> GAMOW:
Game Theory, Green Cred and the Challenge of Financing the Future By Floriane Maman, Ian R Cherradi and Claudia Hitaj
A green transition of finance to support the UN’s Sustainable Development Goals (SDGs) in emerging economies.
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umankind faces a historical challenge in climate change: the way we have done business for the past decades hinders our efforts to reduce carbon emissions and preserve ecosystems.
There is a disconnect between economy, finance and environment: traditional practices and behaviours in all sectors do not permit the swift, collective action needed. Carbon-neutral, and even carbon-negative, projects are one solution — but their financing faces two challenges: designing and developing them at a reasonable cost, and avoiding the pitfall of “greenwashing”, when the green characteristic of a project is lip-service. And these challenges are even greater in emerging economies due to local conditions, the lack of transparent data, and the capacity gap.
Figure 1: Reductions in environmental impacts per 1 million EUR achieved by different renewable energy technologies, on average across a selection of green bonds. Note: NMVOC – non-methane volatile organic compound, Fe-eq – iron equivalent, CHP – combined heat and power (only biomass-fueled CHP plants were considered). Average environmental impact, measured in positive contributions to the reduction of the relevant metrics
Where there is political will and a strategic interest from stakeholders, improvements in environmental performance can be achieved without additional cost. Thanks to a collaboration between architects, engineers, financial and public stakeholders, the construction of the Siemens Middle East headquarters in Masdar, Abu Dhabi, avoided over 90 percent of carbon emissions for the same cost per square metre as a typical UAE HQ. The advent of green finance can be likened to the adoption of a new set of rules to include environmental, social, and governance aspects in financial decisions. Success requires the cooperation of different players. Game theory can shed light on some of these behavioural relationships. GAMOW outlines (in Figure 2) some possible rules, finding inspiration in a traditional Indian game called Pachisi. For green finance to play a successful role, a legal and practical framework must be established. It should offer preferential rates of return and other rewards to those genuinely heading towards zerocarbon emission projects. With that framework defined, the judiciary could allow class actions against greenwashing. 184
per 1 million EUR, for 61 renewable energy projects in 29 countries over the 2015-18 period. Source: LIST
The most telling legal example to date is that of climate activists who had occupied Credit Suisse premises and were escaped penalty because of their motivation. Structural issues need to be addressed to support the growth of green bonds in emerging economies, which have reached $500bn. Issued mainly in Europe, led by the Luxemburg stock exchange, along with Paris, London and Frankfurt, the potential size of the market is estimated at $100tn. This momentum is maintained by increasing demand from institutional investors and pension funds eager to add a climate purpose to their portfolio. Some issues remain. Climate solutions can carry technical risks for investors, since they can take the form of disruptive innovation, or require scaling-up in the case of locally sourced solutions. Counterparty risk, legal risk and credit rating come into play in emerging economies. Green bonds are well suited for long-term, risk-averse institutional investors. However, these investors face fiduciary constraints that allow them to CFI.co | Capital Finance International
choose only investment-grade bonds that are rated equal to, or better than, BBB- in Standard & Poor’s scale and Baa3 in Moody’s. Green bonds are financially similar to conventional bonds. They are priced according to the issuer’s yield curve. (The yield of a green bond for a certain maturity will be the same as the yield of other bonds issued by the same entity for this specific maturity.) In addition, the green bond’s likelihood of credit default is assessed as the risk of default of the issuer, with the bondholder getting access to the balance sheet of the issuer in case of default. The credit rating of the green bond is close to that of the issuer. In emerging economies, sovereign bonds are usually rated below investment grade, which excludes them from the green bonds’ issuer group. Several ways exist for bonds financing projects in emerging markets, such as those in Sub-Saharan Africa, to meet the requirements of institutional investors for investment-grade credit profiles. Project credit features could be (temporarily) enhanced by risk-mitigating instruments,