- There are ways to generate scalable investments that enhance returns while providing the funding required for the green transition.
- All parts of society will be required to contribute, at a cost of around $90 trillion over the next 15 years
- To unleash the full investment potential of institutional balance sheets, both regulatory and government involvement will need to support solutions.
If we are serious about meeting our climate pledges, an innovative approach to financing is needed. Despite increased pledges to reach net-zero carbon emissions by 2050, it’s not clear how it will be achieved.
According to the Intergovernmental Panel on Climate Change (IPCC), all parts of society will be required to contribute, at a cost of around $90 trillion over the next 15 years. Success will depend on governments providing clear direction, a consistent taxonomy, simple frameworks to access funding, and market-based mechanisms to minimise misallocation of capital.
More specifically, there are nine key areas that should be considered if the world is to raise the amount needed to bridge the net-zero funding gap.
Start by understanding the constraints
Since the bursting of the dot.com bubble some 20 years ago, the pension and insurance industries have embraced the concept of asset-liability management (ALM), managing liability outflows with investment inflows, and applying varying capital charges to risky assets. This has served these industries well, allowing them to prosper through the global financial crisis and the recent pandemic. However, by design, it also restricts the types of investments that can be made.
A major part of the ALM process is dependent upon the government bond market, which can be the single largest asset class on balance sheets. To fund the green transition, opportunities are needed that are compatible with the proven ALM methodology and can perhaps also address some deficiencies in the current approach. Emphasis needs to be placed on fixed-income assets that are of a scale that is suitable for large balance sheets. Duration must also be long enough to address the current dearth of long-duration assets that pension and insurance providers in Europe have to grapple with.
Unlock institutional balance sheets
There are ways to generate scalable investments that enhance returns while providing the funding required for the green transition. PricewaterhouseCoopers (PWC), for example, calculates that pension and insurance company assets alone represent around $85 trillion globally. The challenge will be to develop investment opportunities that meet the requirements of these large investors and their regulators.
This must leverage government programmes to increase the potency of public funding and expand existing investment vehicles to capture a greater share of institutional investors’ balance sheets. We need to understand the constraints, obligations and fiduciary duties that have been critical to their success but may also preclude the investments that are now essential.
Develop underutilised structures
The green bond movement has been a true success story since its inception around 10 years ago. With improving taxonomies and information flows and an increasingly global reach, these bonds are a primary funding channel to reposition businesses. An area of the green bond market that has been slower to gain traction yet offers substantial benefits to both borrower and lender, has been government green bonds.
Currently representing only about 0.3% of tradable government debt, they offer the lowest cost of funding and are scalable. Importantly, they fit easily into institutional portfolios with the same underlying credit risk and cash flows as existing government debt - with the advantage of being more transparent.
Symbiotic funding paths
At a time when most governments are highly indebted, green bonds appear to offer many advantages for the issuer. Not only do they signal intent on the part of government to reposition a country and may justify a higher debt load, but the bonds also create greater transparency and accountability and can improve government credibility on fiscal initiatives. This also allows explicit long-duration green projects to be financed with long duration issues, at the lowest funding costs.
This still tiny market offers huge potential.
France was an early adopter of government green bonds back in 2017 and several countries in both developed and emerging economies have also started similar programmes, with the United Kingdom scheduled for its first green gilt issue in September. It is notable, however, that the largest bond market in the world, the United States (US) Treasury market, has not yet embraced this move.
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Improve portfolio duration while reducing the carbon footprint
The rising tide for government green bonds coincides not only with a need for institutional investors to reduce the carbon footprint of their portfolios, but also their need for longer duration, liquid assets. The opportunity to supplement conventional government bond portfolios with new green issues is the only way of reducing the carbon exposures of portfolios.
Government bond holdings cannot simply be reduced due to the critical liability matching role they perform. Consequently, many of the latest green bond issues by governments have commanded a ‘greenium’, -- a green bond premium over equivalent vanilla bonds -- as investor demand outstrips supply. Surely, this is in itself an indication of the underutilisation of this vehicle.
Support overseas decarbonisation and honour COP21
While the government green bond market offers considerable opportunity for expansion, it is perhaps the use of proceeds from such bonds that could have an even bigger impact in the goal of funding the green transition. Governments in developed economies appear to have missed their COP21 Paris commitment to provide USD 100bn funding for developing economies by 2020. Perhaps international development aid should also be considered as part of pre-defined use of proceeds for green sovereign issues. The credit risk would be simply that of the developed market issuing nation and it would offer a cheap way of supporting critical transitions in developing regions.
Focus on leveraging public funding
The proceeds of government green bonds could be used to underwrite new investment vehicles, provide first loss protection, and yield enhancement or a rating upgrade. The multiplier effect that this could create would be significant. A partial-loss guarantee mechanism could raise the debt rating of companies in key sectors to investment grade and open up a wave of new funding at a lower cost. This could help particularly valuable sectors that are needed in the greening of economies. If we are intent on unleashing the full investment potential of institutional balance sheets, then both regulatory and government involvement will need to support solutions.
Seek new opportunities for existing products
While the US has not yet embraced government green bonds, the US municipal bond market, representing around 8% of US tradable bonds offers a good example of how funds can be efficiently raised for needy projects. The European municipal bond market remains small and under-developed, representing only 4% of European tradable bonds. Adding a green arm could help develop this market and make it more significant in terms of European financing.
One of the key incentives of US ‘munis’, is that two-thirds of the market is tax-exempt, which is attractive to investors, but also allows local governments to borrow more cheaply than other debt issuers of a similar level of risk and maturity. Consequently, the market is proven, with high credit ratings and durations aligned with project lifespans and should be seen as a good blueprint for long-duration green financing.
Keep structures simple and robust
Structured products that have proven their worth should also be considered to tap the institutional demand for yield within a fixed income framework. Collateralised Loan Obligations (CLOs) are well established and could be adapted to fund portfolios of new technology loans, for example, with the banks and asset managers well versed in product design and risk control.
US institutions have shown strong demand for CLOs, which offers an opportunity to fund technological breakthroughs. While new ideas and structures should be encouraged, the nature of the net-zero goal and scale of the undertaking will require the highest degree of integrity, clarity, accountability, and transparency in operation. Any breach of confidence could prove fatal in funding the green transition.
Making the difference
The investment needed to move to a net-zero world by 2050 is enormous. By applying established financial structures more constructively and on a global scale, the investment community can make the difference in bridging the funding gap to carbon neutrality. To do so, swift collaboration between governments, regulators and the financial community will be required to unlock the trillions of dollars of firepower sitting on balance sheets.