Green Finance: The Need for a Secondary Market for Brown Assets

The research paper "A market for brown assets to make finance green" by Laura Cerami and Domenico Fanizza published by IMF explores the idea of creating a secondary market for "brown assets" - assets that are linked to carbon-intensive activities - in order to address the funding shortfall for green initiatives. The paper argues that this would allow for the mitigation of risks from stranded assets and an increase in available capital for banks to extend credit for greening the economy, while also providing better risk-return opportunities for dedicated green investors. The paper delves into the challenges and trends in green finance, the potential demand and structure of the market for brown assets, and the role of policies in supporting its development.

The research paper "A market for brown assets to make finance green" by Laura Cerami and Domenico Fanizza discusses the need for a transition to low-carbon-emitting technologies in order to permanently reduce emissions, and proposes the launch of a secondary market for brown assets, resulting from the securitization of banks' exposures to carbon-intensive activities, as a means to mitigate risks from stranded assets and increase banks' available capital to extend credit for greening the economy and providing better risk-return opportunities to dedicated green investors. The paper highlights the public sector is expected to play a key role in the transition to green energy and infrastructure, but the private sector, particularly the financial sector, will have to complement public investments and provide the bulk of the resources needed. The paper presents a simulation of the time required to rebalance banks' portfolios towards green assets through a strategy called passive rebalancing, which involves stopping the rolling over of brown exposures and investing the proceeds in green projects. The simulation shows that it would take 40 years to bring the green assets ratio from the initial value of 7.9% to 50% under this strategy.

Introduction

The research paper "A market for brown assets to make finance green" by Laura Cerami and Domenico Fanizza discusses how the COVID pandemic has highlighted the need for a transition to low-carbon-emitting technologies in order to permanently reduce emissions. The paper argues that the Paris Agreement's commitment to keep global temperature rising below 2 degrees Celsius, and the Glasgow Climate Pact's commitment to cut greenhouse gas emissions by 45% by 2030, require a substantial increase in investments. The 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 to mitigate risks from stranded assets and increase banks' available capital to extend credit for greening the economy and providing better risk-return opportunities to dedicated green investors. The paper is divided into several sections, detailing recent developments and current trends in green finance, the case for a secondary market for brown assets, the potential demand for securitized brown assets, the role of policies to support the development of this market, and the potential benefits of the proposed market for brown assets.

Trends and challenges for green finance

The research paper highlights that the public sector is expected to play a key role in the transition to green energy and infrastructure, with many countries increasing public investment in clean energy and infrastructure. The private sector, particularly the financial sector, will have to complement public investments and provide the bulk of the resources needed. In recent years, there has been a rapid expansion of financial instruments to channel private capital towards green initiatives, such as green bonds and sustainable-linked bonds. However, the funding shortfall remains alarmingly large, with green-linked bond and loan issuance volumes only amounting to about 450 billion euros. Banks are a key source of external financing for the European private sector and are playing a role in green finance through issuing green-linked loans and bonds, but the European Banking Authority (EBA) found that only 25% of the total submitted notional exposure covered by the EU taxonomy is identified as green. ESG investing has the potential to accelerate the journey to achieve climate change goals, but the absence of a regulatory framework might mitigate the risk of greenwashing and incentivize compliance with firms’ declared commitments to greening their activities.

The case for a secondary market for brown assets: a supply-side perspective

This paper presents a simulation of the time required to rebalance banks' portfolios towards green assets through a strategy called passive rebalancing, which involves stopping the rolling over of brown exposures and investing the proceeds in green projects. The simulation shows that it would take 40 years to bring the green assets ratio from the initial value of 7.9% to 50% under this strategy. The authors also suggest that allowing banks to offload a portion of their brown exposures through securitization and sale in the secondary market for brown assets could help speed up the process. They also note that targeted policies and regulations can play a crucial role in fostering the development of such a market, as seen in the European market for non-performing loans (NPLs).

The case for a secondary market for brown assets: a demand-side perspective

The research paper suggests that securitized brown assets, or brown assets-backed securities (B-ABS), can be a hybrid instrument that offers dedicated green investors, who are committed to sustainable finance, the opportunity to support the transition to a greener economy indirectly, on top of financing green projects. The paper examines the structure of the market for green bonds to assess the current and prospective interest among green-concerned investors. The market for green bonds is currently driven by global ESG funds, which have exceeded 6 trillion U.S. dollars in 2021. The paper also mentions the concept of "greenium," which is the negative spread observed, particularly at issuance, with respect to the yields of comparable conventional bonds. This could be attributed to the willingness of green investors to pay a higher price for a bond at issuance, which means they accept a lower yield in exchange for an environmental benefit. The empirical literature on the existence and size of the greenium has produced mixed results, reflecting both identification and measuring challenges.

The role of policies

The research paper suggests that a secondary market for brown assets can be a market solution for the management of the financial risks from the transition to the green economy and promoting green finance. The paper suggests that well-defined climate change policies with clear objectives, measures, and timelines, as well as regulatory frameworks for financial risks from climate change, would set the best conditions for the actual launch of such a market. The paper also mentions that targeted policies such as the experience of the European market for NPL, can play a role. The European market for NPL had been around for decades, but the sharp rise of NPL in some European countries in the aftermath of the global financial crisis renewed interest in this market. The direct sale and securitization of NPL emerged as the most effective tools to speed up the reduction of NPL in banks' balance sheets and facilitate their resolution. The activity in the secondary market for NPL increased further following the enactment of targeted policies to facilitate the resolution of NPL and to support their secondary market.

Conclusion

This research paper proposes the creation of a secondary market for "brown assets" to help in the transition to a greener economy. The authors argue that this market, which would be based on the securitization of banks' exposures to carbon-intensive activities, would help mitigate the risks of stranded assets and increase banks' available capital to extend credit for greening the economy. Additionally, the market would provide better risk-return opportunities to dedicated green investors, potentially making more financing available for the energy transition. The authors propose that the market could be developed by leveraging supply and demand factors reinforced by global efforts to transition to a green economy. The paper also argues that targeted policies could play a decisive role in fostering market development.

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