SPECIAL REPORT: finance in the age of covid
At this moment in time, Latin American markets and economies are flashing red, yellow and orange. It is likely that investors will be looking to cement green financing into their portfolios as the world emerges from the ashes of COVID-19.
by Jo Bruni
The coronavirus epidemic could set off an unprecedented flow of private resources towards ESG (environmental, social, governance) assets in Latin America as the region’s governments gear up for economic reconstruction while accounting for climate change.
However, governments will face the challenge of economic reconstruction with depleted budgets. Already in a weak state, budgets and savings have been further undermined by economic stagnation at a time when increased spending on pandemic mitigation is required. Compounding the fiscal pressure is the collapse of tax revenue collected from key regional sectors, including tourism, commodities and remittances.
Capital expenditures by governments are likely to be further restricted by the need to counter political unrest in devastated economies, just as climate change threatens the region’s fisheries, agriculture, coastal infrastructure, tourism and public health sectors.
“Investors are seeking a return that is less correlated to traditional investments...In the Caribbean and Central America, we are looking at returns somewhere between 10 and maybe 15 percent for renewables.”
MARTIN VOGT, MANAGING DIRECTOR, MPC RENEWABLE ENERGIES
Private participation in ESG investing won’t just be necessary, analysts and market players say. Rather, it will be essential, and likely more attractive, as opportunities grow along with resources to meet these challenges.
RENEWABLE APPEAL
MPC Capital, a German-based global manager of real asset investments is betting on growth in renewable energy investment in Latin America and the Caribbean in the aftermath of COVID-19.
The low interest rate environment, greater price volatility and subdued returns in standard portfolios is triggering increased interest in renewable energy.
“Investors are seeking a return that is less correlated to traditional investments,” said Martin Vogt, Managing Director at MPC Renewable Energies. “In the Caribbean and Central America, we are looking at returns somewhere between 10 and maybe 15 percent for renewables.”
Also, the renewable energy sector is maturing, which means that the risk premium put on top of the considerations to make an investment is going down significantly, Vogt said.
Demand for renewable energy in the region is expected grow as evidence of climate change mounts.
“Decentralized generation through smaller renewable energy generation units are less vulnerable to hurricanes,” Vogt said.
These systems bring the consumer closer to the source of generation. They also decrease the odds of whole systems collapsing in case one power center falls apart.
Institutional investors should also be looking for opportunities in renewable energy projects involving long-term power purchase agreements with international manufacturers, Vogt said. These companies are seeking more reliable power supply in Latin American countries, where grids are often unstable, through standalone generation that also contribute to lowering the amount of carbon in the air.
SUSTAINABLE TRANSPORTATION
In a region with weak public transportation links, an emphasis on infrastructure investment to both boost usage and help the environment will require more financing.
“Investment in sustainable infrastructure will require the private sector to kick in,” said María Tapia, lead climate change specialist at the Inter-American Development Bank, referring to what will come after the coronavirus crisis.
Governments will come out of COVID-19 with reduced fiscal capacity and with a need to focus on social expenditures, making private investment in infrastructure more important in the years to come.
“About 5% or 6% of gross domestic product in annual investment is the amount necessary to cover the infrastructure gap in the region, but in Latin America this number is at 2%, and this is getting worse,” said Ángel Cárdenas, director of infrastructure projects for the south region at CAF, the development bank for Latin America.
“And yes, the private sector is expressing a lot of interest in investing in sustainable infrastructure,” he added.
Yet the extent of private investment in sustainable infrastructure will depend on the pipeline of bankable projects that Latin American governments produce, said Tapia. She coordinates the IDB’s agenda on sustainable financing and all related green bonds, investment vehicles for sustainable infrastructure and other financial mechanisms to help attract private investment to ESG.
“A project pipeline problem existed well before the pandemic in Latin America,” she said, “but it has worsened a bit during the COVID-19 months because governments have been busy attending the health crisis.
The good news, say analysts, is that sustainable infrastructure is gaining priority with the onset of COVID-19.
“The shock of COVID-19 is creating a new awareness of how social and environmental shocks can impact whole systems, and from that there is greater awareness of the need for systemic resilience,” said Kevin Ranney, director of advisor services of the ESG ratings agency Sustainalytics. There will be crop failures, and climate change will contribute to growing pandemics, he said.
World governments are coming together around a “green recovery” agenda. On May 27, the European Commission came out with a proposal for a recovery plan for the next generation. Finance ministers, worldwide, are joining in.
The Coalition of Finance Ministers for Climate Action is currently working on a statement of green economic recovery, Tapia said.
The coalition was launched in April 2019 and includes finance ministers from 52 countries. Latin America and Caribbean nations that have joined are: Argentina, Chile, Colombia, Costa Rica, Dominican Republic, Guatemala, Ecuador, Jamaica, Mexico, Panama, Paraguay and Uruguay.
“Investment in sustainable infrastructure will require the private sector to kick in.”
