Financing the Transition to a Low-carbon Economy

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Over the past 20 years — well before the recent U.N. Climate Summit in New York — reports have been written, conferences held and committees formed looking for ways to avoid catastrophic climate change. Yet the international community has made little progress as it tries to control global warming emissions.

With public spending on clean energy actually in decline (it dropped 20% from 2011 to 2013, according to Bloomberg New Energy Finance) many have decided that the time has come to look past the limited budgets and political paralysis of national governments and engage the private sector in the struggle to fund the world’s transition to a low carbon economy.

Daniel C. Esty, professor of environmental law and policy at Yale and former commissioner of the Connecticut Department of Energy and Environmental Protection, says in an interview, “It makes much more sense to use limited government money to leverage private capital than it does to spend it directly on projects.” In a New York Times op-ed just prior to the U.N. Summit, Esty added that the private sector offers the additional advantage of allowing market forces, rather than government bureaucrats, to pick winners and losers, while encouraging competition that lowers prices.

The sheer size of the financial sector offers enormous potential. According to a recent study by PwC, “Asset Management 2020”, global assets under management will rise from a 2012 total of $64 trillion to roughly $102 trillion by 2020. And the appetite for clean tech investing is growing stronger each year. Already, high net-worth individuals worldwide are investing $3.74 trillion in environmental, social and governance issues (ESG). And, according to Surya Kolluri, managing director of policy and planning, personal wealth and retirement at Bank of America Merrill Lynch (BAML), “Fully half of BAML’s clients say that their portfolios are a manifestation of their values and the kind of impact they would like to have on the world.”

The challenge is coming up with the investment opportunities needed to satisfy this demand. Investors “are not willing to trade off returns for impact,” says Kolluri. While most investors are hungry for yield in today’s low-yield environment, all demand investments that offer both liquidity and returns commensurate with the risk. Fortunately, innovative new strategies and financial instruments are being developed to meet these requirements.

“Fully half of Bank of America Merrill Lynch’s clients say that their portfolios are a manifestation of their values and the kind of impact they would like to have on the world.” –Surya Kolluri

Familiarity Breeds Acceptance

“Green bonds” are simply bonds that are used to finance environmental initiatives. The most successful so far have been “use-of-proceeds” bonds, which owe much of their appeal to how much they resemble everyday fixed-income instruments. As with other bonds, this innovative form is backed by the full faith and credit of the issuer. What makes them green is the issuer’s promise to use all of the proceeds from the investment for green projects exclusively.

The first such bond was issued in 2007 by the European Investment Bank and underwritten by Merrill Lynch. Since then, BAML and other banks have underwritten use-of-proceeds green bonds for numerous issuers, almost all of which have been “very safe, AAA-rated super sovereigns [multi-lateral development banks],” notes Abyd Karmali, managing director of climate finance at BAML.

The success of a green bond issued by the Export-Import Bank of Korea (KEXIM), which is neither AAA-rated nor a super-sovereign, “signaled that investors were interested in a variety of opportunities,” and paved the way for corporations to enter the market, Karmali says. In November 2013, just nine months after the KEXIM issuance, Bank of America became the first corporation to issue a use-of-proceeds green bond.

Interest quickly grew. Within days, a European utility issued bonds of its own, followed in short order by Unilever, Toyota, some U.S. real estate companies and others.

Interest in green bonds is soaring, with the total of use-of-proceeds green bonds growing dramatically between 2013 and 2014. Whether the green bond market will reach, or even exceed, $100 million next year depends, in large part, on how much the corporate segment of the market grows and whether municipalities — which include cities, states and counties — follow the lead of Massachusetts and California in joining the market.

As fast as the market for these green bonds has grown, Suzanne Buchta, managing director of high-grade capital markets for Bank of America Merrill Lynch, believes that use-of-proceeds bonds are likely to play an even greater, more pivotal role in the future. “The beauty of the use-of-proceeds green bonds is that investors can participate without having to change their mandate or do new additional credit analyses,” she says. “The bonds provide a product that is immediately accessible.”

The Expansion of Green Bonds

Once investors grow accustomed to use-of-proceeds green bonds, they often begin to venture further out into the green investment space. “We are starting to hear investors say, ‘This is interesting, but I want to start to look at how I can directly invest in projects,’” Buchta says. “That’s something you would not have heard five to 10 years ago, because green projects were considered too risky for many investors.”

