|Spencer Lake, founder and principal of Four Winds Capital|
In May 2016, HSBC’s then vice-chairman of global banking and markets, Spencer Lake, pitched a new idea for a structure to deal with the many problems involved in getting private capital to take part in climate finance for the world’s most vulnerable countries.
Lake subsequently left HSBC and the idea has not been pursued. It would take some setting up. But it is worth considering in some detail.
At HSBC, Lake had spent a lot of time on green finance and infrastructure and just as much time working with multilateral banks, “trying to get them to work together more, to use their collective firepower to create simple but scalable features and products that anybody could understand,” he tells Euromoney.
At the IMF annual meeting in Lima in 2015, he met Cesar Purisima, the former finance minister of the Philippines and by then the chair of the newly created Vulnerable Twenty (V20) group of nations. Purisima asked what he thought about raising funds for the climate needs of these vulnerable countries.
“I said: ‘It would seem logical to me that there is a solution, but it is going to require the ultimate in collaboration,’” says Lake.
The challenges were many: the smaller countries lacked the GDP and the credit quality, never mind the expertise, to raise big funds. And, when they faced traumatic events, they not only suffered great hardship to their population but lost even more ground in GDP growth. None of that was appealing for investors.
Lake went away to think, then presented to the V20 countries at the Spring Meetings in Washington DC in 2016. His pitch: to team HSBC with Swiss Re to create a financing package, initially $20 billion but scalable, to help address climate resilience and mitigation needs for the V20 over a five-year period.
Lake’s contention was that, until then, financing for risk transfer, climate resilience and climate mitigation had all been looked at in isolation. The idea of the HSBC/Swiss Re deal was a comprehensive financing package that would put them all together, with two benefits. First, that synergies between individual elements could be harnessed, such as the effect of risk-reduction measures on insurance premiums. Second, that it would benefit from economies of scale and be big enough to be interesting.
The V20 Climate Resilience and Mitigation funding programme would be a vehicle that would issue green and resilience bonds, in many tranches and with different risk and return profiles, so as to leverage existing aid commitments and the risk capacity of large reinsurers.
All the investors we talked to on this, they said: ‘We’d buy that, especially if the multilaterals played a role'- Spencer Lake
Alongside it would be a V20 Climate Resilience and Mitigation Wealth Fund, a multilateral vehicle like a sovereign wealth fund to manage the proceeds of the bonds and oversee the disbursement of the loans and the insurance to V20 members. It would provide a combination of insurance cover for pre-defined climate-related loss events, finance for climate adaptation projects to support resilience, such as flood defences and sea walls, and also finance for climate mitigation projects that could be expected to offer a commercial return.
Those pre-defined loss events covered by the insurance might be diversified among the V20 members: a typhoon in the Philippines or a storm surge in Bangladesh.
Structurally, the bonds would have four tranches.
At the top would come a senior tranche, wrapped by multilateral development banks (MIGA, the Multilateral Investment Guarantee Agency, was specifically suggested), and structured to appeal to insurers, private finance, asset managers and the like. A MIGA wrap is considered particularly appealing as it is capital efficient for insurers under the EU’s Solvency II directive. This is where the big institutional money would be brought in.
Below that would come a mezzanine tranche, structured to appeal to investors looking for higher yield. One idea was that this tranche could include a catastrophe write-down feature, or a cat deferred bond.
Next would come a contingent tranche, in two forms: funded, through cat bonds, and unfunded, through the insurance and reinsurance market.
Critical to the whole endeavour would be a first-loss tranche provided by, for example, the Green Climate Fund, multilaterals or developed-world aid. This element could also be partly funded through the V20 countries themselves, perhaps through taxes.
The whole thing, it was proposed, could be sponsored by the G20, V20 and the World Bank, and any other multilaterals that wanted in.
The advantages of the approach are several. One is that it creates a structure within which numerous actors can play: multilaterals, donors, pension funds, insurers. Another is that it should trigger immediate payout when disasters hit, because the money will have been raised in advance, sitting in a wealth fund, and because the parameters for payouts will have been pre-agreed.
The pooling of risk helps poorer countries who otherwise could not access anything like it and the whole thing uses common financial market practices: tranched bonds, including cat bonds, and a first-loss provision.
However, while risk-pooling mechanisms are not new, this one went a little further. For one thing, slow on-set events such as rising sea levels or coastal erosion tend not to be covered by existing insurance policies: insurers do not like them because they are definitely going to happen. The bond financing approach was designed to cover this by the fact that it could take a multi-year time horizon – the programme itself potentially lasting many decades – and because of the first-loss tranche through aid and contributions.
The second distinction is that the investment of proceeds into resilience of infrastructure should, logically, prevent losses from catastrophes, reducing cat bond coupons and insurance premium payments over time, and monetizing the very losses that have therefore been avoided. Since payouts should consequently be less frequent as the defences are built, that, in theory, gradually makes uninsurable perils insurable. As that happens, GDP in the most vulnerable countries should grow without the drag of frequent damage, in turn giving those members a greater capacity to service and repay debt.
“It is a classic securitization structure,” says Lake. “You already have the multilaterals who are huge potential participants. You also already have the big G7 donor countries in the room, dipping into their back pockets to pay what I consider the pure equity tranche. MDBs can come in in the pure equity tranche or at the mezzanine level.
“If you’re talking about raising close to $100 billion, then the equity tranche could be $5 billion to $7 billion of the capital stack, mezzanine another $10 billion to $20 billion and $60 billion to $70 billion of it will be in the green bond market. You get the capital markets and the insurance community to contribute, you have a good public-private sector dynamic. All of a sudden you’ve solved the problem.”
Well, not entirely. The hardest part of the whole thing would be the coordination required to make it happen. Lake was well aware of this.
“I said: ‘The reality is you are not going to get 43 to sign at once. So let’s start with five, make it like an MTN shelf, and add others one by one.’”
Another question is the servicing of the debt. The idea is that commercially viable projects would be responsible for a large part of this, but the ability of V20 nations to meet repayments in the early years would likely be an issue, even if theoretically their economies would improve through better resilience to climate-related disasters.
“Payback primarily is going to be the revenue from the financially robust projects, the renewable energy projects that get put into place,” Lake says. “Adaptation would pay off obligations over the course of time.”
The donor side should not be a problem, he says, because “the big western governments are already footing this bill” in terms of their existing commitments. Nor should institutional investors: “All the investors we talked to on this, they said: ‘We’d buy that, especially if the multilaterals played a role.’”
The idea was taken to the International Finance Corporation, although Vikram Widge, head of climate and carbon finance, does not specifically recall it.
Lake left HSBC last year and is now founder and principal of Four Winds Capital, through which he has invested in and advised a number of companies in the fintech sector. But his passion for the vulnerable funding programme clearly remains.
Since that presentation, it seems, HSBC’s own internal structures in this area have apparently changed.
It’s a grand idea, seemingly in limbo. Will anyone take it up?