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Financing The Environment Sector
by Mark Mansley of Claros Consulting
This article, first published in the United Nations Environment Programme journal Industry and Environment, Jan-Mar 1999, investigates some of the issues surrounding private sector finance and the environmental industry, in terms of how the environmental sector is perceived, what some of the problems facing the sector from a financial perspective are and what some of the new instruments and problems are.
1. Perception of the sector
The financial markets willingness to support and finance the environmental sector will depend on its perception of the risks and rewards involved. Here the picture is very mixed. There is an increasing recognition of the high growth potential of the sector, but this is offset by a caution caused in large part by a disappointing experience in recent years.
1.1. The Future Potential: High Growth
Two factors which will encourage the financial industry to focus resources on a sector are a substantial size and above average growth prospects. There is plenty of evidence to suggest the environment sector meets these requirements. For example, Helmet Kaiser Unternehmensberatung’s (HKU) 1997 survey "The Reorientation in the Environmental Technology Industry" concludes that the market is set to be one of few major growth industries over the next 13 years.
The survey is restricted to the "traditional" environmental sector: companies that work with industry and local authorities to reduce their impact on the environment. Key members of this sector are the large water companies, businesses specialising in waste management and recycling and environmental technology companies which monitor and clean up various forms of pollution. The traditional environmental sector is very much tied up with the public sector, in that regulations will often determine the extent of market opportunities and the development of the sector. In the water and waste industry, the public sector is also often involved as a customer and even a competitor. The sector is generally capital intensive and technologically orientated.
The same growth story also applies to what can be called the "green pioneers". These are companies in various areas of economic activity with a very different approach to environmental issues to their industry norms. Most pioneer industries represent niches within a broader industry (organic farming within agriculture, renewable energy in the power sector, ecotourism in the travel industry). Prospects for growth appear very good for many of the green pioneers: demand exceeds supply in organic agriculture; the EU is committing itself to substantial increases in renewable energy and the industry is expanding globally 15 to 25% each year; eco-tourism is the fastest growing market segment of a high growth growing industry. A word of caution though: the green pioneers can be vulnerable as niche players – once they have developed a market, mainstream competitors can move in and take it over.
1.2. Historic Performance: Disappointment
In spite of its excellent potential, the sector has often performed poorly to date, particularly in terms of the equity markets. To illustrate: the value of Clerical Medical’s Evergreen Fund has grown by 37% in the five years to May 1997, while the UK’s FTSE 100 Index advanced by 67%. The fund was notably limited to a strict interpretation of companies in the environmental sector, rather than the broader approach of its more successful competitors.
There is a similar picture at the corporate level: the share price of CFF in France fell by more than 75% in the early 1990s because its iron and aluminium recycling activities were hit by low commodity prices for metals. Bimec in the UK found that a decline in the environmental engineering market, after a period of over-expansion meant there were no financial resources to face a recession. It went bankrupt in 1993. Kenetech, a US wind energy company (one of the few listed renewable energy companies) was seen as an exciting growth stock, but over-expansion and a collapse in the US wind energy market lead to bankruptcy. Such examples are extreme, and clearly there are many success stories. Nonetheless they cast a deep shadow over the sector from the perspective of financial institutions, highlighting the risks involved and making it easy for sceptical financial institutions to focus elsewhere.
2. Specific Problems in Environmental Sector Companies
Normally, a high growth (in terms of a sector’s proportion of GNP) would be expected to produce good investment returns. The fact that in many cases the environment sector has failed to do so suggest the existence of significant problems. Experience elsewhere suggests these are likely be in areas such as excessive competition, poor management or unpredictable changes (e.g. in technology or legislation). More specific analysis identifies six key problems in the environmental sector, and indicates possible responses.
i: Vulnerability to policy developments
Problem: Many companies in the sector are particularly linked to public policy. Unpredictable policy development means that companies can fail to fulfil their potential through no fault of their own and particularly penalises progressive companies seeking to anticipate such development. Even when policy is developed, the long delay between the announcement of legislation and its effective enforcement creates uncertainty.
Response: Those involved in the public policy process need to be fully aware of the consequences of their actions. In particular, policy "over-reach" is to be avoided. Adequate communication of the effects of legal changes is needed, along with their consistent and timely implementation.
ii: ‘Eye on two balls’
Problem: Many companies in the sector may be driven partly by environmental goals - the desire to "save the planet". While in theory entrepreneurs should recognise that their financial success is essential if they are to achieve their environmental goals, in practice conflicts often appear to arise with the demands of financial performance. This may mean failure to bring in key business expertise or unrealistic over-expansion.
Response: Identify opportunities to train and educate environmental entrepreneurs in good business practice and working with the financial markets.
iii: Public perception
Problem: The environment is a emotional subject and hyped up expectations, allied with "fads" (by investors, consumers, media and the companies themselves) lead to backlashes when exaggerated expectations are not met. Indeed, certain companies have traded on image rather than genuine environmental performance.
