JESSICA’s Vision for Smart Cities: Investment Funds for a Sustainable Urban Future (Part 1)

With research and writing assistance from Ben Falber, Smart Cities Advisors fellow in Summer and Fall 2011

Our previous blog post on urban impact investment funds, Impact Investment Funds for Cities: Insight from the EU’s JESSICA program, looked at the EU’s evolving JESSICA initiative as a promising example of impact investment-type concepts deployed for socially and environmentally sustainable cities. As we’re developing a proposal for an urban regeneration investment platform in Brazil, we’ve found the JESSICA framework useful as a starting point for sustainable, values-driven and profitable urban investment in emerging and developing economies’ cities.

JESSICA-promoted Urban Development Funds (UDFs) will include prototype theme funds to invest in energy efficiency, infrastructure development, environment, “smart city” improvements and brownfield rehabilitations.  The smart city investment funds and brownfield funds are the prototypes that resonate most with developing economies’ urban needs. Our next two blog posts briefly profile how these UDFs relate to the urban growth and investment challenges of developing cities.

The investment mandate of the “smart city” UDF protoype is to renovate and redevelop existing public assets across sectors, including infrastructure and buildings (e.g. train stations, commercial market infrastructure, public housing, office buildings, etc.). The UDF would cooperate with municipalities to improve quality of life and infrastructure, increase the private market value of public assets, lower operating costs and potentially privatize asset ownership.

As investors, these “smart city” funds aim to achieve a moderate internal rate of return (IRR) for private capital while generating measurable positive externalities. Although the investment emphasis is on long-term redevelopment loans for assets already in the utilization stage, smart city UDFs could also invest late-stage equity, aiming to return capital through asset sales over a clearly defined time horizon (e.g. privatized public housing).

Like private real estate funds, the smart city UDF could invest either at the operating company level (in a city-sponsored project company) or directly in redevelopment projects lending to the municipality. As the UDF contributes financial capital and expertise, the city’s in-kind investment can include land, buildings and/or infrastructure. Public loan guarantees can also mitigate credit risk where necessary.

Much like a real estate private equity investor, the “smart city” UDF’s activities can get involved in operational and strategic management to maximize the value of the assets and pursue sustainable development goals, including: operation and maintenance; strategic planning and portfolio management; coordination of capital programs and project management; utility and energy management; and structuring of public real estate finance.

Importantly, “smart city” UDFs help build municipal capacity to carry out urban investment programs by identifying and funding necessary technical inputs (e.g. feasibility studies, tendering processes). Whenever these interventions entail higher operating costs and complexity, these should be justifiable with positive external rates of return and externalities. IRRs to private capital providers would be driven by rising rents and property values, savings on operating costs (e.g. from efficiency or sustainability) and exits through asset sales while positive externalities benefit the public through:

-        Higher quality urban infrastructure, better overall quality of life, improved competitiveness, more amenities and more attractive communities;

-        Lower municipal indebtedness that may free up policy space to pursue other livability and economic development initiatives; and

-        Higher property values and economic development opportunities for all city residents.

At the intersection of old and new, both old and new challenges. Developing countries’ cities also have extensive public sector assets situated on well-located central urban sites, such as underutilized public buildings, schools and housing and poorly maintained markets, historic sites and transport hubs. Retrofitting and repurposing these assets, as is taking place in countries like Brazil and India, will yield new residential and social infrastructure, as well as commercial space, in their space-constrained cities.

The main challenges are risk/return mismatches, capital availability, technical capacity, stakeholder interests, pipeline development and governance – also common themes across impact investment:

-        Cities are expected to identify assets for redevelopment, but pipeline generation still requires a substantial time and resources and cross-sectoral consultations with public, private and citizen sectors. This requires additional start-up equity or grant funding.

-        Risks to implement may be higher in developing economies due to limited municipal technical expertise, bureaucratic roadblocks and legal risks. Given the large up-front capital investments required, lower hurdle rates through a UDF-type structure would help in closing the large margin between “impact” returns and market rates of return. Major anchor urban impact investors, like DFIs and foundations, are needed to help get these off the ground.

-        Stakeholder interests have to be brought into the process, ideally with innovation in inclusive infrastructure finance. Existing communities should be consulted and household contributions integrated where possible. Ideally, new debt and equity instruments would enable housing cooperatives, associations and other community bodies to participate actively.

-        Oversight and governance are necessary to ensure that public funds are leveraged for sustainable projects with risk distributed appropriately among partners, rather than serving narrow political or economic interests.

-        Complex structures require diverse capital providers with varied risk profiles, though this may mean higher fund operating costs for longer-term project and financing negotiations. Again, the role of an anchor impact investor is clear.

Stimulating private investment in sustainable cities makes imminent sense for residents and businesses, but does it make sense for investors? DFIs, foundations and other impact investors will definitely have to back the initial heavy lifting required for market creation and enabling. The question is whether private investment capital will engage on longer-term, triple-bottom-line urban investments at scale. Without substantial lending and capacity building from “urban impact investors,” it is difficult to imagine such initiatives independently evolving in the developing world.

Read on in our upcoming posts about the JESSICA brownfield UDF and the implications for emerging and developing markets like India and Brazil.

Source: Dr. Claudia Kreuz and Dr. Michael Nadler as special adviser. “JESSICA  –  UDF Typologies and Governance Structures in the context of JESSICA implementation” Funded by the European Union.

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