'Environmental Finance — Private Capital and Private Profits for Public Gain— Pretty Promising, though not without Pain'

Posted On Monday, May 17, 2019 by Abhinav Choudhry under Sustainable Development Uncategorized

‘Environmental finance’, the leveraging of the tools of finance for environmental benefit, has been around for a few years, but it has still not gained currency outside a relatively niche community. In fact, many people I have met, prima facie, regarded the term to be oxymoronic even though they were often quite intrigued by it. In this essay, I touch on the motivations behind environmental finance and illustrate with a hypothetical example how it could provide win-win solutions. I also aim at reconciling the very gung-ho view with the more sceptical opinion.

Genesis lies in the tragedy of the commons

Larger social, environmental or governance issues often suffer from the classic tragedy of the commons problem (Hardin 1968). Shared resources are not used optimally because the individual’s selfish gain is at odds with what’s best for the community as a whole. Fisheries are the most tragic example of this problem. The population curve of fish is shaped in a way such that as long as the population of fish remains above a certain threshold, literally called the maximum sustainable yield, fishing populations can be harvested sustainably and yield the maximum fish catch (Gordon 1954; Schaefer 1954). However, an individual fisherman has incentive to fish much beyond these levels, even to extinction, because his personal profits increase with every extra fish caught. No wonder that natural fisheries across the world lie in the overfished zone and current fish catches are far less than the maximum sustainable yield. Generations of future benefits have been lost for trifling gains. The public sector attempts to resolve this dilemma by allocating resources for the public good. This suffers from two problems:

  • The public sector is notoriously inefficient.
  • Public sector financial resources are generally insufficient.

Inefficiency often leads to insufficiency.

Environmental finance attacks both of these problems. It channels the ingenuity and efficiency of the private sector, and mobilizes its enormous resources. The risk bearing capacity of global financial markets is also higher than that for many governments, especially those of less developed nations. Public sector investment of $96 billion in climate change mitigation and adaptation was dwarfed by the investment from the private sector - $268 billion. Yet, this is a far cry from the trillions of dollars of annual investment estimated for climate change mitigation and adaptation (World Economic Forum 2013). While the jury may be out as to the quantum of investment needed for solving larger environmental issues but there is no doubt that existing public sector and philanthropic capital is inadequate.

Why would the private sector be interested?

Firstly, there is an abundance of capital seeking new investment opportunities. This has been especially true for the past few years because of the crash in interest rates of low-risk bonds (this is arguably one big reason for the runaway rally in US equities). Environmental finance provides an alternative investment avenue that quite often diversifies away the systemic risk in investor portfolios. In addition, product or service companies are increasingly regarding corporate social responsibility to be an intrinsic part of their core brand, and this has occurred to a large extent because of increasing environmental and social consciousness among consumers. In other words, the investment is worth a lot more than its monetary value.

Structuring the solution

The trick is to align the incentives of the private sector with larger environmental goals. This could occur in several ways. An extremely simple example is telling investors to invest in bonds for social or environmental benefit now and paying them systematically out of future government budgets, and such thinking spawned the first social impact bonds (Keohane and Saadia Madsbjerg 2016). Private Investors could also invest in stocks or bonds of companies following green practices, or could directly invest in projects with defined environmental outcomes. The very ‘vanilla’ ‘green bonds’ which are normal bonds but issued for a defined environmental objective, are already a $200B market (Sharma 2019).

Environmental Impact Bonds (EIB) go a step further and truly illustrate the potential of finance. Goldman Sachs and Calvert Foundation created the DC Water Environmental Impact Bond in 2016 that combines green infrastructure with a pay-for-performance mechanism. In this case, the green infrastructure consists of natural vegetation and soils that could deal with stormwater runoff much more cheaply and effectively than conventional stormwater infrastructure. The private investors would be responsible for implementing the project, and the government authority, DC Water and Sewer Authority, would pay them based on the actual runoff reduction achieved (DC Water 2016). Since then, there have been two other major EIB issuances, a Forest Resilience Bond in 2018 aimed at forest fire management (Blue Forest Conservation 2018), and the first publicly-issued EIB in Atlanta aimed at watershed management (Quantified Ventures 2019).

A hypothetical avoided-costs scenario

A hypothetical scenario could help explain how environmental finance could help solve shared resource problems. Let’s say a company X is capable of creating a machine to purify a large water body such as a lake or river. Today, the only way forward would be for the company to be financed by the government for this undertaking. However, environmental finance shows another way, which with the right structuring of cash flows could produce a win-win. This happens because poor water quality has dollar costs. These are:

  • 1. Direct expenditure of cleaning up water bodies: The Greater Cincinnati Water Works was spending $7500 a day to remove harmful toxins from the Ohio River (Wolf and Klaiber 2016).
  • 2. Direct expenditure of medical expenses: Bad water could make people ill and these costs are either borne by individuals, insurance companies or the government.
  • 3. Real estate prices are lowered: Real estate next to beaches or lakes is typically valued higher. This price premium could fall sharply if a water body suffers from visible pollution, as in the case of Harmful Algal Blooms (Wolf and Klaiber 2016).
  • 4. Loss of tourism and recreational revenue: Businesses relying on the people visiting the water body lose out on revenue. The overall economy of the area suffers.