MARÍA TAPIA, LEAD CLIMATE CHANGE SPECIALIST, IDB
STARTING POINTS
Sustainable infrastructure pipelines are most developed in Colombia, Chile and Brazil. In Mexico and Brazil, pipelines for private sector investment in sustainable infrastructure and clean energy are more frequent at the subnational level, said Tapia.
To date in the Latin American region, private investors have been prominent in renewable energy. This is due to the smaller scale of these projects, simpler business models, and because the region has worked on the institutional mechanisms to bring in the private sector, said Cárdenas. For example, many Latin American governments have instituted energy auction mechanisms for private investors. But the areas with opportunities for private investment are set to expand.
“We are starting to see a transition towards the identification of sustainable transport projects,” said Cárdenas.
Two areas are gearing up for more sustainable private investment: electric urban transport and inter-urban trains. The substitution of old bus fleets with new electric ones and the building of subways and inter-urban train systems are either being explored or already in the pipeline.
“There’s investor appetite. Developers, other agents organized in concessions or public private partnerships, and municipal authorities backed by national governments are already working on developing these projects,” Cárdenas said.
ESG CAPITAL MARKETS BOOM?
Progress is being made to create the institutional scaffolding necessary for assets focused on sustainability, and the COVID-19 pandemic is likely to accelerate that process.
The Latin America region has issued $19.2 billion worth of green bonds as of May this year, according to data provided by the Climate Bonds Initiative (CBI). Of these, $7.71 billion have been issued by non-financial corporates and $930 million by financial corporates.
Since 2017, Brazil, Mexico, Chile, Peru, Costa Rica and Argentina have released green bond guidelines. The stock exchanges of Argentina, Brazil, Chile, Colombia, Costa Rica, Mexico, Peru, Ecuador and Panama have joined the UN’s Sustainable Stock Exchanges (SSE) initiative and offer dedicated green bond segments, according to the CBI's 2019 Latin America and Caribbean report.
Latin America’s financial sector has also been moving forward with green finance initiatives that include joining global initiatives like the Network for Greening the Financial System. As of May 2020, a total of 106 Latin American investment management firms and pension and savings funds managers are signatories of the Principles for Responsible Investment. And 158 Latin American and Caribbean banks and insurance companies are members of the United Nations Environment Programme Finance Initiative.
Yet green capital markets are still nascent in the region, and the corporate sector is still but a small player, analysts say. To date, the region represents only 2.1% of all world green bond issuances, according to CBI.
“Demand for green bonds has massively outstripped supply,” said Ulf Erlandsson, CIO of the Stockholm based climate impact hedge fund, Diem Green Credit.
Certainly, issuers face many challenges.
“The creation of an environmental, social or sustainability framework is new to Latin American issuers who need support and capacity building in that stage before they can even go to get a second opinion or certification,” said José Alfaro, professor at the School for Environment and Sustainability at the University of Michigan and second opinion expert for the rating agency Cicero Shades of Green.
“Some Latin American countries have organizations actively supporting issuers in the technical aspects of issuing green bonds,” said Miguel Almeida, research analyst at the CBI
But the cost of issuing green bonds is high, especially the first time around because it involves a learning process with substantial legal costs and the need for second opinions.
In Latin America, traditional bank loans are still cheaper than green bonds, said Tapia. The only benefit that corporates have found, is that it opens a new investor base for them, she said.
And the preferences of investors bring in further challenges.
“Historically, green bond investors have been large, fairly risk-averse institutions, often very rating restricted,” Erlandsson said. “This has made the green bond market less good at providing more risky capital, which is really what is needed to make transformations happen in developing markets like Latin America.”
Despite these hurdles, there are clear signs of upcoming growth in the region’s sustainable capital market.
In an attempt to boost the Brazilian green bonds market, which is already the largest in Latin America, the CBI unveiled in late June, in partnership with the Brazilian government, a new roadmap for green investing in Brazil’s agriculture, forestry and livestock sectors.
SMEs and larger corporates have been expressing renewed interest for issuing sustainable bonds, said Alfaro. This interest has been triggered by an awareness that the region’s governments will not have the fiscal capacity to aid the private sector through the post-coronavirus reconstruction period, he said. To bring fresh capital to the reactivation of the region’s private sector, Alfaro said there are efforts underway to develop assets whose repayments are secured by future income streams. The bonds will have government guarantees since they will not be backed by physical assets, but rather the flow of income from operations.
Additional innovations to attract private capital to ESG are in the making. Bolivia’s largest asset manager Capital Safi has been designing an impact fund that will manage approximately $200 million worth of investments working towards the sustainable development objectives, Pedro Von Vacano, investment manager at Capital Safi, said in a webinar organized by CominucaRSE.
And to increase needed investor trust, the IDB is in the process of developing a block-chain based transparency platform for green bonds, adding an extra layer of trust required by investors.
The pandemic is also bringing social bonds into the mix of private sector financing options.
In June, Colombian mortgage lender La Hipotecaria sold $13.9 million worth of social bonds to IDB-Invest, to finance construction of social housing projects, in the first such sale by a private lender in that country.
“Social bonds, sustainability bonds and increasingly pandemic bonds are increasing a lot worldwide, and we expect that to continue,” Almeida said.