Photo: Oliver Dunkley

Knowing Upstream from Downstream in the Green / Climate Investment Supply Chain


As in any market, there is a supply chain in the market for investments.  In the green / climate investments world, how this supply chain operates seems often to be misunderstood.  This is a serious problem given the critical need to get money moving at speed and in volume through this supply chain, to build the infrastructure demanded by the Paris NDCs.  We look at how the market is segmented and who will invest where.

In many supply chains for physical goods, there are “upstream” and “downstream” segments, which generally reflect increasing levels of manipulation or refinement of the product.  In the petroleum industry, the upstream activity is the exploration and development of wells that produce crude oil, and the downstream segment is literally the refinement of that crude oil into products ranging from gasoline to plastics. In agriculture, primary products like milk at the upstream end flow down into yoghurt, cheese and ice-cream at the downstream end.

At each stage, actors with the right skillsets have to be there to do the necessary processing:  a carpenter and a mechanic both work with hand tools, and could both be called ‘handymen’, but that doesn’t mean either could do the other’s job.

Similarly, we mustn’t assume that everyone called a financier is capable of, or interested in, doing any job that involves the matching of money to assets.  There are, for a whole range of reasons from the technical to the regulatory, very clear and largely immoveable demarcations between one kind financier and other.

The upstream ‘raw materials’ of green or climate finance are the actual projects on the ground – the solar and wind farms, bus and tram systems, water and waste projects.  These investments are ‘raw’ in the sense that they have all kinds of impurities in them, in the form of risks:  technology risks, country risks, currency risks, deal execution risks and project development risks.  What’s more, in the context of the $ trillions circulating in the global financial system, even larger projects are, relatively speaking, so small as to be insignificant on their own.

The error frequently made in climate finance is to see institutional investors (such as pension funds) as the financiers of these ‘raw material’ projects*.  They aren’t, and probably never can be, for three reasons. Firstly, skills-wise, they are simply not equipped to assess these ‘raw’ projects and the risks they contain. Second, they are circled about with regulations specifically designed to stop them taking undue risks with the savings of ‘ordinary people’. And third, their cost structures – again designed to protect those savings from inordinate fees – mean that they have to employ relatively small numbers of people to process huge amounts of money, so they don’t have the bandwidth to address small and complex investments.

Pension funds like big and boring – that’s what we were created for

What they need, instead, are investments that made up of raw materials that have been processed to some degree – indeed, generally, to a very large degree.  This processing needs to ensure that the tough bits (the risks)  have been stripped out of investments, and even some sweeteners added, for example in the form of guarantees or hedges against things like political or currency risk.  Better still, these investments will have been ‘branded’, by means of ratings, listings or similar third-party endorsements indicating some level of consistency and quality.  And finally, they need to be mashed up into a form that will pass through the regulation- and compliance-constricted digestive systems of institutions without causing blockages.  All in all, it’s probably not unfair to say they need to become the financial markets equivalent of baby food.

Speaking at a conference on water risks and opportunities we reported recently, Piet Klop of PGGM (an asset manager handling some $270 billion in assets for Dutch pension funds, summarised it well: “Pension funds like big and boring.  Big and boring investments – that’s what we were created for.”

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So if pension funds are at the downstream end of the green finance supply chain, who is at the upstream end, dealing with the raw projects?  The answer is – or should be – the DFIs and MDBs from the public sector, and project developers, investment banks and equity and debt funds from the private sector. These are the actors that need to be brought together to undertake the primary processing function, but they don’t need just to find the money for projects, they need ideally to create financing structures that then enable projects to be aggregated and fed into the giant maws of the institutional investors.

The financial crash has now for a time given a bad name to what was actually a highly effective  packaging tool

This aggregation, standardisation and branding process was seen at work in the securitisation bonanza of the early 2000’s – a bonanza that sadly saw some very dangerous germs left in the baby food.  The financial crash has now for a time given a bad name to what was actually a highly effective way of packaging millions of tiny primary assets like houses and cars into bland investment products palatable to the big institutional investors.

We now are starting to see the process at work in the green bond market too, but there’s little visibility on what proceeds from these bonds are actually being used for.  Given that very little new raw material is being created (projects on the ground), the suspicion is that this is to some degree either a giant refinancing exercise consuming projects that are already there,  or that proceeds aren’t used as ‘greenly’ as issuers might suggest.

As everyone acknowledges, though, we need far greater scale – plankton soups, not jars of organic cauliflower and quinoa mash.  Achieving that means the primary processors in the climate finance supply chain working far more effectively together to grow the raw material of new projects. While the ‘comfort zone’ role of investment banks is to act as the packagers of processed products to the institutional markets, they could and should have a role in this upstream end of the supply chain too, as project financiers. On the private side, this job is currently being left mainly to project developers and private equity and debt providers, including impact investors.  Investment banks, who are the only players that really have the reach and muscle to do this at scale, currently don’t see the opportunities that are out there, or see transacting in these markets as not profitable enough to match the complexity.

So two things are needed. Firstly, the pipeline that’s embedded in the Paris NDCs and related national low carbon strategies needs to be made much more visible.  And second, the economics need to change, so that the cost of the processed investments reaching the downstream end of the supply chain, to be bought by institutional investors, comes down.

That, in turn, means the DFIs and MDBs understanding and playing their role much more effectively, as primary de-riskers of the raw materials of climate or green finance.  Everyone, including the DFIs and MDBs themselves, realises this, but no one seems to know where to start to make it happen.

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  •  A few institutional investors – Axa and US Asset manager TIAA CREF/Nuveen have special “wallets” for smaller and more complex investments.  These are currently mainly aimed at impact investing

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