Capital and the Common Good

How Innovative Finance Is Tackling the World's Most Urgent Problems

Georgia Levenson Keohane

• Publisher: Columbia University Press
• Year: 2016
• ISBN:
  9780231541664
• Topic: Business
• Subtopic: Finance
• Index: Business

Despite social and economic advances around the world, poverty and disease persist, exacerbated by the mounting challenges of climate change, natural disasters, political conflict, mass migration, and economic inequality. While governments commit to addressing these challenges, traditional public and philanthropic dollars are not enough. Here, innovative finance has shown a way forward: by borrowing techniques from the world of finance, we can raise capital for social investments today. Innovative finance has provided polio vaccines to children in the DRC, crop insurance to farmers in India, pay-as-you-go solar electricity to Kenyans, and affordable housing and transportation to New Yorkers. It has helped governmental, commercial, and philanthropic resources meet the needs of the poor and underserved and build a more sustainable and inclusive prosperity.

Capital and the Common Good shows how market failure in one context can be solved with market solutions from another: an expert in securitization bundles future development aid into bonds to pay for vaccines today; an entrepreneur turns a mobile phone into an array of financial services for the unbanked; and policy makers adapt pay-for-success models from the world of infrastructure to human services like early childhood education, maternal health, and job training. Revisiting the successes and missteps of these efforts, Georgia Levenson Keohane argues that innovative finance is as much about incentives and sound decision-making as it is about money. When it works, innovative finance gives us the tools, motivation, and security to invest in our shared future.

1

REDD Forests, Green Bonds, and the Price of Carbon

A picture is worth a thousand words—and sometimes a billion dollars. So thought Norway when satellite images of rain forests in the Brazilian Amazon confirmed the dramatic decline of deforestation, a major source of carbon emissions—and therefore climate change. In 2008, in an unusual pledge, the oil-rich Norwegian government promised to pay up to $1 billion for verified evidence that Brazil was reducing tropical deforestation—even while continuing to produce commodities like soy and beef. The hope was that this incentive—known as pay-for-success funding—would encourage sustainable development: more crops, less carbon. At the end of 2015, verdant photos in hand, Norway paid the final installment of its $1 billion in green for green. Was this aid? Bribery? A case of innovative finance? And what does it mean for climate change and our common future?

Although the consequences of rising global temperatures are challenging to quantify, we know that, if unmitigated, they will be catastrophic: higher sea levels that flood coastal and low-lying communities; warmed water systems and altered ocean chemistry that threaten marine life and the lives of those who depend on it; extreme weather events including wildfires, hurricanes, flooding and droughts, which, in turn, disrupt agricultural production, create famine and health crises, and exacerbate migration challenges. Because poverty and resilience are so intricately connected—the vast majority of the world’s population lives in regions that are either environmentally or politically unstable, or both—climate change imperils the prosperity and stability that are the hard-won gains of development. As Pope Francis wrote in “Laudato Si’,” the first papal encyclical on stewardship, “We are not faced with two separate crises, one environmental and the other social, but rather one complex crisis that is both social and environmental.”¹

And yet, because climate change is man-made, mitigation and adaptation are possible. The primary drivers of global warming are gases like carbon dioxide (CO₂), methane, and nitrous oxide, which are the by-products of industrial production. These gases block heat radiating from the earth, preventing it from escaping the atmosphere and creating a greenhouse effect (this phenomenon is what makes earth habitable to begin with; the problems come when we increase the concentrations of theses gases in the atmosphere and magnify the greenhouse effect).² Moreover, there is general agreement about how much the emissions of these greenhouse gases need to be reduced to hold the increase in global warming to below 2 degrees Celsius (3.6 degrees Fahrenheit)—the level many scientists believe necessary to avoid the most disastrous effects of climate change.

Yet the economics are more challenging than the science. Can we put a price tag on the massive disruptions that will result from unchecked climate change? What does it cost to stem them, whether through reduced greenhouse gas emissions or other means? How do we continue to develop in ways that lift people out of poverty without further damaging the environment—or our collective well-being? How do we begin to produce and consume goods and services that require less energy? How do we encourage the development of robust and affordable sources of alternative energy—a process we know requires trillions of dollars in investment?³

Although the changes necessary to transition to a lower-carbon economy are daunting in dollar and political terms, there is ample evidence that the costs of inaction, of doing nothing but waiting for irreversible devastation—rising oceans, extreme weather, and exacerbated agriculture, health, and migration crises—far outweigh those of cutting greenhouse gas emissions now.⁴ In fact, uncertainty only makes the case for action stronger when we consider the potential for the truly catastrophic—the “tail” risks of extreme weather and temperature rise—which are not adequately captured in our current models.⁵ In finance terms, some have likened these events to black swans: the environmental equivalents of the unexpected but highly destructive cataclysms that led to the 2008 financial crisis.⁶ In that sense, climate change intervention serves as a kind of insurance policy against the risky business of infinitely larger and more disastrous social and economic consequences.⁷

But how do we pay for all this?

