Union Budget 2023-24
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Sustainability Financing - Unconventional Models in Contemporary Times

Sustainable Finance is committed to financing projects that have an environmental and social impact, and promote circular economy. These investment considerations are guided by the aim of helping countries achieve their commitments under the United Nations Framework Convention on Climate Change’s (UNFCCC) Nationally Determined Contributions1. The financial viability of an asset is established when revenue generation post its commercial operation is adequate to meet the servicing obligations of providers of capital i.e., equity or debt. Before venturing into the possible models of financing assets that are key to a sustainability-led development, let us have a quick look at the current Indian macro-economic situation justifying alternate models of financing:

1. Increasing Cost of Debt – As per a recent news article2, Motilal Oswal estimates that in Q3 FY 2023 pre-provision operating profit (PPoP) of Public Sector Banks (PSBs) is expected to grow at 19 percent YoY as against 21 percent YoY growth for Private Banks. However, net profit of PSBs is expected to grow at 44 percent YoY as against 28 percent YoY growth for its private sector peers. This anomaly can be attributed to the reduced provisioning requirements, highlighting stable asset quality and reversal of provisioning done by PSBs in the past decade due to recovery from legacy infrastructure exposures gone bad (on which 100 per cent provision was taken earlier), facilitated through processes such as the Insolvency & Bankruptcy Code 2016 or under extant Reserve Bank of India (RBI) circulars. This clearly shows that domestic Indian banks are well-capitalised to finance the next phase of economic growth, but at what cost?

To rein in inflation, RBI has hiked the policy repo rate by 2.25 percent in a short span of 8 months (from May 2022 to December 2022) i.e., from 4.00 per cent to 6.25 per cent3, which directly translates into an increase in the cost of capital for financing of an asset. During the same period, the wholesale price index (WPI) based inflation has reduced from ~16 percent levels to below 5 percent.4 Considering WPI numbers as a proxy for YoY increase in revenues and costs of any project, the significant increase in the cost of debt being provided by domestic lenders by ~ 56 per cent in the event of complete pass-through, might affect the financial viability of a project.

2. Global Slowdown and Funding Winter – High inflation across the United States and Europe during CY 2022 has led to monetary tightening and reduction of spreads between yield curves of their government securities in comparison to securities/bills issued by the Government of India (GoI). This provides a lucrative opportunity to investors abroad to invest in assets at home which dries up flow of foreign capital into the country, another key source of financing for Indian corporates, particularly start-ups. As per a recent report by PwC5, Indian start-ups have raised $ 24 Mn in CY 2022, a drop of 33 percent compared to CY 2021, with e-commerce, B2C and ed-tech remaining the worst-performing sectors.

The above two constraints, of increasing cost of domestic capital and the possibility of reduction of foreign capital flows, need to be seen in conjunction with India’s estimated investment requirement of $ 10.1 Tn to meet its net-zero target by 2070, as per a report by Council On Energy, Environment and Water – Centre for Energy Finance.6 This urges us to explore newer models of financing our assets, thereby bridging the gap for this funding requirement.

Debt Markets & Thematic Securities

Thematic bonds based on Environment, Social and Governance (ESG) considerations are, today, accelerating the transition to a green economy. However, India’s bond markets are still at a nascent stage and are not as deep as their western counterparts. Green Bonds, which take the lion’s share of ESG labelled securities, have been a part of the Indian market since 2015 and have been used by corporates mainly for financing renewable energy projects. Further, the GoI’s announcement of raising the portion of its market borrowings in FY 2023 through green bonds is expected to provide fillip to the Indian green bond market. The GoI released the Framework for Sovereign Green Bonds7 (SGrBs) in November 2022, which has been reviewed by Norway based CICERO and rated as “medium green” out of the three shades of “light”, “medium” and “dark” green. As per a recent press release by the Department of Economic Affairs, Ministry of Finance, the GoI is set to raise INR 16,000 crores having a tenor of 5-10 years by February 2023,8 through uniform price auction and will invite investment from non-residents as well under the “Fully Accessible Route” i.e., without any investment ceiling and available for investment until maturity. But what remains to be seen is if these SGrBs being issued are able to command “greenium” in comparison to traditional G-Secs, considering the ancillary costs associated with them in terms of disclosures, compliances, regulatory requirements, etc.

Other sections which have been gaining traction and can be looked upon as a source of sustainable finance for green projects are:

  1. Municipal bonds being raised by corporations
  2. Transition bonds for carbon intensive sectors such as oil and gas, steel, cement, etc. for availing capital in order to decarbonize
  3. Diaspora bonds by governments for getting investment from its own diaspora living in developed countries (issued by Governments of Israel, Sri Lanka and India in the past during economic crisis)
  4. Catastrophe bonds against losses linked to natural calamities
  5. ESG labelled convertible bonds (fully or partially convertible into equity)
  6. Outcome-oriented products: The outcome-oriented financing products are gaining popularity as they shift the focus from need-based financing and provide more accountability with respect to the achievement of objectives, which are verified by an independent third-party. These include loans on which interest rates get reduced once desired outcomes are achieved, social/development impact bonds (DIBs) and cash transfers when desired outcomes are met. The DIBs operate in a tripartite framework, wherein an investor provides upfront capital to a service provider and gets repaid by outcome funders if the desired development objectives, initially agreed upon, are achieved.

Blended Financing

Blending involves raising funds from different sources and merging private capital (at market-rates) and development assistance (at concessional rates) leading to the availability of a higher capital base for investing in high-risk projects, which would not have otherwise received private capital, at a lower blended cost. In addition to providing a common pool of capital, blending can take place among different capital providers through risk-sharing instruments such as guarantees, grants or structuring of a tripartite outcome-oriented DIB arrangement.

Asset Securitization & Monetization

Smaller green projects can be pooled together and securitized in a Trust structure similar to Infrastructure Investment Trust’s (InvIT) or Real Estate Investment Trust’s (REIT). This will lead to the democratisation of the risks associated with a pool of green assets and can be used for issuance of longer tenor bonds at a lower weighted average cost. Similarly, the monetisation of existing brownfield assets owned by governments, or its firms/agencies can be used for tapping private capital and using these proceeds towards greenfield investments. The GoI already has in place a National Monetization Pipeline (NMP) and provides incentives to states for the monetization of assets in the form of disposing of non-core assets, stake dilution and/or transfer of usage rights of an asset for a limited period.

Carbon Markets

The recently passed Energy Conservation (Amendment) Bill, 2022 has put a cap on carbon emissions of industries and introduced a carbon credit trading scheme, which aims to set up a carbon credit trading market. The government or its agencies can issue carbon credit certificates which can be purchased by high carbon emitters to meet their compliance requirements leading to decarbonisation of the Indian economy. This will not only provide capital availability for financing green projects but will also accelerate India’s stride towards achieving its net-zero target.