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A Market for Brown Assets To Make Finance Green By Laura Cerami and Domenico Fanizza WP/23/11 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. 2023 JAN * The author was Executive Director for Italy, Albania, Greece, Malta, Portugal, San Marino at the time this paper was prepared. He is currently Executive Director representing Italy, the United Kingdom, and the Netherlands at the African Development Bank. © 2023 International Monetary Fund WP/23/11 IMF Working Paper Office of the Executive Director A Market for Brown Assets To Make Finance Green Prepared by Laura Cerami and Domenico Fanizza* Authorized for distribution by Ananthakrishnan Prasad January 2023 IMF Working Papers describe research in progress by the author(s) and are published to elicit comments and to encourage debate. The views expressed in IMF Working Papers are those of the author(s) and do not necessarily represent the views of the IMF, its Executive Board, or IMF management. ABSTRACT: This paper proposes a market solution to enhance the role of the financial sector in the green transition. Developing a secondary market for “brown exposures” can allow banks to dispose more quickly of stranded assets thereby increasing their capacity to finance green investments. Furthermore, newly created instruments – the brown assets backed securities (B-ABS) - can expand the diversification opportunities for specialized green investors and, thus, attract additional resources for new green investments. The experience of the secondary market for non-performing loans suggests that targeted policy and regulatory measures can simultaneously support the development of the secondary market for brown assets and green finance. JEL Classification Numbers: G21; G23; H63; Q54 Keywords: Green finance; financial innovation; greenium; financial sector; climate change Author’s E-Mail Address: lcerami@imf.org; d.fanizza@afdb.org IMF WORKING PAPERS A market for brown assets to make finance green INTERNATIONAL MONETARY FUND 3 WORKING PAPERS A market for brown assets to make finance green Prepared by Laura Cerami and Domenico Fanizza 1 1 We would like to thank William Oman and Zhongxia Zhang for their helpful comments and suggestions. We also thank Pasquale Lucio Scandizzo, the organizers and participants of the Annual Conference SITES 2022, Università Parthenope, Naples, Italy, September 16-17, 2022, for discussions. IMF WORKING PAPERS A market for brown assets to make finance green INTERNATIONAL MONETARY FUND 4 Contents 1. Introduction 5 2. Trends and challenges for green finance . 6 3. The case for a secondary market for brown assets: a supply-side perspective . 7 4. The case for a secondary market for brown assets: a demand-side perspective 10 4a. The markets for green bonds……………………………………………………………………. 11 4b. The greenium…………………………………………………………………………………………11 5. The role for policies………………………………………………………………………………………….14 4a. The European market for NPL…………………………………………………………………….14 4b. A policy simulation………………………………………………………………………………….15 6. Conclusions…………………………………………………………………………………………………….17 References . 18 IMF WORKING PAPERS A market for brown assets to make finance green INTERNATIONAL MONETARY FUND 5 1. Introduction The COVID pandemic has marked a turning point in the global push to address climate change. The sharp drop of carbon emissions recorded during the shutdowns, particularly in the most densely populated and heavily industrialized regions, provided a stark picture of the extent to which human activity affected the atmosphere directly and, climate change indirectly 2 . Emissions rebounded very rapidly soon after the end of the lockdowns, reaching nearly pre-pandemic levels well before the full reopening of the economy. Thus, it is just not practical to cut emissions by reducing activity in the industrial and residential sectors using the existing energy infrastructure. Reducing emissions permanently will require the transition of these sectors to low- carbon-emitting technologies. This conclusion from the pandemic reinvigorated the public debate around climate change policies ahead of the United Nations Climate Change Conference - COP26 Summit (Glasgow, 2021), which confirmed the commitment, enshrined in the Paris Agreement (2015), to keep the global temperature rise well below 2 degrees Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius. In addition, the signatories of the Glasgow Climate Pact committed to publish updated plans to cut greenhouse gas emissions by 45 per cent by 2030 and to contribute to the net-zero goal by 2050. Achieving the committed global decarbonization goals will require a substantial surge in investments above historical levels and most recent trends. Current estimates range around staggering figures, although subject to a very high degree of uncertainty reflecting the novelty of the models