How to Bridge Financing Gap for Low-carbon, Climate Resilient(LCR)

Infrastructure

Korea Capital Market Institute

Research Fellow, Suk Hyun

E-mail: hyun@kcmi.re.kr/ bigsuk@gmail.com

2 Green Revenue Bonds

3 Green HIT Funds

Contents

4 Summary

1 Background

Background

1

Inter-relationship of LCR Infrastructure, Climate Change and Financial Sector

Climate Change

Financial Sector Financial Stability

Low-carbon Climate Resilient

Infrastructure

Mitigation and Adaptation Gap

Source: EIB(2010), Financing greener and climate-resilient infrastructure in developing countries-challenges and opportunities

Financing Gap for LCR Infrastructure (by sector)

Source: McKinsey & Company(2016), Financing change: How to mobilize private-sector financing for sustainable infrastructure

One of Feasible Solutions…

Rising fiscal burdens in the post-crisis period and falling bank loans under stricter capital regulation (Basel III) make infrastructure financing difficult.

Climate uncertainty, carbon price uncertainty and technology uncertainty widen financing gap for the low carbon resilient(LCR) infrastructure wider.

Asymmetric information between lenders and borrowers due to physical remoteness of given projects make investment decision difficult.

National-local gap of people’s response and acceptance for LCR infrastructure projects.

Hometowners can identify and finance bankable LCR projects based in their hometown with municipal revenue bonds and hometown investment trust(HIT) funds proposed by Dean Yoshino.

Close the Gap

Green Revenue Bonds

2

Innovative Financial Instruments

Characteristics

Revenue Bond Revenue bonds are municipal bonds based on the revenue generated by a specific project, such as a toll bridge, highway and etc. It is different from general obligation bonds (GO bonds) that can be repaid through a variety of tax sources.

Revenue Bond (Yoshino, 2004)

Revenue bonds combined with an internal mechanism to increase commercial viability of a project through a one-off injection of the fixed amount of public funds which is different from the US revenue bonds.

Performance-linked Revenue Bond (Yoshino et al, 2008)

While principal and interest payments of revenue bonds are secured by the future cash flows from the project, the level of coupon payments varies according to the performance of the project.

Green (performance-linked) revenue bond

The proceeds of (perforrnance-linked) revenue bond can be used only for green projects and the bond is backed by the future cash flow from the project not by the credibility of issuing company.

Green Bond

The Green Bond market began in June 2007, when the European Investment Bank (EIB) issued the first “Climate Awareness Bond”. The growth of green bond markets have been led by world’s top credits like supranationals, however recently private companies, financial institutions and municipalities are a growing part of green bond markets

Green Bond Principles(GBP)

1. Use of proceeds. Investment in recognized green investment categories.

2. Process for project evaluation and selection: relating to use of effective criteria.

3. Management of proceeds: Segregation of funds or appropriate tracking of the flow of funds.

4. Reporting/assurance: Disclosure and verification pre- and post-issuance

Municipal Green Bonds (green revenue bond) are issued by state and local governments to fund LCR infrastructure projects. These are not currently a large part of the overall municipal bond market issuance, but recently have gained significant portion because municipalities (hometowns) have vast investment needs for LCR infrastructure.

Convertible (Performance Linked) Bond (1)

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Sources: Hyun, Nishizawa, Yoshino (2008), “Exploring the Use of Revenue Bond for Infrastructure Financing in Asia” JBIC Institute

The return of convertible revenue bond depends on the success of the project.

Convertible (Performance Linked) Bond (2)

Convertible Bond: from fixed to variable interest rate

-This performance-linked variable coupon mechanism(convertible bond), uniquely proposed with characteristics of equity in part, gives investors incentives to closely monitor the project performance that determines the level of interest earnings for the investors.

- To introduce such mechanism in practice, the additional interest payments should be tied to a set of variables to represent the performance of the project.

- However, such a contingent interest arrangement to link the performance of a project with the variable coupon rate should be carefully designed, for example, not to undermine the motivating factor, such as upside potential, for investors to provide equity capital. Perhaps, a maximum rate needs to be specified to establish a ceiling on the performance-linked variable coupon rate.

Debt-Equity Swap Option

- Debt(loans, bonds) is converted into equity to improve the balance sheet of the project. Converting debt into equity reduces the debt/equity ration of a project. The operator manage better its debt and improve cash flow.

