The new colour of money

THE BUYOUT OF US energy concern TXU by a consortium led by Kohlberg Kravis Roberts and Texas Pacific Group will go down in legend as the high-water mark of the recent private equity boom. The $44 billion deal, the largest leveraged buyout in history, is the RJR/Nabisco of this decade.

As Euromoney went to press in early September, the banks financing TXU were rumoured to be asking the private equity groups behind the buyout to drop the bid. The fallout from the sub-prime disaster meant that the institutional market’s desire to pick up the bulk of the deal’s financing had disappeared. It was, commentators argued, surely the example writ large of how the leveraged finance market had overstretched itself.

But will that be how history remembers TXU? Could it in fact be the case that, 20 years down the line, people will recognize the TXU deal as the moment when the need to combat climate change crossed over into the financial markets (see Environmentalists at the gates, Euromoney, September 2007)? Might we look back in bemusement at the concept that, pre-TXU, business and finance had paid little heed to the dire consequences of global warming – particularly now that sustainability had become as fundamental to corporate life as surely as capitalism had defeated communism?

The world’s largest banks are, inevitably, excited at the prospect. Banking is effectively a business of risk and opportunity.

If they, like every other business, from corporates to investors, have to change their strategies because of the risks of climate change, the opportunities are endless.

Think what might happen as the science of global warming is accepted. The investment prospects are hugely exciting. The person who finds the Microsoft, Google or IBM of clean technology will joins the ranks of Bill Gates and Warren Buffett.

But it goes deeper, much deeper, into the very fabric of financial markets. Already companies with coherent environmental policies are outperforming those stuck in dirty technology. M&A business will soon be driven by the new and strong picking off the old and weak; or the ailing trying to renew their business with the acquisition of a bright young thing.

Capital markets will develop a whole new suite of products designed to finance projects such as green buildings, clean energy plants or low-emission means of transport, and enable investors to participate in the only game that matters. Get ready for commercial mortgage-backed securities backed only by receivables from green properties any day soon. Expect the day when the building of an entire city is financed by bonds secured on the income the developers receive from carbon credits, because the population of 50,000 is living in a carbon neutral zone.

Research suggests that the debate about climate change has moved on in the past two or three years. Most people in the developed world, in particular the younger generations, accept global warming – and the role played by mankind – as fact.

And the people who run the world’s major financial institutions have changed their attitudes too. They believe that business has to change, and therefore that they have to change with it. Many feel banks have to do more – that in their privileged positions as intermediaries they can be agents of that change.

And the commitments are huge – generally announced already in the multi-billions of dollars, and with a lot more to come.

Could the banks’ enthusiasm be running ahead of reality? Even the world’s most prominent environmentalist, former US vice-president Al Gore, thinks it might be, but for understandable reasons. "In some cases the commitment of larger banking institutions has run ahead of the expertise and knowledge that currently exists," he says. "And that’s OK. It’s right to try to understand the best ways to maximize the opportunities. It’s a massive shift, and it’s going to pick up speed and be one of the largest movements in the history of business." (See full interview)

Unsurprisingly perhaps, top of the tree is the world’s most global bank – Citi. This year it announced a commitment to invest at least $50 billion in the environment over the next 10 years. Senior Citi bankers say it is merely a "first pass" and expect to exceed the number handily.

It’s rare today to meet any senior banker who doesn’t tell you that green finance is near the top of his agenda. A major bank CEO told Euromoney in June: "I’m not investing anything in this until someone proves the science to me." Unless he’s the only honest man in finance, he’s in a minority of one.

But science aside, there’s a simple reason why banks are investing heavily in green finance – the market is going to get hot. Perhaps the most truthful bank CEO puts it this way: "We’ve invested over $1 billion in clean-tech businesses. They’re doing a great job finding ways to clean up energy. And we’re gonna make a lot of money out of this stuff."

Just how big can green finance become? How long, you might ask, is a piece of string.

"The economic transformation driven by climate change, we believe, will be more profound and deeper than globalization, as energy is so fundamental to economic growth," says Ted Roosevelt, a managing director at Lehman Brothers who heads the firm’s environmental strategy as chairman of its Global Council on Climate Change.

