What would a “Natural Capital Bond” look like?

What would a “Natural Capital Bond” look like?

There is increasing interest in developing financing mechanisms for preserving, restoring, or the sustainable development of natural capital. One notion being advanced, although perhaps in a not particularly systematic or informed way, has been the issuance of Natural Capital Bonds, the proceeds of which could be used for the above purposes.

The frame of reference for this concept seems to be Green Bonds, which have enjoyed considerably popularity in bond markets over the past decade, particularly in the past five years following the issuance of the first corporate (as opposed to, say, sovereign or supranational) Green Bonds. Green Bonds are bonds–obviously–that are issued by a wide range of entities. These include sovereign governments, corporations, municipalities (especially in the US, where the overall municipal bond market is nearly $3.8 trillion), supranational organizations such as The World Bank, and a range of financial entities. Unlike the proceeds of most bond issues, which can be used for a wide range of purposes, Green Bonds are characterized by a pledge by the issuer to apply the proceeds to some Green activity. Often this is well defined in the offering literature; sometimes it is completely undefined. In spite of lots of discussion of Green Bonds standards, the bond market has actually remained pretty relaxed about what can be called Green in this context–it proves to be a wide range of projects, activities, and purposes. In some cases Green Bonds have been issued simply to refinance the acquisition of, for example, wind farms.

The Green Bond Market has been growing robustly over the past decade. In spite of Green Bonds representing only a small percentage (<2%) of global bond markets, they have proved to be an attractive vehicle for both issuers and investors. Over $150 billion of Green Bonds were issued globally in 2017, and that amount may double in 2018.

However, there are some aspects of Green Bonds that deserve comment. First, they’re bonds. From a legal or technical standpoint, there is no difference between a Green Bond and a vanilla bond of the same issuer–they are identical in all respects other than the use of proceeds (and the verification process that often accompanies issuance–a promise to certify that the proceeds are being used as intended.) Another way to characterize Green Bonds, then, is to say they represent the same legal claims on the issuer as any other bond. They are often issued in size, and the size of Green Bond issues can range from, say, €10 million to over a billion. And, like vanilla bonds, bond buyers receive regular interest payments, and their principal back upon maturity. These payments normally come from a range of sources–cash flows in the case of corporations, taxes or other dedicated revenues in the case of governments, aggregated loan repayments in the case of asset-backed securities.

In fact, the only difference between Green and vanilla bonds of the same issuer is this targeted use of proceeds. There is, of course, considerable discussion over the issue of what “Green” actually means. Unsurprisingly, this discussion seems set to continue. It is also important to recognize that these are general unsecured obligations, just as most bonds are. There is no dedicated set of “Green” cash flows underlying the repayment of Green Bonds. In fact, with some specific exceptions (asset-backed bonds), interest and principal payments of Green Bonds come from the same pool of money that other bond repayments come from. Most Green Bonds are not “project bonds,” with a dedicated stream of cash flows devoted solely to bond repayments. Moreover, funds raised by Green Bonds aren’t necessarily the funds spent on the targeted projects. In many cases, the funds raised by Green Bonds go into the big pot of money managed by corporate Treasurers, and the funds for the targeted projects come out of this pot. But it’s not necessarily the same funds.

All of the above suggests that Green Bonds may not be the appropriate model for the concept of issuing bonds for Natural Capital purposes, either its preservation or restoration, or its sustainable use. Natural capital in and of itself does not generate cash flows–and these are necessary to service payments to the people who buy the bonds. In the case of Green Bonds, these can derive from a variety of sources, as noted earlier. But for Natural Capital to generate such cash streams in the first place, something must be done to it, and this may be contrary to the desired effect of preservation or restoration.

There have been some creative attempts to get around this problem. The International Finance Corporation has issued what are called “forest bonds,” where the proceeds are being used for forest conservation in Kenya. In this case, interest is being paid in the form of cash or carbon credits. Even here, though, there was a need for additional support–from BHP, a large mining company, which pays the cash interest. Moreover, the principal will be paid upon maturity by the IFC–not Kenya, where the forests in question are being restored. Thus far, however, this remains the only substantial such deal.

Another approach has been to potentially rely on tourism and use revenues, as has been considered for “reef bonds,” where bond proceeds would help maintain the Great Barrier Reef. In this case, interest would be generated from tourist revenues and fees from users of the reef. How workable this concept might be remains to be seen, however, and it’s unclear how much reliance can be placed on the tourist trade in the event of natural catastrophes such as significant weather events, as Caribbean nations can testify. Moreover, supporting the growth of the tourist trade is not necessarily the best idea in terms of trying to reduce carbon generation–although, in the case of the Great Barrier Reef, that tourism is already taking place.

Another approach, used recently with agriculture in several countries, has been to aggregate the production of small landholders into meaningful cash streams to pay interest and principal on loans. The approach here is hardly novel–the global securitization market does the same thing, in substantial scale. This has been tested successfully in several markets. However, the scope of these projects is invariably small and local, and it’s not clear that these can be scaled up sufficiently to materially address large-scale natural capital preservation and restoration.

Finally, there has been some progress in developing “resilience bonds,’ where the proceeds are to be used for developing some resilience to natural catastrophes such as floods and storms–primarily through the funding of infrastructure projects. However, it is not a major leap to consider natural capital restoration as having equivalent value–replanting coastal mangroves in flood-prone countries, for example. The end goal here is not principally natural capital restoration or preservation–it’s mainly to reduce insurance losses in the event of catastrophes. And again, it’s unlikely that potentially affected countries can issue such bonds on their own–it’s insurance companies that issue such bonds, with reduced premiums to areas that adopt the mitigation measures to reduce damage costs. We have yet to see this concept applied to natural capital restoration but it could be–but it requires a third party issuer. Nonetheless, the concept of “natural infrastructure” has been gaining some currency, as a recent report from WRI can attest.

This creates something of a conundrum. In many cases, the whole point of raising funds for Natural Capital is simply to preserve, or restore, some Natural Capital that actually exists, not to develop it. These funds must come from elsewhere, then. Which suggests that the logical issuers of something that could be called a Natural Capital Bond is likely to be either a government or a supranational organization (such as the IFC) at some level. Private corporations on their own are unlikely to issue and service debt that is not going to contribute to cash flow generation.

If this is the case, why bother with issuing special debt for Natural Capital preservation, or restoration in the first place? Rather, it would surely be more economical for governments simply to get on with the job directly, and to fund these activities from general (or targeted) tax revenues, or from external sources such as NGOs or supranational organizations.

And yet, and yet….even though Green Bonds are still a very, very small subset of the global bond market, there is virtually no one who works in finance these days who doesn’t know what a Green Bond is, or what it’s used for. Hardly a day goes by without some media coverage of some Green Bond, or the Green Bond market. Five years ago this was a novel concept to anyone who hadn’t bought one from The World Bank or the EIB. Today, Green Bond issuance is such a regular event it often passes un-noticed, even by sub-investment grade emerging market sovereigns. “Green Finance” has become a hot topic, and is now seen as a necessary concept for any transition to a lower carbon world, driven by perceptions of the scale and scope of the financing that needs to take place in order to fund such a transition. “Green Bonds” is not only a useful concept to describe a wide range of bonds; it has now become an embedded concept in financial markets.

So perhaps there is, indeed, an argument for the issuance of some Natural Capital Bonds, from national governments, or entities such as the International Finance Corporation or other supranational organizations. If such issuance does for Natural Capital what Green Bonds has done for perceptions of the desirability, indeed the necessity, of developing financing tools for a “Green Transition,” then this should be actively encouraged, indeed applauded. Quick, someone call France!

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