IFR Optimising Sustainable Finance Report
Optimising Sustainable Finance: China’s journey and its impact
Urgent moves to meet the United Nations Framework Convention on Climate Change and UN Environment Programme outputs, via COP and other bodies, have not just pushed global politics and sustainable finance firmly together. They have placed financial sector stakeholders firmly at the centre of efforts to save the planet from irreparable environmental damage stemming from global warming.
The wheels of finance, the role of financial intermediation and the responsibilities of banks, investors and capital market issuers have never had such a crucial set of responsibilities. The sheer amount of money required to finance renewable energy, sunset fossil-fuel usage and get us to where we need to be – estimated at up to US$90trn – is daunting and requires sound and globally coordinated policy actions.
The policy intent is certainly there in principle but meeting climate-change mitigation targets requires concerted action otherwise the rubber (of a zero-emissions vehicle, of course) will never hit the road and words will be no more than that.
This is no easy task. Meeting the urgent needs of sustainable policy goals can’t come at the expense of poverty alleviation efforts in the developing world or economic inclusion efforts in the developed world.
Globalisation is under the political spotlight today like never before and its benefits hang in the balance, as the results of various election and referendum results attest, from the UK’s Brexit vote, to the Italian constitutional reform referendum to the US election that saw Donald Trump elected to the presidency – the latter with a sceptical approach to climate-change politics; and to populist political movements the world over contesting the status quo.
Much of the money to meet the requirements of the 2oC temperature rise cap is likely to be there but stakeholders need to work diligently and urgently to create a world of perfect and standardised information in order to eliminate knowledge asymmetry and create a global flow of investible projects, an adequate set of financial products and other incentives under an umbrella of a robust policy framework.
Green finance was at the centre of what observers said was China’s incredibly successful G20 presidency and there are high hopes that Germany will maintain the emphasis on sustainability in its year of presidency, which began on December 1 2016.
The financial sector has an amazing opportunity to work with transnational bodies and supranational agencies; national, state, regional and local governments; multinationals and the corporate sector; as well as NGOs and civil society organisations to operationalise policy pronouncements. It’s here that banks’ innovation and creativity will need to come to the fore.
The development of the Green bond market has been noteworthy but this is just a start.
As things stand, and despite its impressive year-on-year growth, the green market is not in and of itself going to move the needle. China moved firmly to the forefront of this market in 2016 with a set of top-down rules that has pushed Chinese issuers to the forefront of developments. Others need to follow suit.
We need to get to a situation where the financial ecosystem operates on a basis of full sustainability. Investors, even those who firmly back the sustainable agenda, have pushed back on green financial products that offer them lower returns than conventional products.
Getting the mix right will take a different way of thinking. Despite the challenges, a start has been made but the pressure to move forward will remain.
Optimising sustainable finance
Political, corporate and financial commitment to a sustainable future gained momentum in 2016 in almost all parts of the world. Even where threats to the green transition have lately emerged, the expectations are that the bedrock upon which the movement is built will be solid enough to survive short-term and intermediate stumbling blocks.
The key financial issue is simple: there is no lack of money in the world to address the issues of global warming and sustainability. It is more a question of a lack of unified policy direction, a lack of investible projects, asymmetric knowledge, inadequate measuring, and a lack of instruments tailored to meet the needs of both investors and sponsors. There are still plenty of issues to overcome before we reach a green financial market with the level of scale required to tackle the pressing problems associated with climate change, but a start has been made.
Creating the environment that channels the huge pool of assets under management into efforts that create a green and sustainable future is the task at hand. Governments have it in their power to regulate and provide the policy framework and offer incentives that encourage businesses and investors to incorporate sustainability into their decision making. The recommendations report of the FSB’s Task Force on Climate-Related Financial Disclosures is an important step towards a more unified and transparent framework which will help markets measure and manage climate related risks and opportunities (see boxed item). “This is a much welcomed development, which will help address the challenges of climate change. Indeed, a recent survey which HSBC conducted reveals that a substantial 85% of the polled institutional investors believe that current levels of business disclosure are inadequate,” said Christian Deseglise, co-global sponsor of sustainable finance at HSBC.