In recent years, we have seen the emergence of climate finance: innovative and creative ways to unlock new resources to foster lower-carbon development and investment in alternative energies and approaches to sustainable growth. The first generation of innovative finance in natural resources management has been largely policy driven, often created or shaped by governments to internalize externalities and improve the way we spend dollars—as in the case of Norway and Brazil—to catalyze broader marketplace activity. Pay-for-success programs, whether in the form of pollution or development credits (e.g., payment not to pollute or not to develop) or contingent aid (e.g., payment, after the fact, for proof that deforestation has not occurred), are prime examples. As we will see, newer instruments and configurations—green debt, green equity, and other hybrid arrangements and investments—while still visible hand—are increasingly being created and shaped by the capital markets. Have they been effective? And if so, why?

Market Solutions to the Problem of Negative Externalities

To understand how these new instruments work in practice, we need a little theory. Man-made climate change—and, in particular, unfettered emissions of pollutants like CO₂—is arguably the world’s largest negative externality. That means the costs of the activity are not borne by those responsible. Negative externalities are a kind of market failure—a problem of incentives and resource allocation. The question becomes how we correct incentives to reduce carbon emissions and direct investment into lower-carbon technologies. This involves getting the costs right, which, in turn, involves getting the prices right. In the absence of a price on carbon, people, firms, and countries continue to pump carbon into the atmosphere, even though we know this is the primary anthropogenic cause of climate change, because it costs them nothing. How do we solve this? Let’s begin with some Economics 101.

In 1968, ecologist Garrett Hardin’s tragedy of the commons introduced the imagery and allegory of negative externalities in a metaphor that has animated both theory and practice in the environmental movement ever since. In Hardin’s pastoral “commons,” in which sheep are grazing, each shepherd benefits from allowing more of his sheep to graze, even when the pasture as a whole withers from overgrazing, diminishing overall productivity. Each shepherd would be better off if he restricted his flock, but no one has an individual incentive to do so. The problem is one of collective action, as the incentives of the individual are at odds with those of the larger, common good. “Therein lies the tragedy,” writes Hardin. “Each man is locked into a system that compels him to increase his herd without limit—in a world that is limited. Ruin is the destination towards which all men rush, each pursuing his own interest in a society that believes in the freedom of the commons. Freedom in a commons brings ruin to all.”⁸ It turns out that this tragedy-of-the-commons construct is an important one for many, but not all, natural resource problems and the ways we have intervened to solve them. While dismal, economics isn’t always tragic—especially when we consider the range of policy and innovative finance solutions that can defy or surmount Hardin’s conundrum.

For the first part of the twentieth century, solutions considered for natural resource problems hinged on the work of Arthur Pigou, an economist who showed that government intervention of some kind, typically in the form of a tax, was necessary to correct for negative externalities along the lines Hardin describes.⁹ This view was later challenged by Ronald Coase, who would go on to win the Nobel Prize in Economics¹⁰ for demonstrating that the clear assignment of private property rights, an alternative to government-imposed taxes, could resolve some negative externalities.

These insights about property rights would lay the groundwork for the design of policy instruments like cap-and-trade regimes: when rights to a resource are well defined, all market actors have an incentive to avoid the degradation of that resource. By establishing “property rights” over clean air, for example, individuals or residents can be compensated if firms pollute their “property.”¹¹ Broadly speaking, and as we will see in the chapters that follow, ownership creates and aligns incentives for proactive, productive agency.

Property rights also create what economists call price signals. By making property rights transferable—that is, by giving them a monetary value—policy makers can create a market that encourages environmentally friendly decision making. If pollution has a price, everyone is motivated to pollute less. For example, prices spur consumers to cut back on the use of carbon-intensive energy (i.e., fossil fuels) and purchase goods and services that require less of this kind of energy to produce. Companies, in turn, work to reduce their emissions or invest in alternative energy sources and technologies. This kind of pricing mechanism lies at the heart of market-based solutions not just for environmental problems but also for many of the massive social and economic problems we will encounter in this book. This is the economics-to-finance nexus and reminds us of the important role of policy in innovative finance.

A Little Practice: Property Rights, Price, and Pollution

One of the most successful case studies in pricing externalities comes from the creation of a market for sulfur dioxide (SO₂) emission allowances.

In the 1960s and 1970s, acid rain caused significant harm to forests and aquatic life and was of great concern to communities across the United States. Although the culprit in much of the acidification was well known—coal-fired power plants emitting SO₂ into the air—there was significant debate about how best to curb these emissions. In 1990, with the urging and support of a handful of innovative environmental groups like the Environmental Defense Fund, a cap-and-trade scheme was written into Title IV of the Clean Air Act Amendments of 1990, passed by Congress and signed into law by George H. W. Bush. The idea was that property rights—in allowances or credits to pollute, which could be used or traded—would enable coal producers to reduce emissions more cheaply and more efficiently than would regulations prescribing specific reduction amounts. The hope was to cap annual and aggregate SO₂ emissions to 8.95 million tons at the country’s 3,200 coal plants; this represented a reduction of 50 percent from 1980 levels, or nearly 9 million tons annually.

