According to IDB estimates, Latin America and the Caribbean (LAC) is facing an infrastructure gap of around 2.5% of GDP, or USD150mn per year, lagging behind other emerging markets not just in terms of overall investment needs but also in the quality of investment. LAC holds the second lowest score for infrastructure on the World Economic Forum survey on infrastructure quality, just above Sub-Saharan Africa.
In a region where natural disasters cause USD2bn worth of damage annually and where climate change-related developments are destroying natural habitats, displacing communities and endangering vast territories, there is an urgent need for new sustainable infrastructure that can boost quality of life and economic growth while keeping the countries on track to hit the UN Sustainable Development Goals.
But funding the transition towards climate-resilient buildings and infrastructure networks can be likened to climbing a mountain for Latin America, where many countries are facing widening fiscal deficits and stretched budgets. The key, in LAC and elsewhere, is smart sustainable investing that could in the longer run help nations save billions in their energy transitions and other climate-related costs. Around USD6.3tn of investment in infrastructure is required annually worldwide between 2016 and 2030 to meet the global development needs, according to the OECD. And while an additional USD600bn per year would be needed to make those initiatives sustainable, the incremental costs can be offset by savings of up to USD1.6tn on fuel and energy.
The Rise of Sustainable Finance
Latin America is increasingly turning to ESG-linked funding markets to help address its financing needs. According to the Climate Bonds Initiative, LAC’s green bond markets have picked up strongly in 2019, contributing to 2% of global green bond issuance volume (1% of bonds and 5% of issuers) through H12019.
The total volume of green bonds issued out of the region reached a record USD4.6bn in 2019, driven largely by Chile’s debut dual-currency transaction. Mexico and other regional sovereigns are reportedly next in line to tap new pools of ESG-focussed liquidity.
While most proceeds from green transactions in the region have gone towards land use and industry, energy has been high on the allocations list, as governments double down on developing and expanding the share of alternative energy sources. Roundtable participants saw a natural alignment of ESG investments with the push away from fossil fuels and building renewable energy infrastructure.
“Significant volumes of capital have been going into renewables for some time now,” said one participant, representing major US institutional investor. “Including from dedicated ESG investors, which is a natural fit.”
Investing Through an ESG Lens
Some environmental, social, or governance-related factors are fundamental to getting a complete picture of a borrower’s creditworthiness, but others may be tangential.
“We weigh the relevance of each of those elements to the overall probability of debt repayment. So the “carbon imprint” factor tends to be superseded by the fundamentals of credit quality, and the supply and demand dynamic. An issuer may see more appetite and tighter pricing when the overall conditions are favourable and liquidity ample, but it is all about how much leverage is being placed on the deal – and more often than not, there is too much leverage going into a renewables project than, for example, a gas pipeline.”
Ratings agencies offer a similar approach. Some have begun integrating ESG metrics into their ratings – not necessarily as a measure of ESG impact directly, but rather the potential influence on credit quality and outlook.
“In corporate ratings, if governance is seen as weak or non-transparent, that tends to weigh on their credit rating,” noted Gregory Remec, Senior Director at Fitch Ratings. “So on the project finance side, if it is a single asset with no recourse and governance raises questions about the underlying data, then it would get a lower score. We also examine different elements on the ESG spectrum to establish how it influences the rating. On top of that, the rating of ESG aspects themselves can also be assessed separately, perhaps by dedicated teams within an investment company or a portfolio.”
In the absence of a true global, holistic ESG standard, investors and development banks operating in Latin America tend to either formulate their own approach, piggyback off more experienced and engaged market players – or use a combination of both methods.
Denham Capital, for example, has been investing in renewable energy across Latin America for nearly 10 years and participates in the GRESB infrastructure benchmarking study, put together by the world’s largest pension funds, who wanted to have access to comparable and reliable data on ESG performance for real assets.
“We are also signatories to the IFC Operating Principles for Impact Management," explains Justin DeAngelis, Partner at Denham Capital. “These new Principles provide a market standard for impact investing, in which, in addition to seeking financial return, investments generate positive environmental and social benefits in a transparent and disciplined way.”
DFC, formerly known as OPIC, has developed its own scoring system based on the best practices of a number of different institutional investors.
“We have certain metrics for our 2x borrowers and work with them so they can hit certain metrics now, as well as in the future. This allows them to be aligned with ESG principles,” noted Kristie Pellecchia, Senior Advisor, Western Hemisphere, DFC. “Fundamentals and underlying credit quality remain the decisive factors in drawing investor appetite, however.”
For now, the abundance of options, whether specialized indices, third-party analysis or publicly available ratings, is counterbalanced by the lack of uniformity and international consensus over which are most trustworthy and reliable.
“In our search to discover the best ESG metrics and methodologies, we have struggled to find something that works across the board: we use third party vendors, but it is difficult to translate into a holistic internal framework,” one investor concluded.
