Special Instruments 2024 PDF

Special Instruments Session 5 Impact Investing (7.170), Fall Term 2024, University of St. Gallen Prof. Julian Kölbel Overview Green Bonds Sustainability-Linked Bonds Litigation Finance Blended Finance Green Bonds  Green Bond Market Green...

Special Instruments Session 5 Impact Investing (7.170), Fall Term 2024, University of St. Gallen Prof. Julian Kölbel Overview Green Bonds Sustainability-Linked Bonds Litigation Finance Blended Finance Green Bonds  Green Bond Market Green Bond issuance per year (USD bn) For reference: total bond issuance is about 20 tn USD per year  Ford Motor USD 2.5bn green bond (Nov. ‘22) Proceeds of the bond go into electric vehicle (EV) production Largest green bond issue in the US at the time Ford plans to spend bn 30 USD on EV until 2025 https://www.wsj.com/articles/ford-motor-offers-2-5-billion-green-bond-to-investors-11636413890 Green Bonds “Green Bonds are any type of bond instrument where the proceeds or an equivalent amount will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible Green Projects” Key components to specify: 1. Use of Proceeds clause in the bond contract (proceeds will only finance or re-finance ”green” projects) 2. Process for Project Evaluation and Selection (which projects are ”green”?) 3. Reporting how the proceeds were used https://www.icmagroup.org/assets/documents/Sustainable-finance/2021-updates/Green-Bond-Principles-June-2021-100621.pdf Use of proceeds reporting Once the bond is issued, the issuer must demonstrate a balance of financed project to match the borrowed funds The projects do not need to be new, proceeds can be used to re-finance existing projects For instance, from co- investments in railway infrastructure, savings of 15 million t CO2 p.a. are expected. Projects are not collateral for the bond https://www.deutsche-finanzagentur.de/fileadmin/user_upload/Institutionelle-investoren/green/reports/Green_bond_impact_report_2020.pdf https://www.deutsche-finanzagentur.de/fileadmin/user_upload/Institutionelle-investoren/green/reports/GreenBondAllocationReport_2020_en.pdf Green bonds in the balance sheet Assets Liabilities Plant Property & Equipment Bonds Green Assets Green bonds Cash Equity Etc. Etc. Green bonds need to be balanced by green assets Is there a Greenium? Twin Bunds Two sovereign bunds that are nearly the same in their characteristics (except size) The green twin has a use of proceeds clause Allows to determine the ”greenium” and a yield curve for green EUR securities https://www.deutsche-finanzagentur.de/en/federal-securities/types-of-federal-securities/green-federal-securities/twin-bond-concept (including a slick video with beautiful German Accent)  The Greenium https://www.deutsche-finanzagentur.de/en/federal-securities/factsheet/isin/DE0001030716?cHash=b427cab3cc3a5f84f936a4f23ecbbfb7  Do green bonds have impact? Green bonds often refinance existing green projects, The greenium is small comparing to other factors or finance projects that were already planned determining the cost of capital https://2degrees-investing.org/wp-content/uploads/2020/01/2018-Green-bonds-updated-paper.pdf  Do green bonds have impact? Using a matching approach, Flammer 2021 finds that firms which issue green bonds improve their ESG rating (Refinitiv) reduce carbon emissions Best explanation: green bonds are a signalling device Setting up, and certifying a green bond is costly This costly signal is a way to convince investors that you are serious about going green The greenium seems to be very small for corporates, if it exists at all Flammer, Caroline. 2021. “Corporate Green Bonds.” Journal of Financial Economics (Forthcoming). https://doi.org/10.1016/j.jfineco.2021.01.010. Zerbib, Olivier David. 2019. “The Effect of Pro-Environmental Preferences on Bond Prices: Evidence from Green Bonds.” Journal of Banking & Finance 98: 39–60. https://doi.org/10.1016/j.jbankfin.2018.10.012. Larcker, David F., and Edward M. Watts. 2020. “Where’s the Greenium?” Journal of Accounting and Economics 69 (2): 101312. https://doi.org/10.1016/j.jacceco.2020.101312. Sustainability-Linked Bonds What are Sustainability-Linked Bonds (SLBs)? Two ingredients: SPT: a predetermined sustainability performance target with a date ESG rating level, CO2 emissions, number of female board members, etc. Coupon ratchet: the bonds coupon changes conditional on target status Step-up when target is not reached Step-down when it is reached (less common) SLB Market growth, regional and sector breakdown By year By GICS sector By region Kölbel, Julian F, and Adrien-Paul Lambillon. 2022. “Who Pays for Sustainability? An Analysis of Sustainability-Linked Bonds.” Working Paper. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4007629.  