For these investors, there are now project green bonds, which compensate for higher project risk by offering higher yields. There haven’t been many issuances yet, but in 2013 MidAmerican Energy Holdings Company, a unit of Warren Buffett’s Berkshire Hathaway Inc., completed a $1 billion bond offering to fund continued construction of its 579-megawatt Solar Star project in Southern California.

Asset-backed green bonds bundle together a pool of green collateral in much the same way the mortgage-backed securities bundle together home loans, and they carry similar risks. But their appeal is growing, especially in the solar industry. With the federal tax credit for solar energy projects scheduled to drop from 30% to 10% in 2016, SolarCity, a solar system installer, broke important new ground when it issued $54 million in bonds backed by residential and commercial solar power contracts last year. Now that the SolarCity deal is done, Forbes reports that other solar companies are exploring similar bond offerings.

In 2013, MidAmerican Energy Holdings Company, a unit of Warren Buffett’s Berkshire Hathaway Inc., completed a $1 billion bond offering to fund continued construction of its 579-megawatt Solar Star projects in southern California.

A fourth type of green bond is known as a pure-play bond, because corporations that issue them are considered to be entirely, pure-play green companies. Think of Tesla, which is 100% dedicated to electric cars, or Sun Power, which manufactures solar panels and nothing else. Such companies do not have to use all the proceeds of the bonds they issue for specifically green purposes because everything the company does is in the service of its green business.

Buchta says there are hardly any of these pure-play green bonds so far, because most of the eligible companies are not yet rated as investment grade. “But we envision that in the next couple of years some of these companies may come up the credit scale to the point where they could issue either high yield or high grade bonds.”

Building on Success

In the low-carbon economy of the future, most of our energy is likely to come from wind and solar power. Standing in the way of that future is the relatively high cost of financing utility-scale renewables, which makes them uncompetitive with fossil fuel power. One answer is to drive up the cost of fossil fuels, with a politically difficult carbon tax or indirectly through cap-and-trade mechanisms. While some are following these paths, the outcome remains in doubt.

The alternative is to lower the cost of financing renewables, thereby lowering their cost and increasing their competitive vigor. One innovative approach that shows promise is the use of yield companies or YieldCos. According to a report by the Climate Policy Initiative, “The Roadmap to a Low-Carbon Electricity System in the U.S. and Europe,” such “new investment vehicles designed around the unique financial characteristics of renewable energy could reduce its costs by up to 20%.”

YieldCos take advantage of the fact that wind and solar projects typically have high upfront costs but low operating costs and, with the help of purchase-power agreements, long-term predictable cash flows. A company can spin off the relatively stable operating part of its energy business as a YieldCo, and raise capital by selling stock, with dividends funded by the spin-off’s cash flow. The parent company uses the money it raises in the equity market to fund further growth.

In October 2013, the utility NRG became the first firm to actually create a YieldCo. NRG Yield, Inc. includes three natural gas plants, eight utility-scale solar and wind generation facilities and two portfolios of distributed solar facilities (totaling about 1,324 megawatts of generation capacity). Since its IPO last year, the new company’s price per share has risen about 60%.

Other utilities have followed suit, including most recently NexEra Energy, a subsidiary of Florida Power & Light Company and the nation’s largest solar and wind operator, which raised $442.7 million in its initial public offering. According to InvestorPlace.com, various solar panel producers, including SunPower and SunEdison, also intend to start YieldCos.

Using Public Funds to Leverage Private Capital

Green bonds and YieldCos are attracting private investors without recourse to public money. But increasingly, governments are finding ways to use their treasuries to help mobilize investment dollars.

Important elements in this effort are occurring at the local level, says Esty. He points to the international group C-40, which now includes the mayors of 69 major cities, representing 18% of global GDP. These local leaders, says Esty, have “committed their cities to real action,” as have “400 to 500 mayors across the U.S.” The international nature of this local movement was made clear at the U.N. Summit, where several other international groups of local officials agreed to provide a single annual report on the progress being made by state and regional governments worldwide.

Here in the U.S., green banks are at the leading edge of such local efforts. No two are alike, but the first two in the nation provide a good sense of what these institutions can accomplish.