To make this work, the cap-and-trade program issued pollution allowances to each coal-fired power plant, representing the tonnage of SO₂ it could emit. The utility was then free to determine how best to make SO₂ cuts. If it reduced emissions and did not use all its allowances, the utility could sell them to others who hadn’t successfully reduced emissions (or bank them for future use). The ability to sell (trade) excess allowances encouraged power plants to get below their own caps as cost-effectively as possible.

Thus, a commodities market for SO₂, and the first large-scale cap-and-trade regime, was born. As the commodity is standardized, trading in the marketplace reveals a “price,” and the emergence of trading “infrastructure”—exchanges, brokerages, and so on—lowers the transaction costs even more.¹²

The SO₂ allowance market is widely viewed as a success of policy and innovative finance. The benefits of the cap-and-trade regime have outweighed the implementation and enforcement costs. On the finance side, the SO₂ program catalyzed the emergence of the kind of infrastructure—brokerages and other intermediaries—that can accommodate large trading volumes, as well as a variety of SO₂ derivative products, including forwards and swaps. Studies show the cap-and-trade scheme has indeed stimulated the development and adoption of new pollution abatement technologies. These hallmarks of success—product standardization, decreasing cost, and ongoing innovation—that have brought additional private capital into this public marketplace, make it a useful template for other interventions, including, as we will observe, the case of carbon.¹³

Seen another way, cap-and-trade represents an early kind of pay-for-success financing. The price puts a monetary value on a reduction in pollution, and firms are paid for that reduction with an allowance they can then sell. As in the Norway-Brazil example, it’s a payment not to pollute. We’ll examine many examples of pay-for-success finance under different names and guises in the coming pages of this book.

One of the more interesting outcomes of the SO₂ story is one of unintended consequences. In 1990, the primary concern about acid rain was its damage to the environment. It turned out, however, that the cleaner air from lower SO₂ emissions substantially reduced sickness and mortality, particularly in urban areas. In fact, the greatest gains from SO₂ reductions have come in public health.¹⁴ This, too, is a significant lesson for how we think about—and finance—our larger sustainable development goals, as issues of environment, health, and poverty are necessarily intertwined.

Property Rights and Sustainable Development: Air, Land, and Sea

We’ve walked through the mechanics of SO₂ reduction in order to understand the theory and practice of property rights in innovative finance: how we can use policy to shape market solutions to market problems. Once we know how and why this works, we can see the imprint elsewhere and start to imagine even broader applications.

Indeed, air pollution is not the only sphere where cap-and-trade schemes complement traditional “command and control” regulations. Those of us who live in or visit cities like New York will recognize cap-and-trade in the buildings around us.

Policy makers attempting to balance development and zoning objectives—and using familiar efficiency and cost-benefit rationales—have created transferable development right (TDR) schemes. Accordingly, buildings that have not reached their height limits under zoning regulations can sell their air rights to developers to build buildings that exceed those limits. In Times Square, the proximity of low-lying, landmarked theaters and enormous new skyscrapers is no coincidence; often the latter have purchased the air rights of the former. The same is true in Chelsea, where owners of land beneath and to the west of the High Line are compensated for the fact they cannot build vertically by their ability to sell their air rights to developers who can and do. In midtown in particular, but across Manhattan, petite and soaring buildings side by side often reveal an air rights trade.

Most recently, the Hines real estate development company began construction in August 2015 on 53W53, a luxury skyscraper formerly known as Tower Verre. Perched on West Fifty-Third Street next to the Museum of Modern Art (MoMA), the project is also known as MoMA Tower and will rival the Empire State Building in height, well in excess of local zoning prescriptions. To do this, Hines has been amassing air rights for a decade, paying $85 million for the unused airspace of neighbors St. Thomas Episcopal Church, the University Club, and MoMA. The project only recently lost the distinction of becoming the city’s largest residential tower (that will now go to 432 Park, another air rights vortex).¹⁵ These projects are not uncontroversial. Both these and similar developments have raised concerns about the altered skyline, the shadows they will cast on Central Park, and the ways in which they have perhaps skewed New York’s development priorities.

Developers also seek out TDRs when looking to build over wetlands—marshes, swamps, or bogs that are covered in water for at least some of the year. Developers typically like wetlands because they are cheap, as the environmental services or benefits wetlands provide—water purification, groundwater recharge, flood control, and habitat for many species of fish, birds, and mammals—are not reflected in the property price.¹⁶ Here, again, in an effort to stem wetland loss, policy makers have created markets where there were none for these environmental services or benefits.¹⁷ Cap-and-trade for wetlands, known as mitigation banking, requires developers to offset the wetlands they “convert” (build on) by purchasing a credit to create or preserve wetlands somewhere else. Not surprisingly, there is a growing market and healthy appetite for wetland restoration credits, which can be purchased through brokers. Today there are approximately 2,000 wetland banks in the United States, transacting several billion dollars in credit sales a year.¹⁸ The most famous wetland developer in history might be Walt Disney, who, i...