According to UN’s latest estimate, fight with global warming will require at least $2.4 trillion investment yearly. It is scary, isn’t it? On individual level, you might try doing everything right for sake of fighting climate change. Be it using less energy, walking instead taking Uber, cursing on all the oil and gas companies(aka the bad guys in the room). Yet, summing it all up, it is not even a rounding number to the amount of investment needed to put up the real fight against climate change. Real fight will require immense coordination of governments, industrial players and most importantly the investors to work together to save the polar bears we all love.
In this context, it is no surprise that banking industry also has been going through massive change in the last decade due to better understanding of risks associated with climate change. This new part of finance is best named as Sustainable Finance by private players. One can trace the roots of sustainable finance to first issuance of green bonds almost a decade ago. The first green bond was issued by World Bank in 2008 to support development of projects in support of climate change adaptation projects (nowadays they are part of Sustainable Development Goals projects). European Investment Bank followed the recourse of World Bank by issuing its own green bonds to invest in environmentally friendly projects in Europe. Among private players, Morgan Stanley, HSBC and Bank of America were among the first to issue green bonds mostly to help impact projects, backed by municipalities and governments. In the beginning, this newly emerged financing tool was just considered charismatic, but lacked investor conviction as part of core investment portfolios. But over time, perceptions have evolved to appreciate that investments can deliver both environmental and financial returns. In context of sustainable finance, multiple financing products have evolved and still evolving, such as green bonds, negative screening practices of asset management sector, impact investing and some primitive advancements in risk management practices. Negative screening among all of the above is particularly important to draw interest, since it has been powerful to shape some of the ongoing activities of investors as well as the investee companies in climate change related issues.
Supporters of sustainable finance argue that climate friendly companies will perform better over long run due to their down side risk protection from climate change related events and increasing demand for their products or services thanks to higher sensitivity of general public for sustainable practices. Currently, majority of sustainable investing is done based on exclusion of investment targets from the initial portfolio investment decisions as called negative screening alongside with some incremental developments in impact investing area, which requires solid market returns on top of the environmental/social benefits.
Admittedly, all the practices mentioned in the sustainable finance area are the steps in the right direction. There is abundance of examples from last couple of years, in which companies were able to showcase significant improvements in their environmental footprint or adaptation to climate change thanks to pressure from negative screening activities or lower cost of debt of their green bonds. However, it is absolutely not enough and far from the target to deal with the extent of the problem at hand. On the contrary of the public belief, climate change will be dealt mostly via capital projects, including infrastructure, energy and public service projects, either in form of retrofitting or new investment. This simply means that almost all parts of project financing will require different lenses in very near future to deal with changing landscape of the deals. Unfortunately, there is no evidence that financial models are ready or getting readied for this shift to capture real risks and value created within project financing.
Summarizing project financing briefly, it is the long-term financing of large CAPEX projects secured off the assets of the project rather than off the balance sheets of its sponsors. Main industries require project financing include, pretty much all the industries, which will be significantly affected by climate change, such as transportation, infrastructure, energy especially in renewables, industrials especially in chemicals, waste and recycling, water and sewage. According to Dealogic database, only in 2016, $2.6 trillion worth of projects have seeked for projects financing around the world. The two main important selection criteria of project financing are really forecast of stable of cash flows and risk profile of the project/industry. In current terms, sponsors have sophisticated understanding of both for any industry in question.
Do sponsors have the same sophisticated understanding of the future while dynamics of supply chain management, availability of resources, type of projects and regional demographics evolve massively due to ever increasing temperature, increasing sea levels, changing weather patterns and etc.?
The simple answer is no. Because putting a price tag on all of the additional costs associated with climate change is still hard to segregate at project level. Furthermore, there is problem of agency costs associated with fighting with global climate change at global, regional and national level, yet alone company or project level. However, no brainer that it is massively important for sponsors to figure out all the dilemma to secure their long-term returns from capital projects financing.
References:
https://www.morganstanley.com/ideas/sustainability-morgan-stanley-audrey-choi
https://www.lw.com/admin/Upload/Documents/IFLR-PF2017-Full-Guide.pdf
https://mitsloan.mit.edu/sustainability/profile/renewable-energy-finance
That is a really interesting write up, especially starting to think about scaling sustainable businesses by finding ways to lubricate the funding.
One of the key questions raised was that sustainability focused project may not provide for outstanding returns. However, in the coming world where the ability to capture the cost of pollution is better managed (i.e. carbon tax, carbon trading etc), we should start seeing Green Bonds really yielding returns in terms of mitigating those cost.
Hence perhaps the pre requisite to developing green bonds is to accelerate the ability to capture the cost of pollution, then start seeing how do we lubricate the funding side of the conversation.
This write-up gives the general readers a basic understanding of how financial sector can make a contribution to sustainability in direct and indirect aspects. Some interesting tools are mentioned such as green bonds and negative screening, which I would love and expect to learn more about their application and limitations. I agree with the problems of additional agency cost and financial costs, and I think to recruit more companions in this league to raise awareness from sponsors and general public can be a good way to engender the positive snowball effect.
Interesting way to think of project financing. Investors these days account for many different types of risks in their models. It would help to develop an acceptable model to factor in environmental risk or the ‘homeless polar bear risk’ as you’ve sort of implied. I’m sure this can easily be done if analysts really ‘want’ to do it – given some of these models try to estimate political risk, which is quite difficult to do. It might not be far away given that financial metrics are being developed for all sorts of things – cost of a life, cost of sexual abuse etc. (the TPG Rise model).
Thank you for such a great write-up.
I recently was reading about green bonds (https://www.worldbank.org/en/news/opinion/2018/10/10/the-pros-and-cons-of-green-bonds) and came across this-
“Green bonds are actually not cheaper—you do not save by promising to use the proceeds in a certain way. Why? Because investors look at how likely you are to pay back—your “credit rating”—to tell you what interest rate they will charge you. Whether you spend on solar panels or oil drills does not change your creditworthiness, at least not in the short-term.”
Would like to hear your thoughts on this and if actually Green Bonds will be more impactfull if they include nature of project and carbon footprint into the financing decision.
Thanks for the nice write-up on this angle of sustainable financing. Regarding negative screening, it would be interesting to also look at not only asset management screening by investors but also debt screening by banks. For example, in Singapore, WWF and NUS are pioneering an initiative called SUSBA which holds SEA banks accountable for the ESG impact of their entire portfolios (http://www.wwf.sg/?uNewsID=334230). Since banks are further upstream than asset managers, perhaps their screening could potentially have more impact.