Financing net zero cities – The case for smart legal solutions

Urban centres need new funding models to be in the vanguard of the battle against climate change

Cities are major contributors to climate change, consuming over 65% of global energy and producing more than 70% of greenhouse gas emissions worldwide. In addition, density, growing populations and a lack of green spaces make cities especially vulnerable to climate change. Hence, it is no surprise that urban hubs are a focal point for policymakers attempting to address climate change and improve living conditions.

The EU has just launched a new mission to deliver 100 climate-neutral and smart cities by 2030 (Cities Mission). These cities will act as innovation hubs for the EU-wide commitment to climate neutrality by 2050. The Cities Mission's climate neutrality plans cover areas such as energy, buildings, waste management and transport. The Cities Mission will also provide technical and regulatory assistance as well as funding for research and innovations of around €360 million.

How to involve private finance

There is currently a funding gap in implementing the required innovations at the scale demanded to achieve climate neutrality. Some of this can be provided by the cities as public funding, but large sums will also have to come from private investors. While many investors have committed to support climate neutrality, the amount of investment is still far behind levels required to make net zero cities a reality. This applies in particular to cities which have significant investment potential but are also home to a complex landscape of remuneration models, stakeholder interests, businesses and communities, and revolving administrations with varying agendas. Financing climate-neutral cities is not just about providing money - municipal authorities will also need technical expertise and support in creating citizen demand and making projects financially viable.

Equally, investors must be incentivised and the types of incentives depend on the financial solutions available. Private investors also depend on generating returns, meaning solutions will need to unlock income sources, leading to difficulties where the investment is largely in what are traditionally considered public goods. Large investors have fiduciary duties, limited risk appetite, and depend on stability, meaning cities and governments will need to find ways to reduce investment risks and ensure a favourable environment with a long-term perspective. For example, large infrastructure projects typically require long-term backing and investors need reassurance that municipal administrations will consistently support such projects for at least the next decade.

Smart legal solutions to help finance cities

This leads to a multitude of legal questions, such as:

• How can energy savings and other benefits to citizens be shared with private investors to generate income?
• How can public and private finance be blended to achieve the right risk and return profile?
• How can small-scale projects be bundled to be attractive for investors interested in larger tickets?
• How can cities and investors ensure, in addition to generating financial returns, investments do not lose sight of the ultimate climate goals?

The adviser community has started to discuss these questions, drawing on innovative legal solutions relating to benefit sharing as well as long-standing experience with blended finance in the development capital context. Well-known structures, like funds and other pooling vehicles, can help create scale and join investors. When it comes to focus and incentivisation, the impact investing industry can contribute its experience in defining, measuring, and following up on non-financial targets. All of this will need to be packaged flexibly into smart legal solutions and sophisticated capital structures that help private investors back the development of climate-neutral urban hubs.

Co-operation is key

However, it is important to keep in mind legal aspects are only one consideration among many when it comes to financing climate-neutral cities. Legal solutions can only be smart if they consider all of these dimensions, meaning the adviser community must co-operate closely with cities, the general public sector, innovators, and investors to understand their needs and challenges. As part of our commitment to drive change, Herbert Smith Freehills will contribute to these discussions across all sectors and practice groups, involving experts in our corporate, finance, funds, infrastructure, real estate, energy, regulation and tax teams. The journey has barely begun but we'll get there faster together.