Bretton Woods Committee | Thu, Feb 1, 2024
The purpose of this article is to make the case for the establishment of a new financial guarantee company (referred to as Global Climate Guarantee Company or “GCGC”) that would facilitate and scale up private sector debt financing of climate and sustainable infrastructure projects globally.
Estimates of global financing requirements for climate mitigation and adaptation are staggering and beyond the capacity of Multilateral Development Banks (“MDBs”) and governments – both in developing and developed countries. Sufficient climate related financing is not currently available as public resources are insufficient and most private investors remain risk averse to climate-related finance. However, the growth of the trillion-dollar green bond market, which Scandinavian institutional investors (via SEB) and World Bank pioneered as recently as 2008, shows that there is appetite among private investors to invest in climate-related finance. This appetite would be substantially increased if investments could be adequately “de-risked” via a highly rated entity such as GCGC.
There are a wide range of estimates over different time frames of overall climate financing needs. But it is indisputable that the estimated funding shortfall is very large. For example, according to a November 2022 report from the Rockefeller Foundation and Boston Consulting Group (BCG), “To achieve net zero, public and private sector entities across the globe will need approximately $3.8 trillion in annual investment flows [equivalent to 3.8 percent of global GDP] through 2025. But only a fraction of this capital is currently being deployed.”
The IFC projected climate investment opportunities across ten distinct sectors between 2020 and 2030 in 21 emerging markets totals $10.2 trillion, excluding two sectors that the IFC does not break out by region (nature-based urban infrastructure and reinventing textile and apparel value chains). The IFC estimates an additional $1trillion for each of these two sectors by 2030 or over $12 billion or $1.2 trillion annually.
Considering the vast sums required, it is imperative that the investment risks are sufficiently attractive to enable enhanced participation by the private sector.
COP28 FAVORS DERISKING VIA GUARANTEES
In a welcome development, COP28 endorsed increased attention to guarantees and insurance from MDBs and development finance institutions (DFIs) to attract private investment in climate finance. This was via a Joint Declaration of the participating MDBs/DFIs, reinforced by Statements of Support from the re/insurance market participants and the V20 Chair. The Joint Declaration called for a Task Force (anchored by Nature Finance in conjunction with IADB and DFC) on Sustainability-Linked Sovereign Financing for Nature and Climate to scale up climate and nature-linked financing by sovereigns and other public sector entities with more effective credit enhancement instruments.
While COP28 encouragement may lead MDBs and DFIs to increase accessibility and affordability of their guarantees, their history on guarantees is not encouraging. First, MDB partial credit and partial risk guarantees are complex -- being bespoke -- and therefore difficult to scale up. Second, MDBs are culturally suspicious of the private sector and seek to ensure – rightly – that public funds are not abused for private profit. Therefore, we propose a public private partnership that has both the precedents and the potential for much greater and faster scale.
The capital markets have used financial guarantees to raise substantial funds for projects in both developed and developing countries. A financial guarantee company for Asian markets was established in 1995 (the author was one of its founders and directors) and operated for several years before the Asian financial crisis. Another was established in 2005 and has operated successfully ever since, and a third is in the process of being formed. But to date, these do not offer sufficient scale for the climate challenge.
Private sector financial guarantees, particularly “full wraps” have achieved scale. At their height, before the financial crisis of 2008, they fostered some $3 trillion in guaranteed financings and continue to be used today albeit on a relatively reduced scale of under $1 trillion, mainly in the US and Europe. Their guarantees foster substantial private investment because their structures are simple for investors to understand as the full principal and interest are guaranteed as to timely repayment. The proposed Global Climate Guarantee Company would aim to provide such guarantees with single-A (or higher) ratings for public and private sector climate projects -- and other sustainable infrastructure -- in developing countries.
To guarantee 1% of the financing needs referenced in the Rockefeller Foundation and BCG report (or 3.3 % of the IFC projections), the company would require $40 billion of guarantee capacity. If it is successful, the company could grow rapidly by an order of magnitude. Its capital base, governance, leverage, risk management, use of reinsurance and other forms of risk sharing would be designed to (i) achieve the target single-A (or better) rating, (ii) support the expected portfolio composition; and (iii) meet shareholder preferences. Its capital would be sourced from both the public sector (potentially MDBs and DFIs) and the private sector. Depending on company leverage and reinsurance capacity used, the capital needed could be approximately $4-6 billion (or less with higher leverage). Some of the capital could be drawn over time as the portfolio increases. Liquidity risks would be mitigated with the use of non-accelerable guarantees, as is customary in the financial guarantee industry.