While governments potentially need to encourage banks and other market-related entities to provide the knowledge-sharing and financial instruments that facilitate the flow of capital, the broader narrative needs to change in regard to climate. In particular, the issue needs to be seen as one presenting everyone with an opportunity rather than a burden.
China, in its presidency of the G20 group of nations during 2016, made tackling the green agenda a priority. “China’s presidency of the G20 was incredibly successful,” said Fiona Reynolds managing director of Principles for Responsible Investment (PRI), the investor initiative in partnership with the United Nations. “It was the first time green finance was put centre of the debate.”
The problems associated with global warming and the use of fossil fuels are already upon us: pollution, bouts of severe weather, melting ice caps, expanding deserts and rising sea levels are all issues that affect people, property, industry and countries. It is an issue that affects everybody and all parts of the globe. Without action to address rising temperatures and pollution, not only is the fate of the environment at stake, but it also puts at risk many of the economic achievements of recent years and jeopardises the prosperity of future generations.
It is clear that the transition to a sustainable future cannot come at the expense of wealth generation. The UN’s 2030 Agenda for Sustainable Development sets out “a plan of action for people, planet and prosperity”. It acknowledges that eradicating poverty is an indispensable requirement for sustainable development.
On January 1 2016, 17 sustainable development goals, agreed at a UN summit in September 2015, officially came into force. Political support in tackling the effects of global climate change was further reinforced later in the year when the COP21 Paris Agreement, adopted by over 190 countries, came into being on November 4.
The agreement reflects the attempt to bring down greenhouse gas emissions to levels that can be safely absorbed by natural systems. It also commits world leaders in keeping global warming below a 2°C rise above pre-industrial levels by aiming for the more-restrictive target of a 1.5°C cap on the increase in temperature.
Although the carbon emission curbs put forward by countries under COP21 are not legally binding, the framework of the accord – which includes a mechanism for cranking up those pledges – is compulsory. And, although the Paris Agreement is a great advancement in the attempt to limit global warming, there are already concerns that the commitment does not go far enough to meet the targets in time.
The International Energy Agency (IEA) in its World Energy Outlook, released in November, warns that implementing current international pledges is not sufficient to reach the 2°C average global temperature rise. It estimates that the present commitment “will only slow down the projected rise in energy-related carbon emissions from an average of 650m tonnes per year since 2000 to around 150m tonnes per year in 2040”. That performance will result in an increase in average temperatures of 2.7°C by 2100.
It notes that, although countries will meet and even exceed many of their targets as agreed in Paris, the associated slowing in global energy-related CO2 emissions is not enough to conform to the temperature rise target. Reaching the combined targets of combatting the rise in global temperatures and addressing pollution while, at the same time, eradicating poverty will not come cheap.
To reach the proposed targets, infrastructure investment requirements between 2015 and 2030 could reach levels as high as the US$90trn estimated by New Climate Economy, or some US$6trn a year. In addition, building sustainability into infrastructure requirements could increase the upfront capital costs by up to 6%.
The IEA calculates that a cumulative US$44trn in investment is needed in global energy supply in its main scenario that looks at what is required to achieve the growth of energy demand to 2040 and the required transformative change in the energy sector needed to reach the objectives of the Paris Agreement. It also calls for an extra US$23trn for improvements in energy efficiency.
Accommodating those kinds of sums is an economic and political conundrum on a global scale. It needs the commitment of regions, central, regional and local government and their combined collaboration to change the mindset of a largely carbon-based global economy. It needs the right type of policy decisions to energise the huge investment pools in the developed economies into supporting sustainable transformation at home and in the developing world.
The seeds of a shift to sustainability have already been sown, but as the implications of climate change have become more evident, the momentum behind the change in mindset is increasing. The pace at which this change takes place is likely to increase in subsequent years. There is seemingly no choice.