The logic appears sensible. "The impact on funding markets will be transformational," says Michael Klein, chairman and co-CEO of Citi Markets and Banking. "The sectors that will be most affected by dealing with climate change are infrastructure, transport, energy and technology. These can account for up to half the global financing needed in any given year. The impact on financing could be hundreds of billions of dollars."

Take the UK as an example. The country generates about 50 gigawatts of power every year. Say 20% of that was converted to alternative energy. At a conservative estimate, it costs about €1 million to build 1MW of green energy output. That’s €10 billion of capex. A lot of that will need to be financed in debt and equity markets. And that’s only one country.

Then take the automobile industry. Forecasts suggest that the demand for cars globally is going to as much as double as emerging economies get more wealthy. Imagine if the next wave of car building is dominated by hybrid or clean-tech vehicles. The infrastructure demands would be extraordinary.

So if banking is about risk and opportunity, the world’s largest financial institutions have no choice but to be heavily invested in green finance.

Risk advisory plays a big role. "Corporate CEOs have many risks to address," says Klein. "What if climate change is not attacked on a global basis? I may risk losing my competitiveness if I am subject to regulations that my peer group based in other countries are not. How do I address that challenge?"

For Klein the need to act on climate change goes deeper still. "We have 200 million customers around the world and almost all are being impacted by global warming. Around 80% of the world’s market cap is traded through us. How can we not make these commitments?"

One of the first major banks to bring it all together was ABN Amro, which set up its eco-markets division in September 2006. The aim, says the marketing blurb, was to "combine the bank’s experience and capabilities to help clients manage the new risks and take advantage of the new opportunities related to climate change and the environment".

Like all the initiatives, it sounds impressive but, at this early stage in the market’s development, it remains very much an umbrella organization that taps into existing business lines.

That said, a closer look at the revenue streams that fall under the eco-markets umbrella shows why ABN and other banks are excited: among the 12 business and product focus areas are: commodity and principal trading, credit and alternatives, fund-linked derivatives, structured finance, corporate finance and asset management. 

In essence, it’s the capital markets as we know it, with a few green bells and whistles on it.

Getting disparate internal groups to pull in the same direction for a project that has no proven track record of profitability is perhaps the toughest thing bankers charged with environmental strategy have to deal with.

"In November 2005, we decided that we needed to get each part of the firm focused on the environment and how it could be good for business. We knew if we could pull that off, it would be an enduring strategy," says Mark Tercek, head of the environmental policy initiative at Goldman Sachs as well as its Centre for Environmental Markets. "We pushed hard to get our colleagues to see that an environmental strategy for their business unit would not only do some good for the environment, but it would be good for their business as well."

Most banks are pushing pretty hard now. Barely a day goes by without a big financial institution announcing a new scheme or investment to combat climate change, commitment to the environment, policy framework or position statement.

In August, for example, Morgan Stanley announced the creation of the Morgan Stanley Carbon Bank – aimed to assist clients in becoming carbon neutral, something that the firm itself promises to become by 2008.

The first global bank to claim carbon neutrality was HSBC in 2005. During the summer, it made a media splash with the announcement that it had hired Nicholas Stern – the author of the now famous report that made the scientific argument for climate change and its implications – as a special adviser to the bank’s chairman, Stephen Green.

Hedge funds are getting in on the action as well. Man Group, the world’s largest hedge fund, announced at the end of August that institutional investors had committed $380 million to a "pioneering fund" to invest in technology that extracts methane gas from coal mines in China and uses it to create electricity (see Man Group feature).

The biggest global brands are joining in too. In late July, GE unveiled what it claims will be the first credit card dedicated to reducing US cardholders’ carbon emissions. The Earth Rewards card promises to give consumers "rewards that reduce greenhouse gas emissions with every use".

Perhaps green has already become a part of the everyday fabric of finance. Or perhaps in the rush to show their green credentials, there’s already a danger of the market overheating?

"There may be people who think there is a lot of hype around this area but at Credit Suisse green finance is beginning to influence many of the things we do across investment banking, wealth management and asset management," says Michael Philipp, chairman and CEO of Credit Suisse in Europe, Middle East and Africa.

One of Credit Suisse’s most decisive steps was to make an investment in Eco Securities, one of the earliest carbon-based investment banks. "Eco Securities had hired Lazard to sell a strategic stake. We had worked together with Eco Securities on a number of transactions and it was clear that the combination of their carbon portfolio and our structuring and derivatives capabilities would be a great fit in terms of offering products in this area – so we decided to take a 10% stake ourselves," says Philipp.