Impediments to Green Revenue Bond Financing

Complexity of LCR

projects

Special risks inherent in

LCR projects

Cyclicality of bond

market

development

Lack of depth and

liquidity of onshore

LCY bond markets

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Lack of institutional investor base

Lack of clear definition of ‘green’ project

Environment for Green Revenue Bonds

• Economic Size (GDP) • Reduced Inflation

• Economic Development • Fiscal Stabilization

Macroeconomic Fundamentals

• Banking Sector • Stable FX Market

Financial Market

• Disclosure Index • Property index

• Corruption index • Investment Freedom

Institutional Settings

14

Step 1

• Empirically examine the determinants of green bond market development

Step 2

• Identify the main opportunities and challenges of green bond market development

Further Study

Green HIT Funds

3

Benefits of HIT Funds (Yoshino,2013)

HIT funds can reinforce financial stability by reducing information asymmetric problems, transparency and risk sharing between borrowers and lenders.

HIT funders can monitor the use of proceeds of green bonds with more information of given projects based in their hometown.

HIT funds can supply risk capital as an alternative source of funding because the Basel III prevents banks from making new loans by applying a high risk weight to long-term and risky loans for infrastructure projects.

HIT funders can choose the projects based in their hometown so they are seeking environment protection, poverty reduction, disaster recovery and etc in their hometown as well as financial return.

HIT Funds in Emerging Markets

The idea of HIT can be directly applied to community-based LCR projects in emerging markets. However it has some limitation to implement because of narrow investor base and lack of financial instruments (trust fund) in emerging markets.

Infrastructure investors tend to invest in their home region because asymmetric information results from the projects outside their home region. However, recently some infrastructure funds and pension funds are taking on more emerging markets projects to find more deals and higher returns under the low interest rate environment.

Therefore the idea of HIT fund can be applied in emerging markets by utilizing high savings of Japanese households whose financial assets have amounted to 1,746 trillion yen as of June 2016.

Also HIT bond funds targeting revenue bonds related to LCR projects such as renewable energy and energy efficiency projects can be established because Japanese retail investors have already invested into green uridashi bonds denominated in foreign currencies. The fund seeks to provide innovative financing in the form of revenue bonds to LCR projects based in their hometown. Issuers should build the credibility with investors by managing properly the proceeds of green bonds.

Green Uridashi Bond

Eurobond directed to Japanese retail investors and denominated in usually foreign currencies are called ‘uridashi’. Green bonds designed for Japanese retail investors (Uridashi green bonds) have been popular in Japan.

178.86

10.96 8.76

91.67

394.72

2010 2012 2014 2015 2016

Deal Total Value (million $)

Sources: Dealogic

AUD 12%

BRL 52%

IDR 6%

INR 6%

NZD 5%

RUB 1%

TRY 9%

ZAR 9%

Currency Type

Sources: Dealogic

Feasible Scheme in Asia (1)

Institutional Investors

(pension fund, insurance

company etc)

Green Revenue

Bond (Uridashi)

Company

MDB(ADB, AIIB)

Government bank

Overseas LCR

Infrastructure Project

JPY JPY

Asian LCY

Swap Counterparty/ Financial Institutions Guarantee/

Swap Contract

19

HIT Fund for Green Bond

H O U S E H O L D

(1,746 trillion

yen, June 2016)

Feasible Scheme in Asia (2)

Institutional Investors

(pension fund, insurance

company etc)

Green Revenue

Bond Company

MDB(ADB, AIIB)

Government bank

Overseas LCR

Infrastructure Project

JPY JPY

Asian LCY

Swap Counterparty/ Financial Institutions Guarantee/

Swap Contract

20

Green HIT Fund

H O U S E H O L D

(1,746 trillion

yen, June 2016)

Direct Investment (Equity) Asian LCY

JPY

Database providing information on bankable

projects

Guarantee/ Swap Contract

Summary

4

Summary

Capital market can bridge the financing gap for LCR infrastructure by using innovative financial solutions such as green revenue bond and green HIT fund since the Basel III makes banks more reluctant to long-term and risky loan for LCR infrastructure.

Hometowners with more information of local projects based in their hometown are more willing to finance LCR projects by assessing easily risk and return of the projects due to proximity of given projects.

The emergence of institutional investors (including HIT funds) and retail investor(green uridashi bond) will further spur the development of green bond markets.

Public initiative, innovative financial instruments, data provision to mitigate asymmetric information, and active private sector participation(institutional investors, diversified issuers) can help to close the financing gap of LCR infrastructure.

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Thank You!