Response: Information and education, especially for companies and the financial sector. Engaging the media so that the appropriate message is disseminated in a pragmatic and orderly manner.
iv: Eco-efficiency and changing business practices
Problem: Many environmental companies have based their business on handling industry’s waste. However, industry is now pursuing eco-efficiency and actively seeking to reduce waste, eliminating key markets for the environmental sector. (Conversely, end-of-pipe waste management systems are not outmoded in a day, so markets move at an unpredictable rate.)
Response: Encourage the sector to move upstream and understand its customers’ priorities; educate financiers about the potential of eco-efficiency and potential for waste reduction.
Problem: The high profile presence of the sector and close relationship with the environment can be a dubious business benefit. More is often expected of environmental companies. Regulators often target them, rather than the upstream perpetuators of environmental damage (as in the case of Anglian Water and Severn Trent in the UK, who have had to spend some £900m on lowering nitrate and pesticide levels in drinking water originating from industrial agriculture). Consequences include diversion of management’s time, additional operating and capital expenditure, and concern over potential liabilities.
Response: Development of appropriate policy mechanisms which do not allow such companies to become a "sink" for environment concern - ensure they can implement the "polluter pays principle" too. Education of the public, the media, regulators and markets, and long term approach by investors.
vi: The centrality of public finance
Problem: Many environmental companies may depend on public finance, especially small and medium sized enterprises e.g. for research grants. While useful, such finds are not without drawbacks. Companies may have difficulty learning about the availability of these sources of finance as well as problems in applying for them. Successful applicants can become dependent on such sources of grant money, which often stops before companies are ready to attract private capital – a process termed the "the valley of death" by some observers.
Response: Develop improved communications strategies to inform companies about funds available. Integrate and streamline application procedures. Consider the use of financial intermediaries. Develop mechanisms to arrange a handover to private sources of finance at the end of such programmes.
In theory, the environmental sector has access to most financing instruments available from commercial banks and investors. However, the specific problems discussed above indicate that the sector may at least need help in accessing sources of finance, in terms of improving preparation before talking to the financiers and by helping to change the negative perception of financiers. However, some of the problems of the sector are such that they may be best addressed by a focus on relatively new forms of finance or by innovation in applying and structuring existing financial instruments. This need for a degree of innovation may also be indicated by the fact that environmental sector companies may be trying to change an existing system, which may result in difference in scale, in organisation, or in cash flows which require the use of new or different financial instruments. Thus there are number of new or established financial instruments that are particularly relevant to environmental sector companies. The most relevant are:
Scale: micro: under ECU 50,000, small: ECU 50-500,000; medium: ECU 500,000-5m, large ECU 5m+
Project finance can provide an effective way of providing infrastructure funding. It involves investment into specific, stand-alone projects, with only limited recourse to outside parties if the project runs into difficulties. In the environmental sector, projects can involve water, renewable energy and waste management (eco-tourism facilities and public transport systems can also be project financed). Project finance normally depends on a key contract to supply or charge for the services provided (e.g. power or water). Negotiating a viable and robust contract can be difficult and controversial, particularly in sectors like water where it may result in increased consumer costs. If these contracts are secure there can be some flexibility over ownership of the facility - such as build-own-operate-transfer (BOOT) structures. There has been growing interest in developing countries in project finance.
One key issue for the environmental sector is the need to achieve a certain scale. To justify the transaction costs involved, project finance normally requires sums of ECU 20m and above. This can restrict its applicability in many areas such as renewable energy where few projects reach this size.
Leasing is the provision of finance to acquire a piece of capital equipment, with the finance secured by title to the equipment. It is a highly flexible form of finance used throughout business to finance everything from photocopiers to aircraft. Leasing works best where the equipment is movable and saleable, although it has been used more generally. It can be regarded as a form of sales financing - i.e. it helps customers of a company buy that company’s equipment. Leasing has been used to buy various sources of environmental technology from monitoring equipment to wind turbines, but no leasing companies specialising in environmental technology have been identified. Leasing can be particularly effective if it is combined with tax advantages such as accelerated capital allowances (by transferring a tax credit to an organisation that can use it). If the tax advantages are focused on environmental equipment (as for instance has been done in the Netherlands) it can be very effective in improving the links between the leasing industry and the environmental sector.
Ecological / Ethical Banks and Microcredit
Recently a number of ecological or ethical banks have been formed in developed countries such as: the Ökobank and UmweltBank in Germany, Triodos Bank of the Netherlands, Belgium and the UK, and the Ecology Building Society in the UK. These banks are typically very small (although growing) and they focus on providing lending for "good" projects, which results in a major interest in small projects and business in the environmental sector, where they can be a significant force. They have also been behind the formation of a number of the environmental funds discussed below. In developing countries there has been rapidly growing interest in microcredit organisations which lend small amounts of money to the poor to enable entrepreneurial actively, initiated by the Grameen Bank in Pakistan. While their primary goal is poverty alleviation rather environmental concerns, they can may a useful role in financing certain environmental technology – e.g. home P.V. systems.