Where does green investment start and end? Beware of the hype. Believe, if you must, that investing in an index made up purely of water companies – environment-friendly or otherwise – boosts your ethical credentials. Better still, believe that as water is getting more and more scarce, but ever greater quantities of water are needed, then companies expert in the water industry will surely outperform other parts of the market as demand for their product outstrips supply.

"If water is the gold of the future, then you have to invest in it," says one eco-banker. And he’s probably right. Then again, so could be his competitor, who says that water is the new oil. Others say water is the new carbon, or vice-versa. The more scientifically minded state categorically that it’s "still the same basic old H₂O". Gets a bit confusing, doesn’t it?

What’s not in doubt is that banks are increasingly under pressure from lobby groups to turn down business that harms the environment. But for most bankers, it would be the end of the world to have to turn down a piece of business without ensuring that it had done everything within its power to secure it first.

"The easiest thing is to walk away from a piece of business. But then another firm is likely to come in and do it, and could potentially harm the environment," says Greg Fleming, president and COO at Merrill Lynch. "Instead, we make the environmental impact part of our due diligence process, and try to shape the financing to have as positive an effect on the environment as possible. For example, if we were financing a paper mill, we’d try to ensure the financing incorporated a commitment to sustainable forestry."

Most bankers active in this area admit that they are learning as they go along. They try not to have too much profile – it’s not like, at this stage at least, they are doing 50 green finance deals a day. Environmentalists remain a cure and a curse. It’s not always easy to please them and stay within the bounds of what is commercially viable, both on behalf of the bank and the client.

Some bankers admit to worrying constantly that the firm will become inadvertently involved in a piece of business that has a negative environmental impact. Most now have risk committees to check what the impact of any deal will be.

Caution is the watchword. "We take this stuff seriously. So we don’t want to get caught out and look like hypocrites," says a banker.

But companies are seeking out advice from bankers on how to cope with the significant business risks that climate change entails. And more and more often, it’s leading to business for the banks.

"Even 12 months ago we’d get a lot of questions from clients which were very general about the environment and business risk," says Wanda Kim, head of UBS’s environmental risk group. "Now, the quality of question has certainly gone up."

Bankers say it is getting easier to persuade clients to focus on environmental issues, but that wasn’t always the case. "When I started out in this role, I’d often turn up with the bankers to a meeting with a CEO and the first thing they’d ask me is ‘What are you doing here?’" says Tercek who, in a long career at Goldman, had previously run the firm’s global equity capital markets business. "I’d tell them that Goldman, as an adviser and an underwriter to the client, was concerned about the environmental impact of one or more of their actions. Often they’d get angry at first. But then we would explain that they could reduce risk in their business by improving the situation. We’d suggest they speak to NGOs. Later, they’d come back and say: ‘Thanks, that was great advice’."

Showing your green credentials isn’t just about good PR with clients, shareholders and getting the environmental lobby off your back. It’s crucial to the people who will run your bank in the future.

"When we make presentations at the leading colleges and universities, often the first question we’re asked is ‘what’s your environmental policy?’. If you don’t have a credible answer, you’re no longer going to be able to attract the best and brightest people," says Fleming at Merrill Lynch.

It’s a theme echoed by Tercek at Goldman – albeit that Goldman hit upon the theme somewhat by chance. Goldman, as a result of one of its transactions, had "inadvertently" become the owner of a large plot of unspoilt land in Tierra del Fuego. "We decided to ringfence the land in a trust to preserve it; in the end, we actually bought more land to add to it. Suddenly our perception scores at the leading business schools soared. Consultants told us that the move had resonated with young people."

Much of the discussion about the future of green finance remains just that – a market that might or might not develop in the months, years and decades to come. But one asset class already exists under the green umbrella – carbon.

The market has had a mixed start (see feature on page 110). But what bankers want to know is – how far can the carbon trading market go?

The key to the potential of the carbon trading market is standardization – of pricing, of emission schemes, and of course of take-up. Much uncertainty continues to surround the market. The EU emissions trading scheme has had limited success. US voluntary schemes are up and running but add to the sense of disjointedness. Then there’s the biggest uncertainty of all – that post Kyoto, after 2012, there is no widespread agreement on carbon emissions and right now, no one knows what any new agreement will look like.

