Risk Management for Green Investment

How finance can help impactful projects come to life

The nascent trend among companies to develop new, pioneering, energy and resourceefficient products is met with a big hurdle : risk.

The risk of embarking in the development of new technologies scares away private investors knowing they can turn to the good old non-green assets. Nonetheless, the S&P Green Bond Index stands today at a 10.26% 1YR returns .

How, then, are green assets breaking through ?

In this paper we will deep-dive into what the real and apparent risks of investing in climate-related projects are, and which are the solutions that both the private and public sector provide through the work of financial services.

Vocabulary

To enter the matter, it is worth defining a few terms we find often when dealing with Green Finance :

-Equity is a type of security that is an ownership title. Equity can exist in the shape of stocks or other types of securities. Ownership of non-publicly-listed companies is called Private Equity.

-Risk is the possibility of an asset underperforming in relation to its stated returns. Investors are risk averse, meaning they require a greater return on the capital they invest to compensate for the possibility of losing their capital.

-Risk Premium is the expected return on investment of an asset beyond the risk-free rate of return.

-SPE / Special Purpose Entities are financial bodies that invest their funds with the aim of having a positive outcome in terms of climate or socioeconomic related issues.

-Impact Investing is a form of investing that seeks substantial returns and positive effects for society and the environment.

-Green Bonds are a type of debt-based tradable securities that are specially directed towards positive impact projects. Naturally, these fall under the category of impact investment.

The problems limiting green investment

Impact investing can be of two sorts.

Firstly, the capital can be handed to any company or government that will use it to finance a project aiming to have a positive impact in society or the environment. This can be the development and commercialization of a new product, constructing or upgrading infrastructure utilized for the executor!s activity, like LEGO!s offshore wind farm . The most common instrument that will be used to canalize capital to fund precise projects are debtissuance assets : bonds (green bonds) or loans.

Secondly, the financing may go directly to a company whose business model is built upon the objective of having a positive impact. Think of companies like The Ocean Cleanup whose robotic devices clean large water bodies, and whose main clients are governments. Here the investment will primarily be made in the shape of equity-type assets, private-equity in particular since only a few of these companies are publicly listed.

There used to be a well-known underlying problem concerning impact investment in financial markets. That is, demand for green assets was very feeble when considering their de facto performance. This, ceteris paribus , would result in a high cost of capital for green projects, thus maintaining the green industry!s development at a level below its potential. The scarce demand was a consequence of the investors! perception of the risk these projects are subject to, leading them to require a high risk premium.

That has now changed, fortunately, thanks to financial schemes that aim to reduce the aforementioned risk premium. Let us inquire into the fundamentals of the real and perceived risk ; afterwards, we shall look into the solution brought by financial institutions to uplift the risk.

Technological risk

Green projects depend on new or recent technology, that fact alone inherently makes investors reluctant to unlock their funds. The technology these projects are based on is often very sophisticated and industrious : think of carbon sequestration, or metal recycling, which require large facilities and costly machinery. Long-term performance and reliability of such pioneering projects are negatively perceived by common investors, who deem them to be too recent and uncertain. Notwithstanding, such fears come from a lack of knowledge of the industry by large financial corporations, which are used to working with well-known and long established industries.

It turns out investors are not always rational when evaluating a project, and the positive or negative bias that new technology ignites in investors causes their investment to be disconnected from the underlying value of assets. Think, for instance, of the 2001 dotcom bubble ; many newly-born IT companies were, counterintuitively, getting an outstanding amount of capital, way beyond the discounted value of the future cash flows the companies could prove. Indeed, the market to book ratio of these companies was dismal, and they were still getting plenty of cheap financing.

Exogenous risk (political, policy-related, currency fluctuations)

The second type of risk that bolsters green assets! risk premium is the one relating to the geographical situation where the project will be executed. And impact investment is vastly needed in developing countries where rapid economic growth comes in concomitance with a greater demand for energy, thereby creating opportunities for renewable energy projects and companies to thrive.

International finance has always been subject to contextual risk, most notably policy and currency-related fluctuations. Political arbitrage means the policies that rule the market are unstable. This is a hindrance to impact investing because revenues of green companies often depend on policies related to carbon emissions like subsidies or carbon taxes which encourages demand for renewable energy sources. Thus uncertainty concerning politics in a country affects investors! willingness to do impact investment.

How financial instruments are eliminating the risk

A wide array of financial instruments have been designed to mitigate the risk underlying green assets, some are provided by private financial corporations and others are brought by governmental institutions or subsidiary Special Purpose Entities (SPE).

Additionally, well-informed public and private institutions can reduce uncertainty through their expertise and involvement in the industry of social and environmental development, thereby increasing demand for green assets and reducing the market!s risk premium.

Indeed, money is now starting to flock into the green section of the market : at least $30.7 trillion of funds is held in sustainable or green investments, up 34% from 2016.