In years to come, it might be that 2016 will be seen as the tipping point at which the world took a notable major step towards addressing the impact of global warming and created the environment in which to finance the solutions. It could also be seen, in the light of the US election, as one where it took a step back.
China in the spotlight
China has emerged as a key player in promoting the issue of climate-change impacts and developing a sustainable financial model to support the efforts to mitigate the effects of rising temperatures. “China has made a tremendous effort to benchmark its green agenda against international market practice” said Nicholas Pfaff, senior director, Market Practice and Regulatory Policy at the International Capital Market Association (ICMA).
As one of the two biggest economies in the world – and one of the two biggest polluters – it had already joined forces with the United States in declaring its intentions to lead by example on the subject of climate change. President Xi Jinping and President Barack Obama both signed the COP21 Paris Agreement and further expressed their commitment to work together and with others to promote the full implementation of the agreement to win the fight against the climate threat.
China has been busy in keeping up to its commitment at both home and abroad and, as president of the G20 in 2016, by putting the green agenda and green finance firmly centre stage. “China has seized the opportunity to take the lead in the global discussion on climate change,” said S&P‘s Michael Wilkins. “It has probably achieved more on this agenda in its time as president than any other country.”
Under its tenure as head of the G20, China has presided over and was a prime mover in ensuring the Paris Agreement was ratified in unusually quick time for a multilateral treaty. And it has instigated reforms in its home markets and enthusiastically pushed forward with global collaboration in addressing the needs of sustainability.
Earlier in the year, it established the Green Finance Study Group (GFSG) which during its first meeting in Beijing assumed the task of identifying institutional and market barriers to green finance and to analyse options on how to enhance the ability of the financial system to mobilise private green investment.
The group, co-chaired by China and the United Kingdom, produced a “Synthesis Report” in July 2016 that looked at three sectoral issues: banking, the bond market, and institutional investors. It also focused on the topics of risk analysis and progress measuring.
It came up with a number of options for its members to consider for adoption: the provision of clearer policy signals for investors regarding green investment; the promotion of voluntary principles for green finance; the expansion of learning networks; supporting the development of local green bond markets; the promotion of international collaboration to facilitate cross-border investment in green bonds; encouragement of knowledge sharing on environmental and financial risk; and improving the measurement of green finance activities and their impacts.
It also listed the challenges to be faced by the transition to a green finance world, such as information asymmetry, inadequate analytical capacity and a lack of clarity around green definitions. On top of this are the more finance-related issues surrounding the maturity mismatch between demand and supply of investment in long-term infrastructure projects.
There are a lot of barriers to be broken down before the market can progress above the current less than 1% of global bonds being labelled green and less than 1% of holdings by global institutional investors being directed towards green infrastructure assets.
China is busy tackling the issue with a top-down approach to restructuring its financial system. At the end of 2015, People’s Bank of China (PBoC) published the official Chinese Green bond guidelines, which was the first stage in developing a defined Green bond market in China, despite many of the bonds outstanding in its domestic market already related to environmentally beneficial industries.
The PBoC’s guidelines cover the vast majority of the domestic bond market, and provide guidelines on definitions, management of proceeds, reporting and disclosure, as well as second-party review and third-party certification. Additional regulators chipped in later in the year with guidelines covering corporate bonds. It is the foundation for a market that is tipped to reach around US$50bn a year in broader Panda bonds, including Green bonds, from China by 2020.
Further commitment from China also came before the G20 meeting it hosted in Hangzhou in September 2016 when, independently of the meeting, it released a set of Guidelines for Establishing the Green Financial System with the stated aim of promoting “the sustainable development of the economy, establish a sound green financial system, improve the function of the capital market in allocating resources and servicing the real economy, and support and promote the development of an ecological civilisation”.
They represent the world’s first attempt at designing a policy package that promotes the transition to a greener economy. According to these guidelines, which were jointly released by PBoC and six other government agencies, China will need to develop a wide range of new financial instruments in order to mobilise and incentivise private capital to invest in green sectors.
