Alarming findings from Climate Risk Index reveal that Nepal is ranked as 10th most vulnerable country to climate change-related risks. The risks stem from a combination of fragile mountainous topography and ecosystems, highly variable monsoon-driven hydrology, unplanned settlements, and a lack of resilient infrastructure. In this context, Nepal’s National Adaptation Plan has stated that Nepal will need USD 47.4 billion by 2050 to finance its adaptation programs aimed at addressing climate vulnerabilities and risks from climate change.

In its nascent stages, Nepal is roughly expected to raise only USD 1.75 billion in the next 9 years from the international climate windows. This is nowhere near the amount of USD 47.4 billion which Nepal needs as stated in NAP. It is important for Nepal to take initiatives, both from the government and private sector to explore more opportunities from the international climate window and impact the green initiative in Nepal. Platforms such as COP29 have introduced ambitious goals, including scaling up climate finance to developing countries by providing 300 billion annually by 2035, tripling from the previous goal of USD 100 billion annually.

Especially after the recent developments in implementing carbon trading mechanisms under the Paris Agreement from COP 29, Nepal can and should access financing from international climate window. This of course goes parallel to the opportunities and financing in domestic market.

Promotion of Green Initiatives

Nepal has made some positive strides in recent years. However, like policies in other sectors, the approach in this area needs to be relooked. This is because: (i) new regulatory frameworks have emerged that we should consider adopting, and (ii) some existing regulatory measures were not well-suited from the outset.

Enactment of Green Taxonomy

The Nepal Rastra Bank has recently introduced “Nepal Green Finance Taxonomy 2024” which aims to create a financial ecosystem of market participants including banks, investors, issuers and regulators like NRB, SEBON and Insurance Authority for enhancing projects under the green initiatives. The introduction of Green Taxonomy in Nepal aligns the country's practice with those of other countries to identify green sectors and foster green finance.

To give a brief overview, the Green Taxonomy serves as a reference document, non-binding in nature, which list outs the green sectors in Nepal. This is primarily achieved by recognizing the projects which support the core principles of green initiatives within the broader framework of the ‘Do No Significant Harm’. Additionally, a whitelist approach is used to categorize activities based on their environmental impact. Based on their environmental impact, projects are categorized as Green, Amber, or Red:

-           'Green' indicates projects with transformative aspects for green initiatives,

-           'Amber' denotes activities in transition,

-           'Red' signifies projects that do not align with environmental objectives.

Another important thing to mention in Green Taxonomy is the provisions guiding the issuance of green bond. The Green Taxonomy lists out basic conditions for the issuance of green bonds aligned with the provisions of ICMA principles. With the clarity provided by the Green Taxonomy on green initiatives, this document could act as an anchor for green financing.  Nepal will need to look at other fiscal and no-fiscal incentives to push this sector ahead.

Amendment to the Environment Protection Rules

Another regulatory response conducted by the regulators is to facilitate carbon trading in Nepal with the amendment to Environment Protection Rules 2077 (2020) (EPR). The Ministry of Forest and Environment has recently published the amendment to existing Environment Protection Regulations 2077 (2020). The amendment bill of the EPR amended the provision for carbon trading and aligned the provision of EPR in consistency to the Paris Agreement.

However, some of the provision of the amendment bill is not conducive to attracting private investment. The amendment bill includes provisions for extremely rigid legal compliance for private developers of operate carbon trading projects. For instance, Clause 9 of Rule 28b of the amendment bill of EPR requires the project developer to provide 80% benefit arising from carbon trading to the beneficiary of the project. According to a private developer of carbon projects, executing a project under 80% revenue-sharing model would only generate about 2% of Internal Rate of Return (“IRR”). This approach to develop carbon trading projects based on financial model of public institutions like AEPC will make it difficult to attract private sector funding.

Some Things to Consider

Some of the Issues Requiring Policy Intervention

In alignment with the Green Taxonomy, following policy interventions are some of the many reforms to support green initiatives and encourage green financing. These interventions can take two approaches:

Firstly, Nepal should work towards creating a supportive market environment that encourages private sectors and local banks to deploy the funds into green initiatives. For this purpose, following legal amendments are required to provide access for the fiscal incentives and non-fiscal incentives:

1. Fiscal Incentives encouraging Green Initiative Projects

Under the fiscal incentives, incentives including income tax holidays, reduced tax rate, accelerated depreciation, extended loss carry forward/backward, tax credits can be provided which is consistent with what other jurisdiction. There are currently 114 tax incentives including tax concessions in 17 different countries for green initiative projects. In Nepal, the fiscal incentives under the current Income Tax Act 2058 (2002) (ITA) largely focuses on facilities of accelerated depreciation, extended loss carry forward/backward  tax holiday, reduced tax rate for infrastructure and electricity generation projects. Additionally, the ITA has provided tax incentive to one additional project under green initiative which uses recycled materials which would cause harm to environment for producing goods. To promote green initiatives, it is essential to expand the scope of industries eligible for fiscal incentives under the ITA aligned to the priority sectors identified in the Green Taxonomy.