Example: Holcim SLB Sustainability Performance Target (SPT): 475 kilograms of net carbon dioxide per ton of cementitious material per Key Figures: reporting year Holcim Ltd Chart Title (Swiss building materials producer) 700 600 Notional: EUR 850 million 500 Issue Date: 23 November 2020 400 300 Maturity Date: 23 April 2031 200 Coupon: 0.5% p.a. 100 0 Coupon step-up: 0.75% p.a. SPT Date: 31 December 2030 Potential penalty: ~EUR 2.125 million (Notional*step-up*time to maturity, i.e. 850mn * 0.75% * 1/3 year) https://www.holcim.com/sites/holcim/files/documents/lafargeholcim_sustainability-linked_notes_prospectus_19_nov_2020.pdf Do SLBs have impact? Remains to be seen – most of the targets lie in the future. From the corporate side, there is a clear incentive (even though it might be small). Investors sacrifice returns for an agreed-upon impact, or get their money back. The target needs to be ambitious, i.e. beyond what the firm would have done anyways. There are second-party opinions on this matter.  Are SLBs relevant? Three conditions Size of coupon adjustment (e.g. Size of coupon adjustment 25bp) Remaining time to maturity after the adjustment (e.g. 1 year) Ambition level of the target (e.g. reach carbon neutrality by 2030) Remaining time to maturity If one of the three conditions is close to zero, the SLB contract becomes irrelevant. The SLB Premium Based on a matched sample (SLBs versus regular bonds issued by the same company, similar maturity and size) we find an average premium of about 13 bp for the yield on SLBs. The maximum penalty (step-up coupon * remaining maturity/maturity) is on average 10bp It sees that SLB investors “like” SLBs for reasons other than the extra coupon they might gain. Kölbel, Julian F, and Adrien-Paul Lambillon. 2022. “Who Pays for Sustainability? An Analysis of Sustainability-Linked Bonds.” Working Paper. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=4007629. SLBs in practice The CFO of Axpo told me that the company first decided on their renewable energy strategy, and then issued SLBs on that basis. In practice, SLBs are also a signaling device, but one that is more oriented to the future and more suited to “hard-to-abate” sectors. Litigation Finance Litigation Finance Investor provides funds to claimant to pursue a legal interest After subtracting costs for lawyers, investor receive a share of the payout Can be efficient, as claimant may not have the financial resources to pursue claim, even if the case is won Litigation Finance https://www.europarl.europa.eu/RegData/etudes/STUD/2021/662612/EPRS_STU(2021)662612_EN.pdf Impact and litigation finance 15,000 Indonesian seaweed farmers are suing an Australian oil company for allegedly causing an oil spill that destroyed their livelihoods. Litigation fund provides funding to register and bring a class action suit on behalf of these farmers If the case is successful, it might generate tens of millions AUD in compensation (part of which will go to the fund) Immediate impact is on the seaweed farmers. They receive compensation that they may not have had received without the investment. In addition, the company looses resources that might otherwise have had destructive effects elsewhere. There could be an even wider impact by setting a legal precedent, that could serve to avoid future destruction of livelihoods, by other companies. One of a few funds to pursue this is https://www.aristata.co.uk Obviously, the devil is in the details with such deals!!! Blended Finance Blended finance Blended finance is the strategic use of development finance for the mobilisation of additional finance towards sustainable development in developing countries. https://issuu.com/oecd.publishing/docs/amounts-mobilsed-from-the-private-sector-by-dev-fi Blended finance is about structuring https://www.usaid.gov/sites/default/files/documents/1865/BlendedFinanceStarterKit1.pdf The Allianz SDG Loan Fund Mobilization rate 1:9 FMO (Dutch Development Bank) originates loans to developing markets firms in agribusiness, financials, and renewable energy. Fund participates in 100-120 loans from the balance sheet. FMO IM is an independent manager. Proceeds from the loans go to Class A shares first, then to Class B. The 25 million loan guarantee by MacArthur allows FMO to bear greater risk on their 111 million share in the fund. Expected impact: 60k supported jobs and 450kt avoided carbon emissions. SFDR Article 8 Fund More Details: https://www.convergence.finance/resource/SDG-Loan-Fund/view Challenges One big issue for blended finance is that it development banks may be seen as subsidising private investors Another challenge is that development banks may crowd out private investors Nonetheless, the concept holds promise and offers endless opportunities for smart financial engineers…