How big finance can increase sustainability

J. David Stewart and Henry P. Huntington,

EAGLE RIVER, ALASKA — Addressing the ever-worsening climate crisis will require the largest sustained movement of capital in history.

At least $100 trillion needs to be invested over the next 20-30 years to transition to a low-carbon economy, and $3-4 trillion in additional annual investments are needed to meet development goals sustainable by 2030 and stabilize the world’s oceans.

Mobilizing these huge sums and investing them effectively is well within the reach of the existing global economy and financial markets, but it will require fundamental changes in the way these markets work.

In particular, traditional financial institutions will need help finding the right projects, simplifying the design and negotiation of deals, and raising the capital needed to finance them.

Many sustainability ideas are small-scale, which partly reflects the nature of innovation, in which ideas are developed, tested and, if successful, eventually copied.

But the disconnect between those developing sustainability projects and the mainstream finance world means scaling such initiatives is not straightforward.

At the risk of oversimplifying, sustainability advocates may be wary of “big finance” and its history of funding unsustainable industries.

Investors, on the other hand, may be wary of idealistic approaches that ignore bottom-line realities, and may not be interested in small-scale transactions.

Given this disconnect, how do we scale sustainable projects from small investments to the $100+ million range that is beginning to attract big finance and therefore the trillions of dollars needed to make a global difference?

Three steps in particular are necessary. First, securitization techniques should be employed to aggregate many small projects into one with sufficient critical mass to be relevant.

Securitization got a bad rap in 2007-08 for its role in fueling the subprime mortgage crisis that brought the developed world to the brink of financial ruin.

But when properly managed, joint funding of many projects reduces risk, because the likelihood of all simultaneously encountering similar financial and operational problems is low.

However, for the resulting package to be of interest to investors, the many small projects must have common characteristics in order to be aggregated. It cannot be done afterwards.

For example, we need to develop common terms and conditions for similar asset pools, as is already happening in the US residential solar market.

Next, we need to explain the fundamentals of securitization to more potential grassroots innovators through regional conferences that bring together financiers and developers of sustainable projects.

Second, we need to reduce the complexity of key transaction terms and make it easier to design and negotiate the specifics of the instruments used to invest in sustainable projects.

In established financial markets, replicating significant parts of past successful trades is much easier than starting from scratch with every trade.

This approach works because many of the terms and conditions of subsequent transactions have already been accepted by major financial players.

Making successful innovations more visible to investors is therefore crucial. To that end, we should establish a clearinghouse of high-level open-source information about past sustainable projects, including those that were successfully funded and those that failed.

This would be similar to many existing financial industry databases, but available free of charge, with monitoring by a reputable third party to ensure accuracy.

Third, the range of funding sources for sustainable projects needs to be expanded and made more transparent.

Since sustainable investments may offer lower returns by historical financial market measures, traditional asset allocation practices, in the context of “efficient markets”, would imply reduced attractiveness.

But historical benchmarks don’t take enough account of the burgeoning field of impact investing, which encompasses varying thresholds of returns and time and now accounts for around $2.5 trillion in assets.

Securitizing tranches of different types of impact investments could be a game-changer for sustainable finance.

It would therefore make sense to create an open source database of investor appetite – similar to the project database mentioned above – that is searchable by innovators and designers of new sustainable projects.

This would facilitate the identification of investors – equities, credit or hybrids – likely to commit financing.

The database could be hosted by an organization such as the International Finance Corporation, the United Nations or the Global Impact Investing Network.

There are encouraging precedents. The green bond market started just over ten years ago and total issuance could already reach $1 trillion this year.

And a critical mass of the financial world attended the United Nations Climate Change Conference (COP26) in Glasgow last November.

Led by UN Special Envoy Mark Carney, the Glasgow Financial Alliance for Net Zero (GFANZ) has made $130 trillion in climate finance commitments.

In 1983, Muhammad Yunus founded the Grameen Bank to provide banking services, and in particular loans, to people (mainly women) previously considered “unbankable”.

By the time Yunus won the Nobel Peace Prize in 2006, “microcredit” had become a global phenomenon, with traditional financial institutions involved in the securitization of such loans.

The financial revolution launched by Yunus has transformed retail lending, simplified the structure of these transactions, and tapped into a new source of large-scale investment capital.

To help address today’s existential sustainability challenges, capital markets and their key players need to be even more innovative and open the door to non-traditional and even disruptive voices and ideas.

David Stewart, former CEO of JPMorgan, is a sustainable finance consultant. Henry P. Huntington is an arctic researcher and conservationist.

Copyright: Project Syndicate, 2022.

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