Such uncertainties don’t limit the ambitions of those involved in the early days of emissions trading. "This is going to be bigger than the credit derivatives market," says Louis Redshaw, head of environmental markets at Barclays Capital. "Carbon is the world’s largest commodity market. It is a by-product of almost every fuel source."

Even with present uncertainties, carbon trading is taking off. "Last year, trading 1 million tonnes of CO₂ would take a couple of weeks to execute. Now we can do it in one phone call," says Kevin Rodgers, global head of complex risk for commodities and FX at Deutsche Bank.

How do you put a potential value on the carbon market? It’s not easy. The EU generates roughly 4.5 billion tonnes of CO₂ each year. The US produces more like 5.5 billion. Let’s say the rest of the world matches what the two biggest polluters produce.

Therefore, the total carbon dioxide output globally each year is around 20 billion tonnes. A recent report by Deutsche Bank envisages the price of carbon under the EU emissions trading scheme reaching €35 per tonne. That gives an annual value to the underlying of around €700 billion – assuming, of course, that every nation was signed up to the same scheme.

Those in the forefront of carbon trading seem to have a genuine belief that cap and trade is the best way to limit emissions.

"There are three options," says Redshaw at Barcap. "Regulation is inefficient. Taxation is reasonably cost-efficient but does not achieve the ultimate ambition, because governments do not know the right level of tax to ensure that emissions are cut without distorting economic growth. But emissions trading works: it brings an absolute reduction in emissions as it creates a finite number of carbon credits; people are then incentivized to find clever ways to reduce their emissions and therefore increase their profits; and in turn that makes the cost of introducing carbon change lower as the focus on new technology to achieve it rises."

There is a precedent – in the US, a market-led scheme to cap and trade sulphur emissions achieved notable reductions.

Bankers have been looking for a lead on carbon trading from the most influential environmental opinion former of all – Al Gore. His message to them will offer some, but not wholehearted, encouragement.

"The carbon-trading regime is like a bucket with a large hole in it. I think it will become the principal way that the international political community addresses carbon emissions. But there will be a growing recognition that CO₂ taxes alongside cap and trade represent the most efficient way of reaching the desired outcome."

And even the main proponents of the carbon-trading market agree with Gore that we’re unlikely to ever see a unified global price for carbon. "We expect to see a series of interconnected carbon markets based on CERs from the Kyoto agreement and its eventual successor," says Rodgers. "Our analogy is that it will be similar to the market for natural gas, where prices are local but trading is global and the linking mechanism is liquefied natural gas."

The endgame of the carbon market is – once there is a clear and transparent price – to create a derivatives market as well. That’s why some bankers draw parallels with the evolution of the credit derivatives markets. "We saw how the creation of the iTraxx index transformed the credit derivatives market," says Charlie Longden, head of eco markets and global head of credit trading at ABN Amro. "That was a project contributed to by a large number of market players. In the long term we’ll need to see something similar in carbon."

But the US could come on board the carbon market in the near future. There’s a growing sense in the US that a new president will bring in a federal carbon emissions policy. "There’s a growing consensus in Washington that cap and trade is the way to go," says Truman Semans, director for markets and business strategy at the Pew Center on Global Climate Change, an NGO established in 1998. The Business Environment Leadership Council (BELC), part of Pew, is the largest association devoted to the development of sound corporate strategies on climate change. Its members comprise 44 US companies with a combined market cap of more than $2.6 trillion. Citi and Bank of America are among its financial sector members.

Jon Anda is in a unique position to comment on the role of investment banks in helping to combat climate change. He is a former head of capital markets and vice-chairman of Morgan Stanley. He left the firm this year to join Environmental Defense as president of the NGO’s environmental markets network.

"Policymakers outside Europe are nervous about turning the CO₂ market over to an unfettered marketplace. One thing that banks can do is show those policymakers that the market solution will work," Anda says.

Part of the key will be to demonstrate transparency. That could be where the markets, and the banks, fall down. "Equity is completely transparent through exchanges," says Anda. "But commodities in general are the least transparent asset class. And banks make a lot of money through that lack of transparency."