The incentives include re-lending operations by the PBoC, interest subsidies for green-loan supported projects and the launch of a national green development fund, along the lines of UK’s Green Investment Bank.
Other areas of focus include the development of green credit, green bond and equity index products, green insurance, and carbon trading products. The guidelines also emphasise the role of local government in supporting the development of green finance, and encourage local authorities to establish specialised green guarantee mechanisms and green development funds, in order to crowd-in more social capital for green investment.
With an international outlook, they require a “further expansion in international cooperation on green finance, continued promotion of global consensus on green finance under the G20 framework, a progressive opening of the green securities market, and an enhancement of the level of greenness of China’s outward investment”.
“Some of the green finance work China is doing is amazing,” said Sean Kidney, CEO at Climate Bonds Initiative. “The efforts they are making in the domestic market are really beginning to filter through and they are now exporting their story.”
China’s efforts on the green finance front should also be seen against the wider context of an overall liberalisation of its financial markets. As highlighted by the release of guidelines on bonds and the financial system in general, barely a week goes by without some changes in the financial regulatory environment in China. “China is using the green agenda as a catalyst for reform,” said RongRong Huo, head of China and renminbi business at HSBC. “Accelerating the pace of overall reform by integrating the green issue into the financial system is the right approach.”
In recent years, the Panda bond market (renminbi-denominated bonds launched into the domestic market by offshore entities) has been encouraged to grow to levels that now compare to those of the Dim Sum bond market (offshore renminbi-denominated debt). In February 2016, the PBoC liberalised the interbank bond market, creating a new route for international investors to take exposure to the renminbi through onshore bonds.
Throughout the past year, regulators have continued to relax the tight reins it previously held on foreign investors in terms of the size of investments allowable, the assets in which they can invest, the level of approvals required for any activity and their ability to move cash into and out of China.
According to the State Administration of Foreign Exchange (SAFE), the changes are intended to “… facilitate the opening-up of the interbank bond market and standardise foreign exchange administration for overseas institutional investors participating in the interbank bond market”.
It means more types of foreign investor are eligible to invest in China and with greater flexibility than has ever been experienced before. The inclusion, in October 2016, of the renminbi into the IMF’s Special Drawing Rights (SDR) basket will only increase demand for renminbi assets as the currency is included in central bank reserves. The PBoC is opening up the door to international capital and investors – most of whom will be underweight China – want diversification.
There is still a lot of work to do in order to see that capital starts to flow into China, however. Not only in terms of regulation but also in regard to the approvals process, the legal and tax environment and providing a genuine method of risk assessment through the development of trustworthy credit ratings.
How the whole process unfolds in China will yield important lessons for others seeking to build more sustainable economies. It is sure to make mistakes on the way and it does have real-world challenges to overcome during the transition. But the experience will be beneficial to its own strategy and that of global regulators. And crucially, China remains open to learning from the experience of governments elsewhere that are already addressing the issues in their home markets with policies tailored for their own requirements.
Internationally, China continues to lead the drive on the global stage, even as Germany steps into the hot seat as head of the G20 for 2017. During the November COP22 meeting in Marrakech, Chinese representatives remained vocal as to their commitment to the task ahead – irrespective of the path taken by the US once Donald Trump becomes president. “China’s efforts in raising the issue of sustainability onto the global agenda is a sign that it realises it has a major role to play in the global economy,” said Huo.
Senior representatives from China acknowledged that to reach China’s ambitions to start reducing emissions from 2030 it will need to attract private capital and that climate and green investment has a role in transforming China’s economic structure. They also acknowledged that climate investment is a new asset class and that there is a need for cooperation across borders in order to learn from each other in developing the most efficient financial framework that support the aims of the Paris Agreement.
There was also acceptance that in the process of transitioning to a low-carbon economy, there is a huge gap in demand and supply in climate finance and that this can be closed through effective policies and tools. China is building a green financing system and it has grand plans for rapid development of that system. It is in a hurry and understandably so given the levels of pollution in its major cities.
