President Biden plans to fight climate change and create jobs via infrastructure spending. However, to make America green, the economy must go green: corporations and banks must move towards renewable sources of energy, or renewables.
Some institutions are considering sustainability. Global banks invested $1.9 trillion in renewables during 2016-2018 after the Paris Accords. 5 American banks also pledged to end Arctic drilling investment.
Yet, this transition isn’t complete. Globally, 33 banks invested $1.9 trillion in fossil-fuels between 2016-2019. In the US, banks doubled their investments in fossil-fuels over renewables during 2016-2018. Furthermore, the UN initiative to encourage renewable investment – Principles of Responsible Investing – did little to change investors’ portfolios.
Though institutions are acknowledging climate change, financial realities pose obstacles to going green. To speed this process along, six states, including New York, and some countries, like the UK, have established “Green Banks.” These are quasi-public financial institutions that invest in renewables. Could Green Banks be the answer?
To answer this, I spoke with the Vanderbilt Owen School finance Professor Veronika Pool about the barriers between our economy and a green economy, and how Green Banks may help.
THE INVESTOR-COMPANY BOTTLENECK
A bottleneck in the green transition is the difference in priorities between private investors versus renewable companies. Professor Pool explained that investors may prioritize green short-term investments, but companies may plan long-term projects.
For example, a solar company may require 10 years to pay back its investment. Though some investors may tolerate that window, others may desire returns in only a couple of years. Thus, investors may be reluctant to go in on this longer horizon project. Such a bottleneck can make it harder for renewables to gain financing.
A GREEN BANK CAN OPEN THE BOTTLENECK.
Green banks incentivize private investment. One method to do so is “asset-securitization,” which turns loans to renewable companies into securities (like stocks or bonds) that investors trade.
When a green bank lends to a company, they’re owed interest payments, so the loan is an asset that accrues value over time. The bank can “chop” the loan into bits and convert them into securities. An investor can buy the securities; as the loan collects interest, the security’s value rises and the investor profits.
Professor Pool explained the benefit of asset-backed-securities:
“You can put [Green Banks] between [companies and investors]… to provide a kind of maturity transformation… [and] create financial products that would transform that long-horizon project into smaller horizon securities.”
A company may prioritize the long-haul, but investors may desire returns sooner. With asset-securitization, investors can trade securities in the short term for quicker returns rather than investing in the company directly and waiting for growth down the line.
Furthermore, asset-securitization can reduce risk. Any company that borrows can default on their debt (i.e. they can’t pay it back). If one institution lends to a company, then it carries all the burden if the company defaults. Conversely, if many investors purchase asset-securities, then the burden of losses is spread over many people, so it’s less devastating.
A LACK OF STANDARDIZATION IN RENEWABLES MARKETS
If green banks promoted asset-backed-securities and other financial instruments to fund climate-related projects, then the renewables market could become “standardized.” Let’s explore what that means, and why renewables aren’t currently “standardized.”
Asset-backed securities are types of bonds. When investors buy bonds, their money becomes a loan to the issuer of the bond (e.g. a company), and that issuer pays the investor back with interest.
Bonds follow widely accepted “credit ratings” that indicate risk. A high rating signifies a “safe” bond, meaning that the borrower has a low risk of defaulting; the investor will likely get their money. Standardized ratings let investors universally understand that an A-rated bond (only below AA and AAA) is likely safe, or that a C-rating is risky, so there’s a common code that investors follow.
A similar concept could apply to bonds from renewables, also known as “green bonds.” Rather than signifying risk, such ratings could indicate a company’s “social responsibility.” Investors can know how companies impact the environment – positively or negatively – and companies gain incentive to be socially responsible to gain higher ratings. Standardized ratings can help investors and companies go green, if implemented correctly.
MORE STANDARDIZATION MEANS MORE TRADING
Another benefit to asset-backed securities is that they can have specified prices, returns, and timeframes so that investors know what they’re buying. Investors wouldn’t have to lend to a renewable company and wait for returns based on the company’s timetable. They can buy or sell several small securities whenever they want.
Consider the “typical” scenario in which an investor lends to a renewable company. They’ll probably have to stay in the agreement for its duration; if the investor wants to leave, then they have to find a 3rd party to take their place. This can be challenging: the investor and the company negotiated specific terms that may not align with what other parties are desiring.
However, consider when a green bank creates asset-securities out of loans. Each security has a specific price, percent-return, and timetable. If an investor buys securities, then they’re not engaged in an agreement with the original borrower, as they bought the securities from the middleman green bank. The investors can sell these securities early if they want, and – because each security has standardized metrics – third parties will know the exact conditions of these securities and thus may be more willing to take the securities off your hands.
Professor Pool explains this benefit to standardization:
“Standardization helps liquidity…. private contracts are really illiquid because it’s hard to find a counterparty who meets exactly those features of a contract. If you look at financial markets, all the exchange-traded projects are really standardized, and the reason for that is that you can have lots of buyers and sellers trading in that same standardized product.”
Therefore, asset-backed securities can be easy to trade, enabling greater investment in renewables via the green bank’s financial instruments.
Asset-securitization is one example of how green banks can unite investors and renewables. Green banks can incentivize investors where mandates may fail, allowing the economy to transition more smoothly.
However, green banks are still new. Their annual returns on investment have reached 4-5%, which may not be enough for some investors. Furthermore, as green banks are public, they have restrictions on the risk they can take on. They may not be able to invest in newer companies, which are often risky bets. Green banks don’t want to waste taxpayer funds and thus will be careful. Thus, green banks could pass up some opportunities.
Regardless, green banks may have potential. New York recently repurposed $165.6 million for its green bank with the goal of expanding its capitalization to $1 billion. If they succeed, then the results can be promising for the fight against climate change.