2. Re-financing Sovereign lending to BFIs

Under other forms of incentives, government can utilize sovereign re-financing to subsize loans provided for green initiative identified in Green Taxonomy. It is widely recognized that transitioning to green projects is challenging under traditional commercial lending, primarily due to their typically lower rates of return. One way to resolve the issue could be through mobilization of sovereign lending to fund private sector projects. The government can utilize the sovereign lending obtaining from international climate window to introduce and deploy subsidized loan scheme from BFIs to invest in priority green sectors (i.e., climate adaptation and resilient sectors). For instance, the State Bank of India has established a good precedent in which SBI re-financed the loan obtained from the World Bank to private developers engaged in development of solar rooftop projects.

Nepal has previously implemented direct lending strategies, utilizing subsidized loans and grants under the Renewable Energy Subsidy Policy, aimed at supporting a portfolio of renewable energy projects developed by private sector like Scaling-up Renewable Energy Program (SREP), Nepal Renewable Energy Programme (NREP), South Asian Sub-Regional economic cooperation (SASEC).

3. Other incentives encouraging Green Initiatives

There are some incentives provided under the Renewable Energy Subsidy Policy 2073 (2016) to developers of micro hydro, improved water mill, solar energy, biogas, solar-wind hybrid energy systems. The incentive mechanism generally covers 40% of the total costs with the private sector assuming responsibility for 60% of the required capital invested in cash and kind. However, these incentives are not adequate to support Nepal’s need for a large portfolio of projects on climate mitigation and resilient infrastructure. The Government should introduce additional schemes and policy to provide direct benefits and incentives for project developers engaging in green initiative projects.

4. Mandatory Requirement for Green Transition

Additionally, the NRB should issue mandatory requirement for local banks to issue a certain portion of its investment into green projects categorized under the Green Taxonomy. Under Directive 17 of the NRB Unified Directives, banks are required should mandatorily make certain investment in portfolio of projects with renewable elements like hydropower projects, solar projects, and rural electrification projects. With the recent enactment of Green Taxonomy, NRB may consider investment in Green Projects as compliant within these mandated sectors. This approach probably would allow the banks bigger portfolio basket to invest.

5. Establish Integrated Database on Climate Change Impact

It is important for Nepal to maintain integrated database of statistics and indicators of climate change impacts and greenhouse emissions. This is important for realizing the baseline scenario and project scenario for a carbon emission reduction project. The baseline scenario is the scenario of the area which exists before the operation of carbon emission reduction project. Similarly, the project scenario is defined as the scenario that exists after the project is implemented and operationalized. According to the recent amendment in the EPR, the Ministry of Forest and Environment (MOFE) is considered as the focal point to regulate carbon trading and all climate initiatives in Nepal. For the purpose, the MOFE should establish an integrated system for maintaining database on climate change indicators, greenhouse gas emissions, reporting, performance evaluation and monitoring mechanisms of climate change investment projects and activities which will help to track the climate finance allocation and expenditures to meet the climate action targets. This would help to provide baseline indicators to track the impact of climate change and impact of projects in offsetting the risk.

6. Revision to provisions of Carbon Trading

The amendment bill of EPR issued by Ministry of Forest and Environment has provisions which mandates extremely rigid legal compliance for private developers of operate carbon trading projects. Following are the provisions which requires amendment:

1. Recognition of Carbon Trading Mechanism

The amendment bill has provided the right to government to endorse all carbon emission reduction projects including projects under Voluntary Carbon Market (VCM). The provision needs to revise to recognize independent role of private sectors to develop and operate carbon emission reduction projects without involvement of the government.

2. Broad Discretion to Determine Impermissible Sector

The Ministry of Forest and Environment (MOFE) is provided the role of regulatory authority. Under the authority, the Ministry has sole discretion to determine permissible and impermissible sectors for conducting carbon trading in Nepal. The provision provides broad discretion to the Ministry for declaring an impermissible sector which can lead to arbitrary restriction of business activities. The provision should be amended to provide only specific and exhaustive list of conditions which is necessary for Ministry to determine the sector as impermissible.

3. High Threshold for Revenue Sharing Model

The amendment bill requires the project developer to share 80% of the carbon trading benefit with beneficiary of the project. The provision does not clarify the meaning of “benefit” and “beneficiary”, which makes the cost of revenue sharing model uncertain. Additionally, the threshold of 80% benefit sharing makes the private projects unfeasible due to low IRR. The provision requires revision in the benefits sharing requirement to ensure that the private sectors can develop bankable projects.