To promote low-carbon investment, China needs top-down policies and practices at a governmental and local level, officials have said. City and local government pilots can assist in ensuring strong support for the climate goals and better use of financial tools can be directed at a local level to encourage companies to pursue low-carbon development. China has ambitions to enhance international cooperation on climate finance and is keen to learn from the successful experiences of others.
Likewise the lessons learned by China will also set examples for other nations to follow. There are issues internationally with regard to the incorporation of clean coal into its green taxonomy, for instance. But it will play a major role in tilting the playing field towards financing a sustainable future.
“China will continue to play a leading role in promoting and mitigating the issues of climate finance,” said Martina MacPherson, head of Sustainability Indices at S&P Dow Jones Indices. “It wants to show that it is a key player in terms of green finance and infrastructure and that it is open to foreign investment.”
Climate change will remain high on the list of the G20 agenda with Germany at the helm, but commentators say that the world is looking to China to energise the transition process - particularly as US commitment is in jeopardy.
A year on from Paris
The success of the historic COP21 meeting in Paris in December 2015 and the consequent signing of the agreement in record time were widely seen as signals from governments to business and to the financial markets that a low-carbon future is firmly on the agenda.
As well as this very public political sea-change in approach to global warming, the signatories also committed to the ongoing mobilisation of US$100bn per year from developed to developing countries in climate-change support by 2020 and to increase that level of support after five years. The flow of finance also needs to be consistent with the overall aims of reducing greenhouse gas emissions and developing climate-resilient infrastructure.
There seems to be a firm commitment to put the years of debate and rhetoric into action and there have been a number of developments over 2016 that suggest there is progress.
In December 2015, the Financial Stability Board (FSB) announced the establishment of an industry-led task force on climate-related financial risks. It was charged with developing voluntary, climate-related financial risk disclosures for use by companies in providing information to lenders, insurers, investors and all other stakeholders.
Access to high-quality information is the best way for investors and market participants to better understand and better manage the risks associated with climate change.
The task force, chaired by Michael Bloomberg, published for consultation a summary of the recommended voluntary disclosures and guidance developed by the Task Force on Climate-related Financial Disclosures on December 14. The final report will be published by June 2017. It will deliver a consensus-based view on the characteristics of effective disclosures and best practice.
Those recommendations may mark a major shift in the regulatory landscape as the call becomes more intense for all companies to disclose their green credentials as part of the traditional reporting process. “What investors most want is transparency and data,” said Fiona Reynolds of the PRI. “Without good disclosure they can’t make informed decisions. The baseline is we need to get better data and the FSB’s work on climate related disclosure is a great staring point.”
Michael Wilkins, head of environmental and climate risk research at S&P Global Ratings, added: “it is hoped the recommendations will lead to the creation of a level playing field by which decisions can be made on a consistent and comparable basis”.
Among other developments, the labelled Green bond market has continued on its growth path (new issuance up by over 50% from the previous year), increasing numbers of investors have signed up to the ideas of responsible investing with PRI welcoming its 1,600th signatory. Sponsors, constructors and cities are also increasingly incorporating sustainability into their infrastructure development plans.
There has also been movement at a sovereign level. The implementation of the French government’s requirement for a wide range of investors to report on how they integrate environmental, social and governance (ESG) factors into their investment policies and how they address climate-change considerations in their activities is perhaps one of the more noteworthy.
In what has largely been a year marked by consensual agreement on the need to transition the world to a low-carbon economy and to galvanise capital allocation accordingly, one potential major cloud has emerged to cast a shadow over the euphoria: the election in the United States of an avowed sceptic to the green cause.
We can only wait and see whether the election of Donald Trump will result in a roll-back of earlier commitments. And, even though the green agenda will be re-evaluated in the US, there are business and state-based realities that will need to be considered as a result of any changes.
The business realities were clearly illustrated at COP22 when more than 300 US companies penned a letter to the incoming president reaffirming their commitment to addressing climate change and the implementation of the Paris Climate Agreement.
