Innovative ways to finance sustainability projects

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Investing in sustainability projects, such as net-zero energy systems, reducing waste and resource use, and redesigning products and services often creates value in the medium to long term. Making businesses more sustainable is a good long-term business strategy, but like all investment decisions, it has to demonstrate future benefits to justify the need for short-term expenditure.

Recent energy price increases illustrate this sustainable investment challenge. Higher forecasted energy prices create the possibility of substantial future cost (and greenhouse gas) savings from investing in energy-efficiency measures, eg, smart lighting, low-e windows that have a reflective metallic layer to help heat and cool buildings, solar panels, and heat pumps. But higher energy costs also reduce cash available to invest in these projects, a situation made worse by low predicted growth rates and a likely recession in some economies.

Banks, investors, and other conventional finance providers also face competing demands for their funds, and as a result value-creating sustainable projects remain on the shelf, despite their positive impact on businesses, customers, nature, and the climate.

Becoming sustainable requires cash now in order to reap the rewards in the future. The World Economic Forum estimates that there is a persistent annual gap in global sustainable development financial investment requirements of $2.5 trillion — which could increase to $4.2 trillion if the effects of the pandemic are taken into account, according to the Organisation for Economic Co-operation and Development.

The good news is that many markets, institutions, businesses, and individuals are willing and able to finance this transition with funds earmarked for this very purpose. There are many ways to finance sustainability projects that often have a lower cost of capital, with lower risk structures, and different repayment terms that match the expected positive impact of these projects.

These sustainable financing innovations range from grants or interest-free loans to sustainability bonds, impact investment schemes, and crowdfunding. Many of these innovations involve blended finance packages, which combine public and private sources of finance as well as combining equity and loans. This article explores the potential strengths and weaknesses of these emerging financial products and services to help finance professionals match their sustainable financing needs with different financial packages (see the sidebar, “9 Tips for Financing Sustainable Transformations”).

Free money first?

When it comes to certain sectors and projects, there may be low- or no-cost sources of finance. Many governments or agencies have set specific sustainability goals or targets, such as the European Green Deal, that depend on businesses, public service organisations, and individuals changing their behaviour. To incentivise these changes, governments or agencies provide grants, subsidies, or targeted blended finance packages at low or preferential rates. For example, the UK government announced:

  • The Public Sector Decarbonisation Scheme to fund both energy efficiency and low-carbon heat upgrades;
  • The Green Recovery Challenge Fund, which is a £40 million fund for conservation organisations and their suppliers;
  • A direct air capture programme for developing new technology that captures CO2 from the air; and
  • The Automotive Transformation Fund, which supports capital and research and development projects in the UK automotive industry.

While many of these schemes only apply to particular sectors or technologies, if your business qualifies for them, they can be transformative and well worth investing a couple of hours in research.

The UN has several useful initiatives to help businesses access sustainable development finance. For example, the UN Special Envoy on Innovative Finance and Sustainable Investments described the UN Joint Sustainable Development Goal (SDG) Fund as offering “a sustainable investment model by leveraging the power of markets to accelerate businesses, empower communities, and provide a clear path to self-sufficiency”.

The UN has a number of initiatives that highlight schemes in different countries designed to finance their national priorities, which include preferential access to finance and capital markets.

A useful guide to what constitutes a sustainability project can be accessed via the EU taxonomy for sustainable economic activities. Different countries have their own version of this taxonomy, and they help identify whether your project is officially defined as sustainable. Many sustainability projects are linked to tax breaks and subsidies that dramatically improve the after-tax cost of capital. It’s not quite free money, but it’s always worth checking before looking for commercial deals.

Innovative repayment schedules

Many sustainable investment products don’t use fixed-term interest repayment schedules but try to match the repayment schedule with how the financial benefits accrue. For example, some UK public sector organisations in England and Wales have been able to access loans for installing energy-saving schemes with a repayment schedule tied to actual energy savings. This means that the cost of this type of project is spread over the forecast cost savings, reducing the cash flow risk.