FEASIBILITY DEPENDS ON GETTING TRANSACTIONS TO INVESTMENT GRADE FIRST
It is fair to ask if GCGC is a pipedream. To establish its feasibility, the author – himself a pioneer in the industry - has nonetheless discussed the matter with current and former senior monoline industry officials -- including one current CEO. They have reminded him – as he knows well - that such a new monoline presupposes a programmatic, timely and sustainable mechanism to bring transactions GCGC guarantees up to an investment grade standard before the guarantee. This ironclad requirement is rooted not only in the financial guarantor business model but also in rating agency rating criteria. If this is done, we are highly confident that a GCGC can be established.
How to get to an investment grade standard (particularly on political risks) before the guarantee? There are several options but to date they have lacked scale.
Consider a hypothetical climate debt transaction. Say, it has an equity tranche and two debt tranches. The equity and the junior debt tranche absorb the first loss. If their combined effect provides sufficient first loss, the senior tranche could reach an investment grade standard (say BBB or BBB-). Then it can attract a GCGC financial guarantee. With a single-A (or higher) rating, the senior tranche can be sold to investors worldwide in days or even hours.
The diagram shows potential sources of first loss to achieve investment grade. One option is for the project sponsor to invest in the junior tranche. This is possible but not likely as the sponsor is already heavily invested in the equity tranche. A second option is for the country for which the project is being done (or a donor to that country) to fund the junior tranche. But neither the poor country nor its donors are likely to have sufficient resources for this purpose. Indeed, this is the reason why private capital is needed. A third option is for high yield investors to fund the junior tranche or for political risk insurers to cover the risks. This is already feasible but to date it has lacked scale.
So, it is no surprise that COP28 has urged MDBs and DFIs to improve upon their guarantees. They can and should work with the private sector to build scale within their own understandable capital and leverage constraints.
Consider two ways in which MDBs and DFIs could help, only one of which can achieve scale. One possible method of working with the private sector is “deal-by-deal”. An MDB or DFI individually or jointly with another DFI or MDB buys the junior tranche. This raises the senior tranche to investment grade, permitting a private market financial guarantee. For example, a regional MDB might buy the junior tranche of a renewable energy project in Costa Rica, providing sufficient first loss cover so GCGC can “wrap” the deal by guaranteeing the timely payment of principal and interest on the senior tranche. Then the senior tranche can be sold to investors in volume. The deal-by-deal approach can also allow MDBs and DFIs to securitize their existing loans, as has been done, e.g., by the African Development Bank. But the deal-by-deal approach – which has been available for decades – has lacked scale.
We urgently need a new programmatic MDB/DFI option to get to investment grade, particularly with respect to political risks, with both efficiency and speed. Then a GCGC guarantee could raise the transactions up to Single-A (if not a double-A) by bearing the commercial, structuring, and financial risks for faster capital markets execution.
Why do this? To achieve scale. While the balance sheet leverage of MDBs on loans is generally one-to-one, their guarantees can be leveraged in the case of some MDBs (e.g., for internal country envelop allocations) up to 4 times. A financial guarantee company’s leverage (its gross par insured versus its claims paying resources) could be a significantly higher -- though not as high as 100 times, which is not atypical for a developed market financial guarantor.
MDB/DFI CONSULTATIVE PROCESS UNDERWAY ON THEIR GUARANTEES HOLDS THE KEY
The consultative process anchored by Nature Finance post-COP28 will include a dozen MDBs and DFIs that provide guarantees. That forum should consider the establishment of the proposed programmatic facility to bring emerging markets transactions to investment grade. If this is done reliably and in size, it is likely that a company like GCGC can be formed to help raise tens of billions -- and in time hundreds of billions -- for climate projects.
 The largest MDB guarantor, MIGA, has a gross outstanding guarantee exposure of $27.9 billion with a net exposure of less than a half of this: $9 billion (see its June 2023 Financial Statement, p. 18). The second largest is IFC at about $5 billion.
Mr. Kotecha is President and founder of Structured Credit International Corp. (SCIC), which provides financial advisory services on ratings and capital markets access for emerging markets and other clients. Prior to forming SCIC, he worked for ten years at MBIA Insurance Corporation and CapMAC Asia as Managing Director and as an Alternate Director for ASIA Ltd. Mr. Kotecha helped establish ASIA Ltd in Singapore and ABS Finance in Indonesia. Mr. Kotecha holds a Master's degree in management from the Sloan School of Management at MIT (1974), and a Bachelor's degree in physics and engineering from Harvey Mudd College in Claremont (1970), California.