“We want the US economy to be energy efficient and powered by low-carbon energy,” the letter said. “Cost-effective and innovative solutions can help us achieve these objectives. Failure to build a low-carbon economy puts American prosperity at risk. But the right action now will create jobs and boost US competitiveness …”
Nevertheless, the broad adoption of the green agenda and the enthusiasm with which it has been taken forward during 2016 has been striking. “We’re on track for a much faster change in the transformation to a sustainable economy and financial system,” said Reynolds. “It’s taken a long time to get to this position but now it’s all about scaling.”
China has been, and will remain, one of the key drivers behind the move. In fact, judging by reports from Marrakech, the world is looking to China to take that lead.
Green investing in practice
In the realms of sustainable finance, the Green bond market that has been making the news and attracting the majority of the brouhaha from politicians and regulators in the past three years. That is understandable given its visibility and its ability to grab headlines. It is also a vehicle that is easily understood and one that is readily adaptable into an efficient marketplace.
Reflecting their increased acceptance as an asset class, the market made great strides forward again during 2016, and new issuance volumes are well on the way to pushing close to the longed-for US$100bn level in international and domestic markets for the first time. China has played a major role in expanding the universe of supply: Green bonds form a specific part of its transitioning strategy.
China is responsible for almost a third of the total issuance and it would be responsible for expanding that percentage further if the international definition for green extended as far as those deals in China where proceeds are destined to help clean up coal-fired emissions. The PBoC’s Green Project Catalogue allows for clean coal, which reflects its importance from a local perspective in mitigating the immediate issues with air pollution. Internationally, any investments that extend the life of coal plants do not conform to the definition of green.
Nevertheless, there has been a wide array of issuer types joining the market, with proceeds heading to address different types of projects. There have also been some notable developments in terms of structures. Bank of China, for instance, launched a dual-recourse bond, similar to a covered bond. The cover pool, in this instance, is comprised of climate-aligned bonds that form part of the ChinaBond China Climate-Aligned Bond Index. The bonds will be used to finance renewable energy, pollution prevention, clean transportation and sustainable water management.
A landmark was reached in mid-December 2016 as Poland became the first-ever sovereign to tap the Green bond market. The sovereign printed a €750m five-year issue. Marketing started in the 60bp-area over mid-swaps; guidance was set at plus 50bp-55bp before a further revision to plus 48bp-50bp. The bonds priced at the tight end on indications of interest in excess of €1.4bn, with leads stressing how the deal attracted a new class of investors to the name. HSBC was structuring adviser and bookrunner along with JP Morgan and PKO Bank Polski.
Poland pipped France to the post to garner this accolade; France had been set to be the first of a number of sovereign issuers due to launch Green bonds expected in 2017 to source the finance needed to reach their climate-related pledges. Investor engagement also continues to build to justify the rising levels of issuance.
“Green bonds are the instrument of choice for mobilising investment into climate-related projects,” said Michael Wilkins at S&P. “They used to be the domain for niche investors but now their appeal has broadened to the mainstream.” And these investors have a part to play in pushing the development of the Green bond market even further.
“The Green bond market is largely investor-driven,” said Sean Kidney at CBI. “Perhaps this is best illustrated by the fact that Green bond issues are regularly over-subscribed. But institutional investors need to push issuers, consultants, managers and corporates even harder to get more and more opportunities into the market.”
Their presence is also illustrated by the numbers of investors joining up to the Principles for Responsible Investment, which now represents potential assets under management directed towards green finance towards the US$65trn mark. The interest in sustainable financial instruments is unquestionably growing.
“Investors need to manage their liabilities over the long term,” said Fiona Reynolds managing director of Principles for Responsible Investment (PRI), the investor initiative in partnership with the United Nations. “And that means they must take into account the risks and opportunities of their investments, including the material risks to portfolios of fossil fuels.” Likewise, there are an increasing number of peripheral developments around Green bonds that contribute to the transparency of the market.