A similar logic applies to financial products designed to operate in accordance with Islamic principles, such as Green Sukuks, where the repayment is triggered by the achievement of specific positive benefits derived from the assets funded by the loan. These types of financial products are particularly useful for projects where future cost savings do not occur in a linear fashion or may take a longer time to occur. For example, the greenhouse gas absorption capacity of newly planted forests grows over time and may not reach optimal levels for up to 100 years. If the repayment schedule reflects this natural process, it is then likely to act as an incentive for much-needed investment in nature-based climate solutions.

Sustainability bonds and contingent interest instruments

There is a growing market in sustainability bonds, issued by commercial companies and government agencies. A number of companies have created special bonds designed to fund their sustainability transformation projects; eg, since 2017 Scottish and Southern Energy in the UK has issued green bonds worth €2.75 billion to ensure it can operate sustainably and responsibly.

Sustainability bonds have two main features. First, issuers commit to restricting the use of the actual funds to achieve pre-specified SDG objectives. Second, they have a covenant that links the investors’ returns to the issuer’s achievement of these objectives, with possible decreases or increases in the investors’ returns. This variation in return to investors is a way to share the risks and benefits accruing from the use of these funds. For example, climate bonds include interest rates pegged to a schedule of reductions in greenhouse gas emissions. This means if the business’s greenhouse gas emissions rate of reduction exceeds a specific target, then a lower return is paid to the investors, whereas if greenhouse gas emissions’ rate of reduction is lower than the target, a higher return is paid. This provides a financial incentive for the business to invest in projects with a greater possibility of reducing emissions.

These bonds go by many “brand” names, based on the outcome of the loans and any restriction on how they’re spent. Green bonds are restricted to projects that reduce environmental impacts. Blue bonds are targeted at projects that reduce water use or protect the oceans. Nature performance bonds are intended to fund projects that reduce biodiversity damage. SDG-linked bonds are used to fund projects that support the achievement of the SDGs. Sustainability-linked loans exist across different sectors and are designed to incentivise borrowers to hit specified sustainability performance targets or submit to sustainability-related processes, such as gaining B Corp Certification, submitting to human rights audits, developing low-carbon products, or showing high levels of resource re-use or recycling. These bonds often require enhanced accountability or assurance procedures.

Impact investors

There is a growing consensus that long-term financial returns depend on robust and resilient socio-ecological systems and all of humanity benefits from maintaining these systems. Linked to this perspective is the growth in impact investing, where individuals, philanthropic foundations, private equity, and financial institutions fund projects or businesses with the express purpose of achieving specific social or environmental outcomes as well as secure financial returns. While some of these impact investors are connected to philanthropic foundations, such as the Rockefeller Foundation, most financial institutions, eg, BlackRock, have launched impact investment funds or instruments. Even Harvard Business School has entered this market with its social enterprise impact fund. A number of leading private-equity companies are also developing impact investment funds.

These impact investment funds often focus on funding for specific projects, technologies, or infrastructure that has measurable social, economic, and environmental benefits. The advantage of impact investment is that the funder often has high levels of expertise to help design, measure, and support the delivery of positive impact. In addition, impact investors can tailor the terms of the investment to the activities and may even take shared ownership of assets over the long term.

Impact investing requires greater levels of collaboration and engagement between funder and borrower than other forms of sustainable investment products. This level of engagement leads to greater shared knowledge about projects that may have high levels of technical or financial uncertainty, which allows informed decisions as to appropriate high set-up costs, risk premiums, and cash flow assumptions.

The customisability of impact investments can result in a substantially lower cost of capital over the life cycle of the project. In addition, there is a “greenium” (green premium) attached to this type of investment activity, given the reputational benefit of being associated with projects or businesses making a positive impact.

Crowdfunding

Sometimes the financial market, governments, and even impact investors lag behind the innovative potential of businesses, particularly startups or small or microbusinesses. This is understandable, as they are obliged to act with a level of prudence, limiting their risk-taking. This can mean that transformative technologies or products fail to get off the ground or are unable to scale up. This is a space where crowdfunding has particular advantages.