Secondly, Nepal should resolve prevailing issues existent in the current regulatory framework to obtain financing from global climate financing windows. For the purpose, following policy reforms may be considered:

1. Assess to Innovative Financing Modality for Green Finance

The existing provisions in the NRB Bylaws may create some hindrance in the entry of foreign loans in Nepal:

1. Payment Before Disbursement:

The NRB Bylaws allows the borrower to make payments to the foreign BFIs only after the first disbursement has been made. However, the local borrower may be required to make certain pre-payment and upfront cost to the foreign lenders for issuance of green bonds. For instance, the lender may require pre-payment from the borrower for reporting and verification costs to ensure alignment with ICMA green bond principles. To make the issuance of bonds feasible, it may be necessary for NRB to waive the restriction for payment before disbursement in case of issuance of green bonds.

2. Third Party Involvement and Payment:

Similarly, the NRB Bylaws restricts the Nepali BFIs from making payments to a third party. If payments need to be made to third parties, such payments need to be made by the foreign BFIs and may recover such costs from the Nepali BFIs as/in the form of cost of financing while complying with interest and fees thresholds. This is a hindrance during payment of third-party fees to international consultants, experts and agencies which facilitates the deployment of Green Finance. There is various third-party cost involved in issuance of green bonds or verification of carbon project including certification fees, legal and consulting fees, and expenditures associated with carrying out in-depth sustainability and environmental impact analysis.  Due to the higher cost involved for third party involvement, the lenders may not agree to bear the cost involved in payment to third party. Thus, the NRB should create an exception against restriction to thirty party payment for local borrower during issuance of green bonds, financing of carbon reduction projects and other green initiatives.

2. Issues in Issuance of Innovative Financial Instrument

Mezzanine instruments increase viability of certain investments for the investor. A straight loan transaction may not be viable in certain transactions due to reasons that may include uncertainty of revenue and market, insufficient assets to create security, high construction risks, late start of revenue period and other bankability risks.

DFIs including World Bank, Asian Development Bank have used mezzanine finance to fund the green initiative projects. For instance, the Asian Development Bank under the Asia Climate Partners (ACP) Fund has used mezzanine facilities like subordinated debt, preferred stock or debt with warrants to climate mitigation projects receiving equity investments from ACP that have exhausted traditional fund-raising avenues.

The current legal framework lacks any provisions allowing for lending or financing through hybrid structure. To enable such mechanisms, there is a need for the Nepal Rastra Bank (NRB) to amend its bylaws to explicitly permit this type of financing. The NRB should take steps to implement the changes especially after the commitment made by the Budget Speech 2024/25 which has stated to advance financial sector reforms by utilizing innovative instruments such as green finance.

3. Security over the Green Finance

The carbon credit projects require extensive initial investment for development, verification and operational activities. The developers might also face the difficulty of raising debt from lenders for project development due to concerns of liquidity to make regular interest repayments. Globally, ‘carbon credits’ have started to be recognized as intangible property including in EU, UK, Colombia. Given the tradeable nature of voluntary carbon credits, market participants including banks have started to use such credits as a form of collateral for loans or other forms of financing. It is essential for project developers to use ‘carbon credits’ as a form of collateral against the repayment obligations or even primary repayment tool against their debt obligations. In the context, the NRB should facilitate the private sectors to obtain debt financing in exchange of carbon credit certificates. 

4. Foreign Currency Risk-Hedging Facilities

Nepal has enacted Hedging Regulation 2079 (2022) (Hedging Regulation) which facilitates aims to establish hedging fund to mitigate foreign currency risk. This regulation is based on the structure that (i) NRB to establish a hedging fund, (ii) hedging facilities can be granted to eligible projects and (iii) also provides mechanism to share hedging cost for certain eligible projects NRB has not yet established this fund.

The eligible projects include bigger infrastructure projects like National Pride Projects and National Priority Projects. These are narrow in scope and likely to miss other green projects.

5. Guarantees to access International Funds

Credit guarantees and risk participation products can have a positive catalyst. According to ADB program on IF-CAP, it observed that USD 4.5 dollar of climate finance could be generated for every USD 1 dollar of guarantee. This illustration shows the importance of guarantees to ensure access to green financing.

NRB By-Rules provide mechanism where local commercial banks can enter into credit guarantee or risk participation arrangement with financial institutions. This provision, however, does not permit specialized infrastructure development banks like NIFRA and should be included. 

The current rule imposes a cap on the fees that can be charged on these products- lower of 1.5% or published fees of the bank which it charges to its customers. The commercial realty of the green projects may demand higher fees to be charged. NRB may carve out this pricing cap for green projects.

(Anup Raj Upreti is Managing Partner of Pioneer Law Associate who specializes in corporate law practice and has an extensive experience more than 20 years, Smriti Sharma is head of Public Sector Engagement & New Initiative at Nepal infrastructure bank and has 17 years of experience in bank and financial institutions, Srijan Pant is a legal associate at Pioneer Law Associate who specializes in energy sector and carbon markets and Aarya Aryal is a legal associate at Pioneer Law Associate who specializes in energy sector and carbon markets.)