A range of indices has developed to provide benchmarks against which performance can be measured and there are signs that funds have begun to track these benchmark indices as part of their investment decisions. The rating agencies are incorporating the need for an improved level of transparency with respect to evaluating the climate-related risk assessment from an investment.
S&P, for instance, is sounding the market with its proposed framework for evaluating the green credentials of projects financed by Green bonds. The evaluation is not a credit rating but “will enable investors to compare adaptation projects funded by Green bonds based on the increase in resilience they offer”. It plans to launch this evaluation tool early in 2017. Moody’s Investors Service launched its Green Bonds Assessment criteria in early 2016.
ICMA, which provides the secretariat for the Green Bond Principles (GBP), recently launched its online GBP Resource Centre, which contains standardised disclosure templates on Green bonds from issuers and external reviewers, as well as other relevant market resources. The resource will add significantly to market transparency allowing investors to determine the extent to which Green bond issuers are aligned with the GBP, according to ICMA. This will also support the growth of green bond investment and promote further development of the market.
“It gives investors a clear process in determining alignment,” said ICMA’s Pfaff. Launched at the end of October, the resource is already being used by nearly 40 issuers, Pfaff said. All of these developments are being replicated or are expected to be replicated with a domestic bias in China as it uses Green bonds as a key building block for its transition.
Privates on parade
The public bond market goes some way to answering the question of how to mobilise private finance towards financing the green revolution but it is no panacea. Traditionally, over 60% of infrastructure projects have been funded publicly. But with the levels of funding required when public purse strings are held tight, the private sector needs to play a role in filling the infrastructure funding gap.
At a time when yields are historically low in the bond market, investing in real assets is becoming increasingly attractive for institutional investors. Debt and equity investors are drawn to assets that match liabilities in terms of tenor and also afford returns over and above those in the public financial markets.
Private debt markets are growing in Europe, and an increasing number of fund managers are locking in lucrative returns in long-dated exposure to real assets, or at least the senior debt backed by real assets. “We aim to capture the illiquidity premium over the traditional liquid bond markets,” said Rene Kassis of La Banque Postale Asset Management. “It gives investors the opportunity to match their long-term liabilities with long-dated assets, diversify their fixed-income strategies, and also provide some shelter from the volatility of financial markets where assets are valued on a marked-to-market basis.”
Institutional investors, such as pension funds and insurance companies, are in the game for the long haul. They are buy-and-hold investors that need a comforting level of assurance from their investments, which ordinarily means that assets in the developed world are favoured. That is a problem in attracting funds where they are most needed: in developing economies. It highlights some of the obstacles that need to be overcome when matching investor requirements with the needs of borrowers around the world.
Fund managers want access to safe, long-term performing assets that satisfy the returns expected by their investors and those expectations increasingly include environmental, social and governance issues. “ESG is a growing theme within the industry and clients expect it to form part of the investment criteria,” said Kassis.
The development of a green financial system is aimed at alleviating some of those demand and supply mismatches. That is where efforts to develop green funds or mobilise the funds already embedded in multinational development banks, agencies, cities and local governments can play its part.
Debt investors prefer to support brownfield projects that are already up-and-running and already have established (and often guaranteed) cashflows in place to service future coupon payments. The building of infrastructure, however, entails upfront costs before any cash flows are realised.
Public finances can be mobilised to take on risk at different stages of a project. Development banks can use their funds to mitigate the risks involved in infrastructure investment, either through credit enhancements, insuring against political risk or acting as lead investors. They are also key to educating and advising investors and issuers.
Private capital has traditionally come from the banking sector, but the increasing regulatory costs incurred by banks for lending over the long-term is suppressing the supply of long-dated bank capital. Any gap in funding will need to be filled by institutional investors. There is capital waiting to be deployed but it needs viable structures to be put in place before it can fill the gaps in the bank loan market.