What role might the capital markets play in developing green-related products? The likely answer is that existing technology will be adapted to incorporate environmental aspects. Project finance and securitization will increasingly have a green tinge.

The number of green receivables is only going to grow as consumers get in on the act. And this could be a big bonus for banks with a large retail franchise. "We have 57 million clients in the US domestic market and they have gone beyond the tipping point in terms of environmental awareness," says Richie Prager, head of global rates, currencies and commodities at Bank of America. "We’re going to see more credit cards, auto financing and home loans aimed at making a contribution to combating climate change."

In Europe, in particular, banks are creating structured products aimed at giving investors exposure to climate change. Many at this stage are principal-protected. But it is a fast-growing market that is set to spread elsewhere.

One vision of the future – both in terms of the way that we may live and the financing opportunities that climate change creates – is the Masdar clean energy fund.

Masdar is the brainchild of the Abu Dhabi government and is part of the Abu Dhabi Future Energy Corporation, which has committed up to $10 billion to ensure that the oil-rich emirate stays at the forefront of the energy business even when the black gold has run out, by investing in alternative energy technology and business.

Masdar’s start-up capital was $250 million. The Abu Dhabi government put up $100 million, as did its adviser Credit Suisse. Property magnate Vincent Tchenguiz came in for the remaining $50 million. Since inception, Siemens has been brought in for $25 million.

Masdar’s main aim will be to make investments across the world in the alternatives sector.

However it has one very grand plan – to create the world’s first carbon and waste-free city. Described by its architects, Foster and Partners, as "a green utopia in the desert", Masdar City will have a population of 50,000 people. If Masdar City works, then expect the concept to be rolled out to other parts of the world. And for the Abu Dhabi Future Energy Corporation, and its co-investors, to make a lot of money.

Masdar City will cost about $5 billion to build. Much of that will come from traditional funding sources. But what about in the future? Cities such as Masdar will qualify for carbon credits. And they will be able to sell those credits. We could see the day when new carbon-free cities are built and, in part at least, financed by securitizing the receivables from the carbon credits they do not need.

In the meantime, investment bankers and equity capital markets specialists are licking their lips at the prospects of a slew of IPOs as energy companies wrestle with the question – is my alternatives operation more valuable as part of my existing business or separate?

In October, Spanish utility Iberdrola is to spin off part of around 20% of its renewables business, Iberdrola Renovables. This part of the business alone is likely to be valued at about €20 billion.

Energy bankers say they expect Iber Renova to price at a multiple of about 20 times earnings, compared with just 12 times for the overall business. "There’s a pull from institutions to get into green investments," says one. "It’s become a need, if not yet a panic."

Iber Renova has a good precedent in EDF Energies Nouvelles, the alternatives equivalent of the French power group that listed in November last year. Its share price has risen by almost 70% since. "The performance of EDF Energies Nouvelles shows how rapidly the investor community is becoming aware of the growth value and importance of renewables," says John Lynch, managing director in the energy and power group at Merrill Lynch.

How will the relationship between old energy and new, cleaner energy play out in the corporate world? Perhaps an answer lies in the example of the telecoms market.

Many of the fixed-line telephone companies spun off their mobile businesses when the market was in its infancy. Once mobile became integral, even preferential, to the old telephony, the major operators tried to buy their mobile businesses back in.

Of course, financial markets react as well as adapt. And as the world gets warmer, one area that’s likely to grow fast is catastrophe bonds.

The effects of climate change could have a huge impact for insurance companies. Recent data show that, although there is no indication that the number of hurricanes rises as the world warms, the severity of each storm grows. Previous thinking was that for every 10 miles per hour the wind blew harder, damage rose by a factor squared. Latest estimates suggest it rises by the cube. Changing weather patterns should also finally mean that weather derivatives play a prominent role in financial markets, at least a decade after they were first rolled out.

All of these new products will need to find a willing investor base. Most bankers suggest that investment institutions – probably with one eye on their fiduciary duty to maximize returns for clients – have been slow to pick up speed on environmental investments.

That is starting to change. "We have had clients call us to say they would like to put large amounts of their money to work in the climate change/green technology area," says Roosevelt at Lehman. "But it is sometimes difficult to find opportunities to put sizeable funds quickly to work."

