Accelerating capital market access for restoration using securitization: promoting the rise of nature-backed securities

The problem

Independent estimates of global land restoration needs are in the range of USD 200–300 billion per year.

In comparison, the market size of the private sector investments in sustainable land use and restoration is currently estimated to be in the region of USD 8-10 billion, a 10 to 38 ratio representing a paltry 2.5-5% of the total demand.

While many underlying reasons have contributed to this imbalance, the main barrier to correct it has been the inability of the sustainable land use (SLU) finance community to tap into capital markets. With an estimated global value of USD 100 trillion and USD 90 trillion for the bond and equity markets respectively, capital markets are the only source of finance whose depth is capable of matching the magnitude of the sector’s funding needs.

This inability is the result of a mismatch between most SLU investment opportunities and what capital markets expect in terms of asset requirements and risk-adjusted re-turns: SLU investments are typically small, complex and considered abnormally risky for their projected returns. They are linked to individual projects that rarely scale well or are too small to allow for an adequate diversification of risk. Due to their non-standard na-ture, they are difficult to compare and value, and even more difficult (if not downright impossible) to trade. For that reason, they have been largely confined to the portfolios of impact investors and the books of progressive banks.

Capital markets are on the other end of this funding spectrum: they demand liquidity in the form of fungible instruments with common key characteristics, on a scale that yields economies of scale (in the form of very low unit transaction costs) while rendering port-folio diversification possible.

Very few people will dispute that making SLU finance compatible with capital market exigences will be a major landmark towards the sector’s mainstreaming, by giving sudden access to a massive flow of capital in search of a yield and a purpose.

But how to make these two extremes converge? How to turn something small into something big? How to transform a risky and idiosyncratic proposal into a safe and diver-sified opportunity? How to turn individual projects into commoditized products that can be infinitely scaled?

The solution

During the 70’s in the USA, the financial institutions Ginnie Mae and Freddie Mac found the answer to those questions, using a clever solution that irreversibly changed the financial industry globally: securitization. They invented the first mortgage-backed securities (MBS), a form of collaterized debt obligation (CDO) that consisted of packaging many small mortgages (with their interests and principals) into a security that investors could buy.

While MBS and CDO have had their reputation tarnished by the 2008 financial crisis, the basic concept remains brillant for several reasons:

• It allows the banks to pass the long-dated investment risk on to investors, freeing up capital in their books to expand their lending operations, resulting in the steady increase of investible capital;
• This transfer of ownership gives investors the opportunity to be exposed to an asset class that was previously inaccessible, giving them a chance to further diver-sify their asset allocation and contribute to the rise of a sector that benefits society (by making housing accessible to the US’ booming population in the case of MBS, by investing in nature in the case of future NBS)
• Thanks to their structure, MBS and CDO are great diversifiers: as long as the un-derlying assets are carefully chosen, the final product is by construct less risky than each of the individual positions it is made of, which is hugely beneficial for sectors considered high risk;
• MBS were originally protected by the government
• Finally, in pooling together a large number of small loans into a unique package, the resulting security becomes sufficiently large to interest institutional investors and market makers. The vehicle’s structure can be standardised and replicated, generating significant economies of scale.

These significant advantages, which propelled MBS as the main driver of growth in the financial sector for the period 1980-2007, could have the same transformative effect for nature-based investments today: hundreds if not thousands of small restoration, rehabi-litation and regeneration projects, across countries, landscapes and sectors, sourced by banks and impact investors, could find their way into groundbreaking nature-backed securities (NBS), generating yields and impacts commensurate with the growing appetite of investors for nature-based solutions and ESG.

These NBS, especially if they are supported by public-sector de-risking mechanisms, would propose a competitive risk-return ratio relative to their peers. They would be easy to trade due to their availability, low transaction fee and low cost of entry. More im-portantly, these instruments would give serious ESG investors a chance to invest directly in nature-based solutions without relying on uncertain corporate actions.

MBS securitization in the US grew six times in just about ten years, from a capitalizat-ion of less that USD 500 million in 1996 to USD 3.2 billion in 2003. A similar trajectory would definitely cement nature-based investments as a mainstream asset class, accessible by millions of investors, large or small, motivated by the common goal of building back better.

What UNEP can do

UNEP could support the development of a pilot NBS program whereby it would encourage a pioneer bank to look into their credit portfolio with the intent to identify existing credit positions transferable to a special purpose vehicle (SPV) and facilitate its subsequent purchase by investors. The SPV can be structured in tranches to access different segments of the investor base and can receive public support, in the form of a junior position or a guarantee to increase its return/risk ratio beyond comparable market products.

Environmental integrity will be guaranteed by the enforcement of an impact framework developed jointly by the banks and UNEP. The considered credit positions will have to meet the framework’s criteria/targets in order to be included in the SPV.

The advantage for the banks is the ability to benefit from a green origination business that does not eat into their capital and does not require them to manage the risk position or the less standard aspects of the deals, like longer-than-usual tenor or reduced collate-rals. In removing the main risk and capital bottlenecks, it has the potential to provide a strong incentive to banks to increase their green offering to clients while boosting their green credentials and reputation.

For the investors, the NBS is an opportunity to have access to a portfolio of earmar-ked, diversified direct investments into green projects, compared to investments in com-pany stocks that cannot really be traced back to green interventions, let alone impacts. These investments will have been assessed by the bank and shall ensure an acceptable and predictable level of cash flow.

For both, it’s an investment strategy that is quicker and cheaper than alternative opt-ions (like land use green bonds) since it is constructed from existing positions, hence overcoming the issue of searching for and vetting new investment opportunities, which usually is a complex and expensive process.