What Value Does Australia Put on a Green Investment Bank?

The formation of a Green Investment Bank in Australia can provide a vital, necessary link between projects requiring long-term debt funding and demand from an existing, large group of private sector bond investors. It can also explore the creation of new markets for financial products with hybrid characteristics. The main challenge will be to find the right structure for government support that balances the allocation of risks and returns between the public and private sector. Phil Preston says this in Climate Spectator.

Phil Preston in Climate Spectator (20 July 2010):

Those who oppose economic intervention may shudder at the prospect of a Green Investment Bank, but the reality is that urgency is required to build renewable energy infrastructure. Recent conversations in developed countries have focused on the potential for such a bank to help mobilise private sector savings.

As Giles Parkinson points out, the concept has gained traction in the UK and it is an option for Australia to consider. We must ask the question though: can a Green Investment Bank work in practice?

To answer this, we need to consider the features of project financing, the natural investors for such projects, and the role that a Green Investment Bank (GIB) could play in mobilising capital. We must be careful that we are not fooled by the simplicity of the concept, as there are some key elements to get right if it is to be a serious option at all.

The cycle of project financing

Project financing has several stages that can be broadly classified as feasibility, financing, construction and operating. To be feasible in the eyes of private sector sponsors, the basic project economics need to stack up. That is, the likely returns achievable from the equity invested in them must be commensurate with the risk taken. I’ll come back to that point in a moment, but assuming a given project is feasible, the debt and equity financing needs to be locked in and then the project needs to be built, successfully commissioned and operated.

At various points, the project’s risk profile changes and investors will be sensitive to their point of entry. Financing a tested and fully operating project is a different proposition to financing construction.

A side point here is to note how critical the off-take pricing of, say, a renewable energy project is to its feasibility. Currently, fossil fuel-based energy is cheaper than renewable energy – so government policy is required to stimulate investment.

A feed-in-tariff is one such government intervention, in this case to regulate the off-take prices for the energy produced. Such intervention at the project level ensures that energy prices, and therefore revenue, can be forecast in advance, which reduces revenue risk for the project sponsors. It also allows more debt to be raised against the project’s value, because lenders are faced with less risk.

Government support could also include such measures as carbon pricing or favourable tax treatment – some readers may recall the much sought after infrastructure bonds of the 1990s; economists can argue over which mechanisms will work the best – the point is that government support will be vitally important for project feasibility and will help shape the subsequent actions of the private sector.

Who are the natural investors during the various stages of a project?

Initial sponsors would typically be dominated by construction and energy companies. Once a project is commissioned and proven operational, then construction companies usually head for the exit in order to recycle their capital into new opportunities. This is the point where both listed and unlisted infrastructure funds find the lower risk and reasonable return prospects attractive and may build positions, or the project may simply stay on an energy company’s balance sheet.

The debt financing of project construction requires sophisticated lending skills. The major commercial banks possess those skills and have the right business structures to assess, manage and monitor project debt. Once the project is operational, the sponsors will want to refinance the bank debt with longer dated debt or bonds. The banks won’t mind – they prefer to recycle their capital into other projects because they are penalised from a capital perspective for holding long-term debt. The natural holders of long-term debt are those investors with long-dated liabilities: superannuation funds and insurance companies.

So there is a clear cycle of natural investors, starting with construction companies and banks and ending up with listed or unlisted funds and bond investors. Energy companies may also retain interest through some, or all, of this cycle.

What role is there for a Green Investment Bank?

Assuming feasibility has been dealt with through government mechanisms, the main issue is financing. Energy companies with large and solid balance sheets could undertake and finance projects themselves, however the quantum of capital required will limit the amount they can supply.

How can a GIB help to mobilise capital quickly? As per Murray Ward’s analysis, there is a vast cavern of capital sitting in pension, insurance, sovereign wealth and other private funds. A GIB can play a key role as an intermediary between projects and the providers of debt.

Firstly, it can act as an underwriter of debt, meaning that it commits at the financing stage to buying long-dated bonds when the project is successfully commissioned and operating. This has the benefit of reducing uncertainty for the sponsors and banks, who still retain the construction and commissioning risk. The GIB also becomes a hub for investment specialisation, a skill base that is expensive to re-create for each of the investment teams acting on behalf of the natural long term investors.

Secondly, the GIB can retain the long-dated bonds on its own balance sheet and issue its own bonds to match the needs of investors, whether they are short or long-term focused. By having the capacity to issue shorter-term debt they attract a much wider, global investor base. If the GIB can achieve a decent credit rating (of AA or AAA) and issue bonds in deep, liquid lines into the market, then it will be able to mobilise a serious amount of capital. Investment managers will buy highly rated and liquid bonds in spades without needing any specialised skills of their own to do so. In my experience, as the debt proposition becomes increasingly complex then the universe of potential investors falls away at an exponential rate.

The GIB may also have a role to play in providing equity support. Discussions in the UK include a host of ideas on this front. The designers and owners of the GIB would need to think long and hard about capital efficiency and conflict of interest under this approach – it may be more effective to consolidate equity support activities under an investment fund structure rather than as part of a special purpose bank. Mobilising debt funding should be its main purpose and priority.

What are the main challenges in the formation of an effective GIB?

This is no ordinary bank. It has an asset portfolio that consists of loans to renewable energy projects, which means that its assets are concentrated in one area. In layman’s terms, it has all of its eggs in one basket. An unexpected change in technology or regulation could seriously impact the value of its portfolio. To get a decent credit rating it would need to either hold a large amount of capital relative to traditional commercial banks, thus straining the economics and feasibility of a commercial return from the equity in the GIB itself, or receive some form of explicit government support.

Another problem is the mismatch risk in its portfolio. It owns long-dated bonds and funds them with shorter-dated debt, which can lead to trouble if the market goes through a credit or liquidity crisis, which it invariably does every five-to-ten years. This is an area in which government may be able to get more “bang for its buck” by providing explicit, contingent financial support that could be drawn in the event of asset quality problems or market disruption. It could be in the form of additional equity or lender-of-last-resort for refinancing debt, or a combination of the two. It is not ideal, but may be necessary. Because the support is contingent, it has close to zero cash cost today, which may be politically appealing. The downside is that it may become a burden in the future. Organisations such as the World Bank perform a similar role in developing countries. A major reason they achieve their AAA credit ratings is because their member countries commit to providing additional capital if required.

Further discussion is needed to tackle the issue of exactly who provides the equity and owns the GIB, and how a balance can be achieved between public and private objectives. That discussion will be driven by the nature of the explicit government support, should it be provided.

There has also been discussion in the industry of GIBs issuing instruments that are hybrid in nature, such as bonds whose returns are somehow linked to carbon prices. It is premature to consider these options seriously before getting the basic structure right. If a massive amount of capital needs to be mobilised, then there is a compelling case to raise it using existing markets and mechanisms that we know will work. Hybrid instruments may work in the future. They require new markets to be formed and the risk and return characteristics of those instruments will be very complex. It would be wise to view them as a ‘phase two’ idea.

Can it work?

The formation of a GIB can provide a vital, necessary link between projects requiring long-term debt funding and demand from an existing, large group of private sector bond investors. It can also explore the creation of new markets for financial products with hybrid characteristics. The nature of its assets and activities means that it will need explicit government support in some form to ensure its own viability. The main challenge will be to find the right structure for government support that balances the allocation of risks and returns between the public and private sector.

Phil Preston is the principal of Seacliff Consulting, a firm offering specialised consulting services in the financial and responsible investment fields. His prior work includes 17 years of financial research and portfolio management in the funds management industry.

Source: www.climatespectator.com.au