Crowdfunding is one way that businesses, particularly startups, can raise money directly from the public, particularly if they are related to products or services that grab people’s attention. Crowdfunding is basically a form of matchmaking on the internet where businesses pitch their business concepts to nonprofessional investors, normally through a web platform.

Giving money through crowdfunding is flexible and can involve very small sums of money. Crowdfunders are often motivated by nonfinancial factors, such as picking a winner, being part of something innovative, backing a “cool idea”, engaging with a business, or having a sense of making a difference. But getting in early means that high financial returns can be earned, although this has to be balanced with greater risks.

Often crowdfunding is sought at the product concept stage, where there is no guarantee the product will even make it to market. Some types of crowdfunding are regulated in certain jurisdictions. In the UK, the Financial Conduct Authority (FCA) regulates:

  • “Peer-to-peer lending”, where consumers lend money to businesses in return for interest payments and a repayment of capital over time.
  • Where consumers invest directly or indirectly in businesses by buying investments such as shares or debentures (unsecured bonds).

The FCA also regulates payment services related to:

  • Donation-based crowdfunding.
  • Pre-payment crowdfunding — where consumers give money in return for a future service or product.

Crowdfunding, particularly pre-payment crowdfunding, has been successfully used by larger corporations, including Tesla. The company pre-sold its cars — an electric alternative to petrol-fuelled, carbon-emitting vehicles — for delivery in the future and raised enough money to bridge a massive financial hole the company was in.

Crowdfunding can provide much-needed finance at relatively low cost, particularly donation-based crowdfunding; the pre-payment model also provides greater certainty of future sales. The ease and flexibility of crowdfunding enables many low-wealth individuals to invest in or support purpose-driven sustainable businesses or projects. Individuals can participate in investing in a sustainable business simply by pre-buying a proposed product or donating a small sum to an entrepreneur in the hope they will make a difference and where their contribution will be acknowledged in some way.

My partner and I have helped crowdfund authors who couldn’t get commercial support for their books. One book even made it onto The Sunday Times Bestseller list, making us cleverer than publishing companies, even though we were only one of hundreds acknowledged at the end of the book. A good outcome for a £10 stake.


9 tips for financing sustainable transformations

Don’t limit your thinking to borrowing money or issuing new stocks or shares. Apply a bit of imagination to look for alternative sources of funding that are aligned with what you want your project to achieve:

  1. List the positive sustainable benefits the project will achieve and the negative impacts it will avoid. Use this list to search for innovative forms of sustainable funding that match those impacts.
  2. Search for industry- or business-specific grants and subsidies that cover the sustainable impacts of your projects. If you feel your project doesn’t fit, consider modifying it accordingly.
  3. Search for nongovernmental organisations, charities, or philanthropic foundations that share your aspirations and where there can be a meaningful collaboration. Don’t be afraid to undertake pioneering projects where you can be an exemplar for these organisations. Often funds are available for these innovative, transformative projects.
  4. Search for targeted financial products or sources of funding linked to the potential impact of your project, eg, impact investors or sustainability bonds.
  5. Consider blended finance products that combine public and private sources of funding.
  6. Consider joint ventures with other commercial businesses, as this may make the project more investable for finance providers, eg, by having large enough scale, shared risks, and reduced set-up and monitoring costs.
  7. Keep an eye on market innovations, as the finance market is dynamic, agile, and fast-moving. Don’t discount crowdfunding and even consider pre-selling sustainable products.
  8. Always consider the after-tax cost of any financial instruments, as different funds and projects may have different tax treatments.
  9. Check for any additional disclosure requirements, enhanced assurance, or accountability requirements attached to the funding, as this could add to the cost.

Ian Thomson, ACMA, CGMA, is professor of accounting and sustainability and director of the Centre for Responsible Business at the University of Birmingham in the UK. To comment on this article or to suggest an idea for another article, contact Oliver Rowe at Oliver.Rowe@aicpa-cima.com.


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