Private Sector : Credit enhancement companies

Limiting risk by backing investors' funds by means of financial instruments

Let us delve into the financial schemes that canalize impact investment by starting with a case study of an American insurance company, affiliate of Axa : New Energy Risk. This fnancial services company works closely with bigger and more widely known financial corporations, as well as with green technology companies. Their goal is to enable the investee (the company that will carry out the project) to have access to funding at a reasonable cost they would otherwise not have access to. In essence, their objective is to reduce the market!s risk premium on the envisioned debt issuance the investee would make to fund its project. New Energy Risk (NER) does just that by providing capital as an insurance to the investors : it pledges to guarantee they will not lose their money in the event of the project failing with two main financial insurance instruments, namely guarantees and liquid grants.

A guarantee legally binds the provider (the insurance company providing protection, here NER) to pay the recipient (the investor benefiting from the insurance service) in the case of the investee being unable to pay back. Grants are a more liquid type of instrument that NER puts directly at the recipient investor!s disposal so they are reassured they will not suffer any losses. Both financial tools inherently reduce the perceived risk and the risk premium ipso facto.

Limiting risk through knowledge of engineering

Furthermore, NER has a sharp knowledge of the real risk of project failure which enables it to adapt their insurance instruments to better suit investors. Their expertise of engineering in the context of new energy-efficient technology allows NER to enlighten investors with a professional assessment of the risks involved in the project, whereas large financial corporations may lack such knowledge.

In 2019, NER helped Fulcrum BioFuels (a firm that converts trash into low carbon fuel) get a 175 million-dollar twenty-year bond from investors with an interest rate two-hundred basis points lower than that JP Morgan had offered them before they had partnered with NER .

Institutional sector : States, Funds and Multilateral Development Banks

Equity raising

There are more financial instruments that canalize capital towards impact investments. We have only mentioned debt-type assets so far, which aim to finance specific projects. Now let!s take a look at equity type securities.

When seeking to raise capital, green companies may be disappointed turning to fnancial institutions looking for financing, finding out investors are rather reluctant when it comes to investing in equity positions in green companies. The aforementioned problem, risk, is the hurdle that persists. Most green companies are not listed in the stock market, so investors! reluctancy does not come mainly from fluctuations therein but rather they fear companies may fail and go bankrupt.

In comes the huge financing capacity of governments : fiscal revenue allows governments from all over the world to individually or multilaterally create Special Purpose Entities (SPE) like Funds or Multilateral Development Banks (MDB) to prop up impact investment. The Climate Public Private Partnership Programme (CP3) is a fund set up by the British government under the guidance of HRH the Prince of Wales aimed at canalizing private financing towards private equity investment in green companies. The CP3 is what we call a Pledge Fund, that is a Fund that has an initial investment made with the initiator!s (here the government) money in order to attract other investors to join the fund. What increases this method!s effectiveness is that private investors feel reassured whenever institutions set up by, or related to, the State, are involved in the financing scheme, that makes them more prone to channel their capital into such projects or companies.

We talk of a Subordinated Equity Fund to refer to a specific category of funds that will provide a significant portion of private equity in a company to invite private investors to join, with the peculiarity that the Fund!s part will be the most junior equity. That is, in the event of a bankruptcy all assets held by the company will be sold and all other equity holders will be paid before the Pledge Fund is paid. Not only that but dividends are paid to the Fund only after other investors have received theirs, and the Fund may receive no dividends if need be. This chevaleresque gesture appeals investors to channel their money towards green companies.

Aiming to combine all of these financial schemes, the EU Commission presented on 14 January 2020 the European green deal investment plan, which will mobilise at least €1 trillion of sustainable investments over the next decade. It will enable a framework to facilitate public and private investments needed for the transition to a climate-neutral, green, competitive and inclusive economy.

Debt insurance by non-private institutions

Multilateral Development Banks (MDB) can provide insurance services for investors like the ones previously mentioned in the private sector section : they can emit direct loans, and they can buy subordinated bonds which, like junior equity, are paid last and attract other investors to join and take the prioritized bonds. It is estimated that for every dollar invested, MDBs can leverage an average of 3 dollars. The World Bank is an example of these public and private funded MDBs. The World Bank created in 1992 a fund called 5 the Global Environment Facility that has provided close to $20.5 billion in grants and mobilized an additional $112 billion in co-financing for more than 4,800 projects in 170 countries.

Conclusion

The risk of impact investment is not negligible, and investors will never put their money where they are sure to lose it. However, private and public financiers can make sure, through the works of finance, that investors will make money while tackling climate change.

Risk management has always been one of the primordial tasks that financiers have undertaken in order to help newborn industries come through and flourish. It is now the time to do the same for projects that have a double mission : making money and embellishing the world.

Martín Palomar