and the long projection horizons. For example, according to McKinsey (2022), achieving net-zero emissions by 2050 would require about 275 trillion U.S. dollars in cumulative spending on physical assets, or approximately 9.2 trillion dollars per year, over the next three decades. In the European Union alone, the investment needs are estimated at 28 trillion euros (McKinsey, 2020). Because of the potential downside risks from a climate strategy focused exclusively on green activities, this paper puts forward a more balanced approach that considers the need of promoting both the dismissal of carbon intensive technologies, and the development and adoption of clean technologies. Specifically, this paper proposes the launch of a secondary market for brown assets resulting from the securitization of banks exposures to carbon intensive activities, as a means of on the one hand, mitigating the risks from elevated stranded assets and increasing banks’ available capital to extend credit for greening the economy, and on the other hand, providing better risk-return opportunities to dedicated green investors, and thus possibly making more financing available for the energy transition than otherwise. The remainder of the paper is structured as follows. In section 2, we describe recent developments and current trends and challenges for green finance. In section 3, we present the case for a secondary market for brown assets from the supply-side perspective, based on a stylized bank model of exposures and exploiting the outcome of the European Banking Authority (EBA)’s climate risk mapping exercise 3 . In section 4, we explore the potential demand for securitized brown assets from the point of view of a dedicated green investor. In section 5, we examine the role for policies to support the development of a secondary market for brown assets. 2 Laughner J.L., Neu J.L., Schimel D., and Zeng Z., Societal shifts due to COVID-19 reveal large-scale complexities and feedbacks between atmospheric chemistry and climate change. Proceedings of the National Academy of Science USA. 2021 Nov 16;118(46): e2109481118. doi: 10.1073/pnas.2109481118. 3 European Banking Authority (2021). Mapping climate risk: Main findings from the EU-wide pilot exercise, EBA/Rep/2021/11, 21 May 2021. IMF WORKING PAPERS A market for brown assets to make finance green INTERNATIONAL MONETARY FUND 6 Lastly, section 6 summarizes the main conclusions and highlights the potential benefits of the proposed market for brown assets. 2. Trends and challenges for green finance The public sector is expected to play a key role in the green transition. Seizing on the opportunity to support the recovery from the pandemic as well as on the need to strengthen energy security and resilience in response to the economic fallout of the conflict in Ukraine, many countries are increasing public investment in clean energy and infrastructure. In Europe, for example, the majority share of the national Recovery and Resilience Plans, supported by European funds (NextGenerationEU), will be spent to accelerate the green transition. The private sector, particularly the financial sector, will have to complement public investments and provide the bulk of the required resources. The range, size, and depth of financial instruments to channel private capital toward green initiatives have expanded rapidly in recent years. Green bond issuance volume in Europe increased by 90 per cent from 2020 to reach 252 billion euros in 2021 4 , on the back of a more prominent participation of sovereign and supranational issuers. In the same year, green bonds constituted about 11 per cent of total European bond issuance. The total outstanding volume of green bonds at the end of 2021 reached about 700 billion euros. These bonds were predominantly issued by investment grade corporates in the form of plain vanilla fixed coupon bonds with a maturity of up to seven years and denominated in euros. There has also been a growing interest in sustainable-linked and transition bonds. The formers are performance-based bonds with payments contingent on key performance indicators aligned with a sustainability strategy. Transition bonds are proceed-based like green bonds but have a narrower scope, as they are typically issued by carbon intensive companies to start greening their operations. Finally, the green securitization market, although still small, has also recorded a remarkable growth in 2021, with a total issuance of about 4.5 billion euros. Green capital markets are complemented by the supply of green-linked loans, which partly contributed to the development of green securitization. Despite the rapid development of green finance, the funding shortfall remains alarmingly large. In 2021, green- liked bond and loan issuance volumes amounted to about 450 billion euros, only a half of the annual investment needs to achieve carbon neutrality