Thus, one could save a lot of future money by taking some preventative action now. As the effect is spread disproportionately and across multiple groups, we could adopt the same solution here as used in insurance: pooling. There are numerous possibilities even in our simple example. Local homeowners or business associations could pay for the purification work directly just as if they were paying insurance premia, or other private investors could pay for it and collect money from the avoided costs over time. Investment bankers could leverage the ample tools of finance: options, government guarantees, insurance and tiered payment structures to structure this transaction to our convenience. Having different representative stakeholders working together is key to practical success.

There is indeed a lot of low hanging fruit in terms of practices which might actually increase the pool of available resources for all and produce win-wins. Sustainable agriculture, sustainable fisheries, renewable energy, green infrastructure - there are a lot of practices which are incredibly beneficial for society but as the benefits accrue to people at large, it is often infeasible to process individual consumer transactions. The government can represent the individual customer and help solve this problem. It can also act as a financial partner. This ‘blended finance’ is already practised through development financial institutions in regular infrastructure projects. In environmental finance, governmental financial support is strategic, usually not expected to be substantial (is often a guarantee), and is sometimes conditional, but its very presence helps attract greater volumes of private capital.

Why are these win-wins not happening more often then?

There are practical complexities regarding rights, jurisdiction, and so forth which make the designing of financial incentives complex. From a pure finance perspective, cash flow unpredictability is the biggest problem. An investor has to recover capital within a finite time horizon and also has liquidity concerns and the realization of returns cannot be left completely to the vagaries of often uncontrollable factors in complex ecological systems. The estimates for the value of environmental services and avoided costs also vary widely. It is a challenging undertaking to design a cash flow structure that incentivizes good practices but is flexible and recognizes that uncontrollable factors may influence actual impact. A notable related concept that has run into similar problems is payment for environmental services (PES), in which practices are encouraged with explicit payments. Though Costa Rica’s forest conservation program has shown success with this concept, the idea has stalled elsewhere because the ecosystem services are valued very differently by different actors. There is no price discovery mechanism, as in a market and this has restricted practical application (Pattanayak, Wunder, and Ferraro 2010).

Another issue is the inherent lag in the realization of tangible benefits from sound environmental practices. This necessitates using intermediate metrics, at best, to evaluate performance, and their scientific validity could be subjective. This adversely affects pay-for-performance designs. Badly designed performance indicators could, on the one hand, reward ineffective practices, or on the other hand not reward good practices. The right metrics to use is a scientific question particular to the environmental objective. USA and Canada may have explicitly specified nutrient loading targets to reduce pollution in the Great Lakes under ‘The Great Lakes Water Quality Agreement’ (Government of Canada and the Government of the United States 2012) but that is only a final target which would need action to bear fruit. Measuring the quality of such action is technologically difficult (as in the case of non-point sources of pollution). Agricultural best management practices may very well reduce nutrient runoff to nothing and yet, it may not be measurable in a short monitoring period (Mulla et al. 2008; Meals and Dressing 2008). This measurement aspect is far less acute for social impact bonds; bonds targeted at reducing prisoner recidivism are a prime example.

Technology, and policy would lead the way

With smart technology, monitoring and surveillance costs are likely to fall sharply in the future. This could bring accountability to the use of environmental resources. It would be far easier to measure how much harm or benefit someone is causing to the environment. With aggregated data, one could finally come closer to developing an effective mechanism to put a price on it. This could be a game changer for environmental finance. The elephant in the room is government policy. Legislative support is cardinal for providing the framework in which environmental finance could thrive. As environmental projects would only show benefits over time horizons that could span several government terms, election-cycle focused politicians would not be enough. It may be too much to ask for, but one should prefer to be optimistic.

Many do not like the idea of putting a price on the environment and profiting from it. I contend that profiting from actions that bring benefits to the community in general, as happens in environmental finance, seems to be the ideal type of profit. Resources are going to be exploited whether we like it or not and when we deem a common resource as something that ‘cannot be valued’, we risk giving it a null value.

The world can hope for more altruism, but not depend on it.

References

Abhinav Choudhry

Abhinav Choudhry is currently working with Tata Cornell Institute at the Cornell SC Johnson College of Business, Cornell University on topics at the intersection of agriculture and its relationship to public health. Abhinav graduated with a Master of Public Administration degree from Cornell University with a concentration in Environmental Policy and also completed a fellowship program in Environmental Finance and Impact Investing. In 2017, he worked with the Environmental Defense Fund in California, the USA on projects aimed at finding conservation finance solutions for mitigating greenhouse gas pollution and agricultural runoff. He has also consulted for a startup solar energy company in Nigeria in 2018.

Abhinav has a Masters in Finance & Control from the University of Delhi and a Bachelors in Computer Science Engineering. Before concentrating on issues relating to sustainable development, he accrued over four years of experience in finance in the private sector, working with Citibank and Nestle in India.

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