With banks looking to structure products and indices for investors to put their money to work in, a whole new industry is growing up – the green rating agency. For example, ABN Amro’s Total Return Water Index carries the stamp of Standard & Poor’s approval as index calculator. Others, such as the FTSE4GOOD and Dow Jones Sustainability Index, are becoming more important as investors seek verification of what counts, and what does not count, as green.

That could bring a new role to the environmental groups. "We get an unbelievable number of calls from investors, or people on Wall Street, asking for help in setting up a large-cap sustainable fund," says Semans at the Pew Center.

And this is effectively what Generation Investment Management, a long-only equity fund established in 2004 by David Blood, the former head of Goldman Sachs Asset Management, and Al Gore, is already doing on its own account.

Generation invests in primarily large-cap companies worth $3 billion or more. Its portfolio in the summer of 2007 contained about 45 stocks. And its investments are decided by a unique, research-driven approach.

"We believe that sustainability – from the environmental, social and governance aspects – are key drivers of business success," says Blood. "For that reason, we fully integrate sustainability into the investment process."

What that means is that Generation has a team of 14 in-house researchers who have the ability to undertake deep analysis of both financial and environmental issues. "The important point is that we do all of this in house, and we don’t in any way separate the sustainability – it is simply not a question of how much of the investment decision is financial, and how much sustainable."

Green finance is also part of the new philanthropy. The leading wealth managers are almost falling over themselves in the rush to give environmental investment opportunities to their richest clients. "I recently saw the CEO of one of Europe’s largest family-owned businesses," says a banker. "We were together for almost two hours. All we talked about was the environment, philanthropy and micro-finance."

At the other end of the scale is the venture capital market. "We anticipate that much of the cutting-edge technology will come mostly from small and medium-sized enterprises," says Roosevelt. "I suspect it will be similar to the biotech or pharmaceutical business. Identifying who those enterprises are with the right technology will be key."

And the potential gains are already high, especially for those funds with real expertise in clean technology. One such is Braemar Energy Partners, a venture capital firm that invests in companies that are creating technologies that make traditional energy sources cleaner, cheaper and more sustainable. Most of Braemar’s partners have more than two decades’ experience in energy, like Bill Lese, the firm’s managing director. A typical Braemar investment will range from $1 million to $5 million, often with partner investors.

One of Braemar’s most successful investments was in Enernoc, a US company aggregating back-up generation units for use in demand response programmes managed by electricity grid Independent Systems. In essence, Enernoc helps reduce congestion in the grid, and therefore makes for a more efficient use of energy.

Enernoc floated in May, in an IPO led by Credit Suisse and Morgan Stanley. The flotation valued the company at £400 million. Braemar, founded in 2001, made an initial investment that was just $210,000 out of a $800,000 financing round. Lese says: "Enernoc has traded at close to 40 times what we invested in it." No wonder he says he is getting more and more interested calls from private equity and hedge funds.

And that is beginning to be a source of concern to some. When Euromoney recently met an investment bank CEO, we were told that environmental finance would be "bigger than the internet". The unspoken meaning was that the reaction to climate change would have an even more profound effect on society than the internet had over the past decade.

But the analogy could have less positive implications. The growth of the internet coincided with a tech boom and bust that caused havoc in financial markets. Could the coming green boom have the same repercussions?

"There’s a lot of money flowing into this area and it is clear that large chunks of the investor community do not understand the underlying risk characteristics of these markets," says Semans at the Pew Center. "We’re going to see some growing pains."

Anda confirms: "There’s definitely a danger of a bubble in cleantech. That would not be good. We want to see more investment in this area. But there’s a lot of state pension funds investing in these areas and an overheated market would be unfortunate. We’ve already seen a boom/bust cycle in ethanol."

But greater issues are at play here. "The technology behind the internet was not driven by irresistible external conditions," says Richard Burrett, global head of sustainability at ABN Amro. "If you believe in climate change science, then this is very different. An iPod is a nice thing to have; it’s not essential. But water and energy are. There’s still 1 billion people in the world with no access to electricity, and 2 billion without access to clean water."

It seems certain that green finance is here to stay. "This was not a subject bankers in general had great deal knowledge of," says Klein at Citi. "As bankers our role is to give long-term advice after digesting significant facts. The last thing we want to get caught in is a fad. At first, climate change did not seem relevant to us. It was a controversy, not a defined science. Now the science is clear."