutional transformations and policy changes with a view to enhancing sustainable development. One of the key criteria of the CDM is promoting sustainable development through additional financing and innovative market oriented processes and products. The complexity of integrating the CDM with sustainable development requires innovation and entrepreneurship. This can be done by DFIs which have a strong commitment to entrepreneurship and accept high risks as part of promoting sustainable development through a CDM which is favourable to poor economies. A majority of African countries have poor economies and desperately need investment flows, technology transfer, additional financing, and knowledge and information resources to boost sustainable development. It is evident from the emerging CDM market that DFIs can play a role in promoting CDM activities towards achieving sustainable African development.

Financial risks are prevalent in African countries where savings are low and hence raising capital from domestic markets is difficult. To some extent, poor infrastructure and weak investment flows lead to high transaction costs and in general this limits the potential for reduction of emissions. But DFIs' ability to leverage financial and technological resources has the capability to integrate CDM project and transaction costs into normal bank operations and provide an opportunity for promoting CDM activities in Africa at low cost with the potential for high returns on investments and social benefits. However, the return on investments may take much longer and is not guaranteed, owing to political sensitivities and institutional instabilities. Some of these risks can be managed or leveraged through partnerships developed by DFIs for the purpose of promoting CDM in Africa.

Additional information

Notes on contributors

Patrick Karani

Respectively, Vice-President, Infrastructure, Private Sector and Regional Integration, African Development Bank (AfDB), former Chief Executive Officer (CEO) and Managing Director of the Development Bank of Southern Africa (DBSA); and Environmental Strategist, DBSA, Advisor, BEA International, CBNet representative in Africa, and co-editor, CDM Investment Newsletter.