In Europe, the number of infrastructure investment funds and debt funds is increasing in order to fill the gap, and structures are evolving to encourage the flow of funds into projects. “There is space for institutional investors to stay and grow in the infrastructure debt market and their outlook is maturing quickly,” said Kassis. “Three years ago, investors were mainly comfortable with traditional fixed-income assets such as liquid bonds with make-whole provisions, listings and ratings. Now they are a lot more flexible in their approach.”
There has also been regulatory encouragement for institutional investor in Europe in the form of a reduction in the capital charge for European insurers’ investments in infrastructure projects. Public funds and regulators play their part in establishing the best platform to attract private capital.
Public and private partners
In 2013, the World Bank outlined the key features of the public private partnership (PPP) approach to climate finance, noting that:
- The principles of project finance and environmental economics can be combined to lay out a simple, solid rationale for public support of projects,
- The effective use of scarce public funds must be used to leverage private financing through an equitable sharing of responsibilities across the stakeholders,
- Growth can be supported by locking investment into new technology, appropriately valuing and monetising environmental externalities and adding the necessary levels of support to make projects bankable – albeit in a non-political way.
“A country’s policy environment should serve as the basis to help governments play a responsible role in creating a conducive investment climate and to level the playing field for low-emission projects,” it said. These features were reflected in China as part of the guidelines it issued in September 2016 where it argues for the creation of green development funds to support the mobilisation of social capital through PPP.
“The central fiscal authorities will set up a national-level green development fund … to demonstrate the government’s strategic guidance and policy signals for green investment.” It wants to engage and encourage local governments and private capital to set-up their own green funds and to ensure that these funds invest in a market-based approach, under the premise of executing national strategies and policies.
It notes that local governments could support the projects invested by green development funds through measures such as relaxing market-access restrictions, improving pricing of public services, granting franchises, implementing favourable fiscal and land policies, and improving benefit and risk-sharing mechanisms. It also advocates improving the relevant rules and regulations on green PPP projects in order to encourage all kinds of development funds to support green PPP projects.
This will be especially pertinent in its One Belt, One Road (OBOR) aspirations. Drawing on the commercial links of the ancient Silk Road between the east and the west, OBOR represents a strategy to unite continents through a network of links across borders and organisations through the development of infrastructure and trade.
The aims of the project run parallel to the aims for sustainability, and China has declared that it should meet the primary objective of being clean and green. Supporting the venture are newly established investment funds, such as the Silk Road Fund, which is financed by Chinese state enterprises with the intention of investing in the OBOR initiative. It has been joined by the Asian Infrastructure Investment Bank in its attempt to pro-actively “focus on the development of infrastructure and other productive sectors in Asia”.
There are some misgivings as to the benefit of these new funds, including the Green Climate Fund, which was created by the UN Framework Convention on Climate Change with the aim to “support a paradigm shift in the global response to climate change”. To date, the fund has disbursed a relatively small amount of finances (US$1.17bn); but critics have questions about governance, transparency and whether it is impeding the flow of investment to more established climate funds.
These funds are described as “big on ambition but small on action” or alternatively as “getting a little bit carried away” in their investment strategies. As to whether their presence will realise their aims to support or hinder the allocation of capital into sustainable projects will remain open to debate – especially as there are already a number of national and multinational development banks in existence.
Banking on reform
The majority of infrastructure projects are sponsored by the public purse and, in theory, developed for the public good. In times of pressure on central government funding, there needs to be wider participation by the private sector. The problem is that the primary motivation for any borrower or lender is always cost. Issuers will tap the lowest-costing form of capital and investors are obliged to chase the best returns. In other words, it all comes down to bankability.
The most common complaint from the investment community is that there are just not enough bankable assets in which to invest. Many players will be needed in order to channel the huge pool of assets under management into the projects needed to address climate change – and other ESG issues. Regulators need to ensure that they create an environment that facilitates that process.
The climate agenda has been raised to top billing on the political landscape and that level of noise is welcome but there remains a lot of work to do. The commitment is there and the process has started but it remains to be seen how long the exercise will take and if it can weather the storms of any potential political setbacks.
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