Venture capital is a specialist form of investment that provides equity capital to small, new companies. Small companies with no track record can have difficulties raising capital from most investors, and venture capitalists aim to fill the gap. It is normally high return / high risk - venture capitalists expect to see returns of over 25% from their investments but accept that a certain number will fail. Normally, they have a relatively long-term focus, aiming to hold companies for several years before selling them and have a more active approach than most other types of investors, in terms of participating in management of the company. Venture capital often has a focus on technology, with information technology and biotechnology being recent favourites. Venture capital has been strongest in the US, although it has grown substantially recently in Europe and in the developing world as it is seen as encouraging entrepreneurial activity and economic growth. While many venture capital groups will look at environmental technology there are few specialists in the area.
Initial Public Offerings:
Obtaining a stock market listing and using the opportunity to raise capital is a mainstream financing activity which has been used by the environmental sector, e.g. Sto and Sero in Germany in the mid 1990s. The growth of second tier stock exchanges focusing on smaller companies in many countries should help make it easier for environmental sector companies to obtain listings and raise finance. This process would be made easier still if investors were properly informed about the environmental sector and had faith in the development of environmental policy.
Environmental Sector Funds
Dedicated environmental sector funds fall into two categories: Those investing largely or solely in listed investments and those investing in unlisted ventures or projects.
Listed funds were the first to be launched and have been the most prominent. Several such funds were launched at the height of interest in the environment in the early 1990s. Many of these funds have not performed well, because they were launched with a limited understanding of environmental trends and too narrow a definition of "environment". As a result they invested in waste management and end-of-pipe technologies just as the market was shifting to cleaner production and waste minimisation. More broadly based environmental funds have performed satisfactorily.
As these funds buy listed environmental company shares on the market they do not channel any new money into the sector except at the initial public offering (IPO) stage, or subscribing to rights issues and other new share issues. However, buying these equities supports the market valuation of sustainable development companies, thereby encouraging more companies to be bought to the market and highlighting investor interest in the sector. The funds can also become forces for maintaining pressure upon the company’s operations.
More recently, the attention has shifted to unlisted funds. These funds focus on providing new money to projects and ventures within the environmental sector. They can make a positive contribution to sustainable development, by channelling funds to key areas.
The most prominent example is the "green" funds launched in the Netherlands. These funds have focused on providing debt for environmental projects, and have been made especially attractive with the provision of tax concessions to investors. The other area where there is current activity is in the emerging markets where development banks are keen on developing targeted investment vehicles with a sustainable development emphasis.
As well as providing capital, such funds can help overcome some of the obstacles encountered by emerging environmental industries, by building up industry knowledge and providing financial expertise.
Non-Government Organisations (NGOs)
NGOs have also played a role in mobilising finance for sustainable development. Notable has been the work of US foundations, such as the MacArthur Foundation and the Rockefeller Brothers Foundation in supporting the development of innovative financing vehicles in areas such as photovoltaics and other renewable energy projects; as well as sustainable forestry. They have helped to create vehicles like the Environmental Enterprises Assistance Fund, which provides funding for small scale renewable energy projects and E&Co, which provides pre-development finance for projects. In other countries there is possibly a greater reliance on the public sector for such support. This has its drawbacks as the public sector can be slower to respond and less open to innovation than independent organisations.
Public Sector Investment Banks
Public sector investment and development banks can play a role in encouraging the private financial sector to support the environmental sector, by supporting research and innovation, providing part funding and by working through intermediary financial institutions. A number of development banks have recognised that with the expanded provision of private finance in many markets, they must redefine their roles. A natural step for them to take is to lead in the provision of finance in new or underfinanced areas, particularly those relevant to broader societal goals, such as sustainable development. Thus financing the environmental sector appears a suitable opportunity for them. Among the multilateral development banks, the European Bank for Reconstruction and Development has the need to support sustainable development in its statutes and has an active environment department. One area where it has been particularly active is supporting energy efficiency and the development of energy service companies. The World Bank Group, notably the International Finance Corporation, has also started to focus its attention on the financial opportunities and challenges of sustainable development and has built up a portfolio of activities.
4. Analysis and Ways Forward
In financial market terms the environmental industry represents something of a paradox: great fundamental prospects but poor performance. This combined with a number of more technical factors has deterred investment. To overcome this and help the sector develop its full potential there are a range of possible policy measures.
Should governments adopt an aggressive program of such actions, they could greatly encourage financiers to support the environmental sector and thus accelerate progress towards sustainable development.
Mark Mansley, Claros Consulting.
Based on Chapter 6: the Environmental Sector in "The Role of Financial Institutions in Achieving Sustainable Development", Report to the European Commission. Mark Mansley, Delphi International/Ecologic.