“Green finance” is not naturally low-cost finance; with their fiduciary duty, investors expect appropriate returns. Focus should be on enhancing sources of finance and structuring
What is now undisputed is that the amounts of monies required for green transition runs into trillions of dollars over the next few decades – and this is just for India.
Green transition is expensive – and expansive
The definition of transition itself is getting more expansive as it encompasses not just the efforts of mitigation (the greening of various conventional industries from power to transport to hard-to-abate sectors), but also the development of adaptation measures (for example, what do people do when struck with longer and frequent heat waves) and resilience (how does one rebuild after devastating floods). “Just transition” requires both monetary and social commitment for members of society who may not be very well equipped to handle the transition.
Opportunities spawned by mitigation efforts are more suitable from a private investment perspective. In the case of mitigation (or lowering of carbon emitted in the process of delivering a product or service), a natural market is being created by regulatory pronouncements and direction-setting. Governments have committed to timelines for converting their economies to Net Zero and this is prompting the private sector to come forward and invest in the transition. The dynamic behind the big push here is clear: old industries will give way to new and hence it makes economic sense to back the new ones (even if there is some technology risk in the process).
When it comes to adaptation, resilience, or just transition, the onus falls largely on the public purse. It is typically left to the governments to find monies to invest in these aspects of transition. The idea of a loss and damage fund that was mentioned in the recent COP27 highlights that the world is beginning to bring such issues into consideration from a multilateral perspective and not just leave it to individual states. Even in the case of mitigation above, to make industries and transition viable economically, governments across the world are being required to give incentives at production or consumption levels. All this means that the requirement of funds for governments, as they work their way through the transition, is very large.
The questions hence are whether: (a) monies are available at low(er) cost – the price of capital, P, or (b) more quantum, sources, or types of funds are available – the quantity of capital, Q. Ideally, a good combination of low P and high Q is required.
P = price of funds
For the Indian government, the recent issue of the sovereign green bonds (SGBs) offers good insights into whether low-cost capital is available when the end-use is clearly specified as green. Before the issuance of these bonds (two tranches each of INR 40 billion for two maturities of 5-year and 10-year each – for a total of INR 160 billion), rules were relaxed for various large institutional investors like banks, insurance companies, and global funds to participate actively.
SGB issues were subscribed at yield which were 4-6 basis points (one basis point is a hundredth of a percentage point) below the prevailing yields for the corresponding 5- and 10-year government securities (g-secs). With overall yields for government paper being upwards of 7%, this reduction in cost was anyways not material. Over the last month or so of the SGBs being listed, this premium has diminished to zero: the bonds now trade at yields similar to other g-secs. The trade in the SGBs is comparatively limited which means that many holders may have acquired bonds to hold till maturity.
This is not a surprising outcome. Other governments, for example, the UK, that have issued green sovereign bonds have found that the yield difference, if it persists, is a miniscule basis point or two. Investors who are willing to nudge the government to invest in the green transition also need to ensure that they meet their fiduciary duty to their ultimate providers of capital who still want appropriate risk-adjusted return, irrespective of the end-use. We note that the OECD report (which details the funding offered by the developed world to the developing world under the Cancun declaration of USD 100 billion a year) routinely points out that the largest chunk of capital available for green transition (upwards of 80%) is commercial capital like debt or equity; only a small portion is grants.
Q = quantity of funds
The other lever of increasing green finance availability is to simply have more of it, even if it does not cost materially lower. This requires work on two fronts: (a) new providers of capital, and (b) new types of instruments.
New providers of capital include green climate funds created out of multi-governmental efforts (like the Green Climate Fund, or the recently proposed Global Climate Alliance), local government-backed impact funds (like those announced in the Budget last year), export promotion funds (from countries that have equipment or technology that can aid in green transition), or philanthropic funds. In an OpEd in this paper (Attracting Large Pools of Capital for a Green Transition, Jun 17, 2021), we had noted of that fossil fuel countries and companies can be a large pool of capital for the transition – since then, the high prices of oil has meant that such entities have more funds to commit. Such new sources of funds can invest with governments and private sector in green transition.
The funds themselves need better structuring. As noted above, plain products end up trading close to their non-green counterparts. Some aspects of structuring to consider are: (a) risk sharing facilities which reduces the overall risks in a portfolio of projects, (b) partial credit guarantees, (c) first loss default guarantees or first-loss absorption capital, and (d) long term currency hedging instruments. These products can also help more projects of green transition viable.
In the matter of P and Q of green finance, the lever to focus on is Q.
The author is with National Investment and Infrastructure Fund Limited. Views are personal.