by 2050 in Europe. Banks remain the main source of external financing for the European private sector and are playing a key role in green finance by issuing green-linked loans, bonds (whose proceeds are intended to extend loans for green projects), and asset-backed securities resulting from the securitization of green loans. However, according to the findings of the first pilot exercise conducted by the European Banking Authority (2021) to map climate risk in the European Banking sector, only 25 per cent of the total submitted notional exposure covered by the EU taxonomy are identified as green. Moreover, the green asset ratio, that is the primary indicator of greenness proposed by the EBA for the disclosure by banks is estimated at just 7.9 per cent. According to the mapping exercise, more than half of banks’ exposures (58% of total non-SME corporate exposures to EU obligors) are allocated to sectors that might be sensitive to transition risks. These findings clearly show that greening banks’ balance sheets is still a far distant goal. 4 Association for Financial Markets in Europe - AFME (2021). ESG Finance Report, European Sustainable Finance, Q4 and 2021 Full Year. IMF WORKING PAPERS A market for brown assets to make finance green INTERNATIONAL MONETARY FUND 7 Environmental, social, and governance (ESG) investing has the potential to accelerate the journey to achieve climate change goals, even though the evidence is not conclusive, partly reflecting the absence of a regulatory framework, that might mitigate the risk of greenwashing and incentivize compliance with firms’ declared commitments to greening their activities 5 . From this perspective, recent progress towards the adoption of common taxonomies of green activities, such as the EU taxonomy, and related disclosure and reporting requirements for the corporate and the financial sector can help mitigate the risk of greenwashing, which constitutes a major obstacle to a more rapid expansion of green finance. Other policies and regulatory measures can provide further incentives to green investments and attract private capital. However, some of the envisaged policies or their specific design, might also have the unintended consequence of increasing the cost and, hence, reducing the supply of private capital for green projects. For example, a sharp increase in carbon prices to achieve the emission reduction targets would hit firms that have heavy carbon footprints, leading to higher defaults, which would result in impaired credit quality for the banks exposed to those firms 6 . This example shows how climate policies by narrowly focusing on the green economy at the expense of carbon-intensive infrastructure and activities might accelerate the depreciation of brown assets over much shorter periods of time than feasible to ensure a smooth and efficient transition. The emergence of the so- called stranded assets is a challenging risk to manage for the financial sector, and to duly consider by policy makers in the design of climate policies. As first underscored by H.-W. Sinn in his provocative book, The green paradox (2008), today it is widely accepted the view that climate change policies aimed at curbing consumption of fossil energy can have the opposite unintended effect of accelerating the production of fossil energy and, thus, climate change. A more pragmatic approach to mitigation, on the other end, might be more effective. 3. The case for a secondary market for brown assets: a supply-side perspective Banks are expanding their green assets portfolios but starting from a very low level, presumably on account of both demand and supply constraints. On the demand side, bankable green projects might still be limited, albeit are expected to grow in response to the global push to climate action, which has more recently been reinforced by growing concerns over energy security. In the current environment, it is reasonable to expect a lasting increase in fossil fuel prices and a weakening profitability trend for business activities with high-carbon content. Public policies, such as carbon pricing, may further tilt lenders’ appetite towards green investments. On the supply side, banks might be capital constrained because of strict capital requirements and the legacies of past crises, most notably the unwinding of pandemic-related support measures. However, macroprudential measures, such as the so-called brown penalizing factor (i.e., higher risk-weight in capital requirements for carbon-intensive assets) and conversely a green supporting factor that adjusts capital requirements for green bonds, may ease balance sheet constraints. 5 For instance, Elmalt et al. (2021) find a weak relationship between emissions growth and ESG scores, with firms with better scores displaying only somewhat slower emissions growth. 6 Climate stress tests conducted by banking supervisory authorities