Greenwashing and Other Issues
Still, as investors and portfolio managers fall under increasing scrutiny and pressure to prioritize sustainable assets and projects, one of the biggest concerns from their perspective is “greenwashing”, whether on purpose or through negligence and lack of follow through, by issuers, banks, or other market agents.
“Even though there is a lot of buzz about ESG investment, there are big questions about the type of assets and companies that are sitting in those public ESG indexes,” DeAngelis admitted. “Within those portfolios you might see food manufacturers, tech firms and other major corporates and multinationals that often end up having little to do with sustainability in any practical terms. So the question is, as an investor, how do you independently measure impact in a public market context? How do you separate real impact from greenwashing?”
There still remains intense debate over whether the ESG label should be limited to those companies that generate a net positive impact on the environment – or whether it can also include those in historically “dirty” sectors, such as coal or mining, so long as the issuer or borrower demonstrates their commitment to improving, even if incrementally, their ESG metrics, either by reducing environmental or social damage or giving more priority to enhancing ESG outcomes otherwise.
Some of the larger institutional investors have a mandate that is expansive enough to include the latter.
“Our strategy involves us broadening out to include communities that, for example, are still heavily reliant on coal – even though we don’t do any new coal investments now – and we have to work together with those communities to articulate strategies of transitioning away from fossil fuels. Even if that transition is incremental, we have to remain realistic and be supportive of those initiatives,” the insurance company representative noted.
Another is supporting tangentially-related but nevertheless enabling segments. One such example is transmission infrastructure: while not directly part of what can be called “sustainable infrastructure”, transmission lines are often integral to supporting the development of such projects, and ultimately making renewable energy more efficient and accessible.
“While that doesn’t exclude or excuse cases of “greenwashing”, their impact is important, even if it is harder to gauge in terms of ESG scores. That is why developing more in-depth sustainability strategy becomes the goal, rather than focussing all efforts on a given project,” the investor explained.
The S in ESG
Another investor points out that it is hard to view the ESG element on its own, stripped of geographical, regulatory, and social context.
“When, for example, a corporate in a historically “green” industry is looking to launch a project in a country that relies heavily on hydrocarbons exports, you can expect the “social” element to generate more risk, even though the overall ESG impact of the initiative may be net positive,” admits a private credit investor focused on infrastructure .
Investors and issuers present at the roundtable conceded that, when it comes to South America, the “social” element in ESG is the hardest to assess, particularly over the long-term, and can actually clash with the environmental goals set out by either by industry or local regulations, or internal business objectives.
“We need to be careful in separating the environmental and social elements because they are not always in alignment when it comes to making improvements in a country or a community. Depending on a country’s source of financing, renewables aren’t necessarily the best solution,” said a finance manager of a power generation company operating across Latin America.
One example pertained a recent toll road project in Colombia, where the environmental licences were successfully secured, only to be undermined by a flaring of tensions in three separate communities along the route that demanded additional capex investment for tangential projects, such as hospitals and water processing plants, that would have been nigh impossible to anticipate and “price in”.
Another example can be found in Peru, where cheap gas, combined-cycle power generation and mountainous landscapes mean hydropower is actually cheaper and more convenient than solar energy. Following several years of government’s incentives to expand solar and wind power generation, the industry has grown at a significant rate. But although from and environmental perspective it is seen as better option, a single hydropower plant generates far more power and at cheaper rates, so it is actually preferable to the communities where it is built.
“Those aspects need to be taken into consideration when analysing the true extent of impact from an ESG perspective. Perhaps the next step is to differentiate the three elements of the ESG and weighing them up separately, rather than as a bundle.”
“In Latin America particularly, the social aspect often poses a big unknown, Chile being the clear example of how quickly things can escalate,” another roundtable participant observed. “Those risks are harder to price in some places than others – and that’s just in the construction phase of a project. Assessing its lifelong impact on the environment, the community and so on is even more challenging.”
One investment manager insisted that the notion that early stage investors are oblivious to such risks is a myth because “smart money is always concerned about the potential for social discontent around their investment”.
“Ultimately, even if our investment horizon is, for example, five years on a thirty year project, you would have to sell it on at the end of those five years, and you would have to assume the buyer has to be pretty stupid to pick up a project at risk of collapse – due to popular discontent, for example. In reality, that is almost never the case, and that is why at every stage of investment the full due diligence and analysis of the public sentiment is required, irrespective of one’s investment horizon,” the investor said.
An Impressive Regional Track Record
Even though overall volumes of “green bonds” and broadly sustainable finance deals in the region haven’t quite reached levels seen in Europe or Asia, the sector has seen a steady deal flow and arguably some of the most exciting structural innovation in region’s capital markets. Corporates, many of which were represented at the roundtable discussion, have led the way in this segment, even though pricing benefits haven’t always been apparent – a demonstration that, for some, commercial pressures do not always trump the need for long-term sustainability.