Connecticut was the first state to launch a green bank, creating the Clean Energy Finance and Investment Authority (CEFIA) in 2012. According to the organization’s 2013 annual report, CEFIA has generated about $10 in private investment for every one dollar contributed by the state’s taxpayers.

“This is a watershed moment, because, by doing this deal, it proves that energy efficiency is able to attract private capital.” –John Kinney

Much of the heavy lifting in Connecticut has been done by Connecticut’s Property Assessed Clean Energy (PACE) program. PACE allows property owners to finance up to 100% of clean energy improvements to their homes and repay the investment through an increase in their property tax bill. An upfront evaluation helps ensure that energy savings more than compensate for the additional tax charge.

PACE loans can in turn be used to attract private investors. Earlier in the year, California securitized $104 million in residential PACE loans, and in May, Connecticut’s CEFIA sold bonds backed by a portfolio of $30 million in commercial PACE loans. “This is a watershed moment, because, by doing this deal, it proves that energy efficiency is able to attract private capital,” says John Kinney, CEO of Clean Fund, which purchased the bulk of the CEFIA portfolio.

Rather than offering a PACE program, or any specific program of its own, New York’s Green Bank will provide a range of financing support for projects that meet its goals but can’t be completed with private investment alone. Among other strategies, the bank will use public funds to provide credit enhancements, which reduce the risk on clean energy loans and leases, and aggregate numerous clean energy projects that are otherwise too small to warrant attention into investible portfolios.

Approaches for the Developing World

Many of the financing strategies that show promise in the developed world face daunting challenges in other parts of the globe, including political and regulatory risks, currency and interest rate volatility, and technology and infrastructure risks. National, regional and supra-national agencies are increasingly looking for ways to use their funds to help overcome these challenges.

The Green Climate Fund (GCF), a U.N.-sponsored entity, is one such group. GCF’s first challenge is securing the working capital it needs to succeed. When it was launched in 2009, donor countries pledged to come up with $100 billion from public and private sources by 2020. But the first step, known as the Initial Resource Mobilization (IRM), is to reach $10 billion over the next three years. Just $2.4 billion has been pledged so far (most of it at the U.N. Climate Summit), but hopes are high that the remaining $7.6 billion will be forthcoming in time for the official IRM meeting.

GCF’s second challenge is how to use the money that is collected most effectively. The World Resources Institute (WRI) has spent 12 years researching financial instruments that public institutions can use to mobilize private sector investment and is now exploring the experiences of large funding organizations. According to Giulia Christianson, associate for the climate finance project at WRI, the Institute is encouraging GCF “to have a suite of instruments. What we’ve seen in the research is that it’s not enough just to have concessional loans or grants,” which is all that the GCF board has so far allowed.

“Everyone is trying to think of how to bring public and private financing together, to make that the norm rather than the exception,” notes Christianson. But GCF is likely to be cautious, looking first to see its initial loans repaid. Still, says Christianson, the GCF board will likely be talking about how to phase in additional instruments at its next meeting, most likely beginning with loan guarantees and both political and regulatory risk insurance.

Other groups are looking to move faster. The Global Innovation Lab for Climate Finance is drawing on expertise from both the public and private sectors to design and pilot the next generation of climate finance instruments. The first seven ideas to be piloted include long-term currency swaps (to help reduce the risk posed by volatile currency exchange rates), insurance for energy savings (to protect against the risk that energy-efficiency projects might not achieve projected savings) and a debt fund for prepaid energy access (to help scale up a proven model for prepaid off-grid renewable energy). By quickly developing and demonstrating the real-world effectiveness of such tools, the Lab hopes to build new markets and attract new investors to climate financing in developing countries.

The Lab is part of broader government and private-sector efforts to scale up climate finance. Another such effort, Finance for Resilience (FiRe), is designed to identify the best existing ideas and ensure that they are scaled up as quickly as possible. While FiRe’s focus is global, it is currently developing four strategies aimed specifically at challenges in the developing world. Among these are: the expansion of an energy-efficiency financing program into China, Brazil and India; the establishment of a guarantee mechanism for green energy bonds in emerging markets, and an attempt to raise $1.4 billion for investments in developing countries by scaling up a public-private fund-of-funds established by the Global Energy Efficiency and Renewable Energy Fund.

It’s too soon to tell how effective all these efforts at climate financing will be at breaking the gridlock, but the growing collaboration between public and private sectors at least promises a a way forward.

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