One issuer who financed a solar project in the Southern Cone with green bonds said that ESG is certainly intrinsic to the renewable energy sector, which makes it a natural choice for them.
“The green bond option was suggested by our lenders and certification was fairly easy to secure in our case, because we didn’t need any major overhaul – our business model already includes those conditions and metrics as a matter of standard practice and due diligence. That said, it is hard to assess if there was any significant “green discount” – certainly not as much as was sold to us by the arrangers. Still, pricing was not top of mind for us when making the choice to go “green”.”
A good deal of research has been conducted over the past few years on whether a green premium exists – or, if it does, its range – but most of it has been inconclusive. There was, however, some evidence to suggest that green bonds tend to perform better in secondary trading.
A joint Climate Bonds Initiative and IFC research paper comparing data on European green and comparable vanilla issuances in December 2018 indicated that 7 days after pricing, 56% of green bonds had tightened more than comparable bonds, and 71% of green bonds had tightened more than their comparable index. 28 days after pricing, 44% of green bonds had tightened more than comparable bonds, 67% of green bonds had tightened more than their comparable index.
Investors were generally split on why green notes saw better secondary market performance than their vanilla peers.
“Perhaps from a risk management perspective – namely, the expectation of long-term strengthening as ESG goes mainstream – can account for better performance. Another reason could be investor psychology: while most private placements are buy-and-hold, it may be that more investors are drawn to green bonds because they think they will be a more liquid asset going forward, if they eventually decide to sell,” one participant suggested.
Who Foots the Bill?
Questions were also raised about the costs of – and the need to maintain – compliance with ESG metrics by issuers, as well as investors. This is an ongoing – and often heated – debate in the industry, and to no surprise, the roundtable did not bring about a consensus among issuers, investors, or intermediaries. There was, however, some agreement around the fact that ESG metrics will become increasingly integrated into broader credit analysis and rating systems, slowly shifting from optional to mandatory practice.
“It’s like taxes – it depends on the market conjecture, on pertaining power and a host of other factors,” said a lawyer, who preferred to stay off the record. “The burden would be assumed by the party that has less pertaining power. Governments play an important role here, because it is necessary to price those intangibles – the benefits of ESG compliance. Governments ought to put work into developing and improving the methodologies to make those assessments more accurate.”
Participants were complimentary of the role played by governments in helping to foster this market. Some, like Chile, have sought to help create a domestic sovereign green curve by issuing green securities, while others stepped up their focus on scrapping coal plants in favour of renewables projects and incentivizing private investment in sustainable projects.
Future of ESG in Infrastructure Financing
Fernando Rodriguez Marin, a Partner at Bracewell, admitted that one reason the “green label” has played a limited role in project financings was the fact that it is still a big challenge to determine and then track the relevant metrics throughout the entire life of a project, across multiple stakeholders and stages of completion.
“However, there has been a tangential improvement in one sub class: that is, sustainable financings by banks, or so-called SDG-linked loans, which, going forward, will be increasingly more attractive to lenders as the quality of green verification/auditing services continues to grow,” Rodriguez Marin said.
While being ESG compliant is not in itself a recipe to successfully raise debt, CFOs and Treasurers recognise such considerations feature more and more prominently in many project development and construction processes. Ensuring emissions are kept to a minimum and all necessary certificates of sustainability are attained is becoming an important part of corporate risk management, and this is perhaps where the biggest opportunities for growth may lie.
We are also increasingly likely to see funding structures with pricing linked to ESG key performance indicators, explained Aurelio Oliveira, Head of Administration, Finance And Control, South America, and CFO Enel Americas S.A, which issued a pioneering SDG-linked bond last year.
“As an issuer, we were very much in unchartered territory with the SDG-linked transaction,” Oliveira recalled. “It’s a very innovative but at the same time simple concept, because the use of proceeds was not assigned to a single project. The transaction was challenging at the start, but the market was very receptive to the issuance and as a starting point it was a big success, paving the way for more innovation,” Oliveira explained.
The CFO noted that the transaction was a learning curve for the company, entailing a significant shift in corporate mentality and focus.
“That is why we began to increase our renewables assets and to work on improving the quality of life in the regions and cities we are present in. That includes reducing pollution in the big cities and leveraging our financial and reputational strength to influence our counterparties and the market become more sustainable – that is why we did the SDG bond, which allowed us to take on more “clean” assets,” Oliveira concluded.
SDG-linked bonds and loans are helping to bridge the gap between UN’s sustainability goals and how proceeds are deployed. They also offer an incentivised route for those corporates in “dirty” industries to gradually transition towards a more sustainable model while also remaining commercially viable. And as the UN has put infrastructure at the heart of its Sustainable Development Goals, such instruments could soon become an indispensable tool for developers and construction firms across the region as they work to close LAC’s infrastructure gap.