Trends: Investment opportunities in sustainable cities

This article first appeared in Personal Wealth, The Edge Malaysia Weekly, on July 9, 2018 - July 15, 2018.
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Innovative forms of financing, such as urban wealth funds, green bonds and social bonds, can help facilitate efficient and targeted infrastructure investments. This leads to greater economic growth, higher employment, more tax revenue and lower social costs.

Investors looking for both financial and societal returns can align their strategies with the UN’s Sustainable Development Goal No 11 (SDG 11) — sustainable cities and communities — as it represents the greatest financial opportunity at US$2.1 trillion. This includes investments in both physical and social infrastructure, according to Citi GPS: Global Perspectives & Solutions.

In its recent report, titled “UN Sustainable Development Goals: Pathways to Success — A Systematic Framework for Aligning Investment”, the authors say that for physical or infrastructure investments in urban populations, some US$329 billion is needed to get global growth back on the long-term desired trend of US$600 billion per year. For social infrastructure investments, the authors break down the required investments into housing (US$650 billion per year), education (US$186 billion per year), health (US$140 billion per year), recreation (US$315 billion per year), smart cities (US$600 million per year) and buildings (US$460 billion per year).

“In summary, these add up to an urban financial spending opportunity of US$2.1 trillion per year. While this may seem extraordinarily large (when compared with the ‘cost’ or benefit of other SDGs), if we remind ourselves that over half of the global population lives in cities, that many of the sustainability challenges are focused and concentrated in cities and, most importantly, that cities generate 80% of the global gross domestic product (valued at US$60.5 trillion), this figure at 3.4% of urban GDP starts to look less extreme,” says the report.

While the challenges for cities around the world are divided into those in developed markets and those in emerging markets, the report says the greatest challenges, and hence opportunities, undoubtedly lie in the latter. “The one billion extra urbanites whom we expect to live in cities by 2030, will grow to two billion extra by 2050. And of these, 1.2 billion will be in Asia and 0.8 billion in Africa. The majority of these cities already have meagre revenue bases and, hence, struggle to support their existing populations, let alone a further one or two billion people, especially if the employment opportunities do not exist for them,” says the report.

With limited revenue in these cities coming from central governments, external capital generated from green bonds, social bonds and urban wealth funds is key to facilitating these investments. “Enhancing the creditworthiness of these markets is key to unlocking the trillions of dollars of private capital, which is desperate for long-dated, asset-backed income streams to match their liabilities, which infrastructure investment lends itself to so well. Rather than investing directly, if development finance institutions can use their capital to provide risk mitigation mechanisms, they can effectively leverage their capital and free up these vast reserves of private capital, which collectively do genuinely have the power to tackle one of the defining challenges of our times,” says the report.

The failure to tackle these obstacles will see these cities fall into the vicious circle of underinvestment in infrastructure, which causes slower economic growth and activity, greater social costs, lower revenue and interest burdens from borrowing to balance the books, which leads to lower infrastructure investment, among others, the report adds.


Unlocking the value of public wealth

Achieving a reasonable yield on public commercial assets could free up more resources than most cities’ current investments in infrastructure, which include roads, railroads, bridges, water, electricity and broadband, says the report. It points out that governments around the world have an estimated US$75 trillion of these assets and with smarter use of them, most cities could potentially more than double their investments. This figure nearly equals one year of global GDP and comprises everything from real estate to government-owned enterprises.

The report says a higher return of just 1% on these assets would add US$750 billion to revenues. “In the context of global annual infrastructure investment of ~US$2.5 trillion, this could facilitate a 30% increase in global levels of infrastructure investments — and clearly, the impact in terms of urban infrastructure investment would be proportionally much greater. Moreover, the impact of this spending on global economic growth, if conducted efficiently, could be considerable,” it adds.

Urban wealth funds — the concept of having a publicly-owned holding company run by professionals recruited from the private sector — are a tool to leverage public assets to give cities economic vitality and financial stability. According to Swedish public finance experts Dag Detter and Stefan Fölster in their book, Public Wealth of Cities: How to Unlock Hidden Assets to Boost Growth and Prosperity, this would be created by placing the publicly-owned assets of a given city in the fund, which is “at arm’s length from short-term political influence”.

The fund would be under the purview of independent managers [with expertise in real estate and finance] who would be tasked with maximising the value of the portfolio. The government will then receive dividends — a better revenue stream and option than cutting services or raising public debt or taxes.

The report says the funds’ essence is that while cities may be well aware of their cash flows, current assets and liabilities, they rarely have any idea of the value of their longer-term assets. “Often, these assets may be poorly run and not earning nearly enough of a commercial return compared with their potential market value, and at the extreme may be vacant, given the impact which technology and automation have had on the physical provision of civic services. If you have no idea of the value of your assets, it is not possible to generate an implied yield and to make informed decisions about whether to develop a waterfront from a partially used port or airport into a booming new residential district, building a new airport elsewhere or having a smaller, newer and more efficient port somewhere else,” it adds.

To create an urban wealth fund, a proper schedule of assets — both long and short term, as well as liabilities — must be formed to build a fully-inclusive balance sheet based on current values instead of historic ones. The next step is to outsource the management of these assets to a well-qualified external third party that can manage the assets efficiently, says the report.

“Their task will be to compare the revenue generation (or cost saving) from these assets against their current market value to examine implied returns, to consider what alternative solutions are possible and to identify the biggest gaps between current returns and potential returns, thereby identifying the greatest opportunities,” it adds.

“These greater returns (essentially more money either through income or reduced costs) can afford a city much greater opportunity to either invest in further physical infrastructure, which if handled efficiently can produce a significant economic multiplier effect, thereby boosting employment and the economy, as well as potential social benefits by the increased or improved provision of services to the populous, such as transport, telecommunications, water, energy or waste services.”

Another potential benefit of urban wealth funds is that a group with independent oversight of assets, which is removed from the political pressures of taking shorter-term and vote-winning actions, may be more at liberty to do what is right for a city from a longer-term perspective. Furthermore, with the right governance and oversight, the independent structure can reduce the risk of corruption, nepotism and institutional inefficiency, says the report.

“Conversely, an urban wealth fund may be criticised by some as ‘selling off the family silver’ to what are perceived to be purely financially-oriented private interests. This does not have to be the case since the assets or benefits of selling, moving, replacing or restructuring them will be still be ‘owned’ by the city,” it points out.

“However, the right structure and oversight, and explaining the concept and benefits fully to voters, should help to alleviate, if not totally eliminate, these concerns. We believe urban wealth funds to be certainly one of, if not the single biggest opportunity to facilitate investment and further the development of sustainable cities around the globe.”


Catalysing sustainable cities with green and social bonds

Green bonds are a form of financing that can help build sustainable cities and tackle issues associated with rapid global urbanisation, says the report. Recent years have seen the emergence of this fixed-income instrument, the proceeds of which are used exclusively to finance green projects. Apart from promoting progress on environmentally sustainable activities, these projects must also be in accordance with the Green Bond Principles released last month by the International Capital Market Association (ICMA), according to the report.

The four types of green bonds are green use of proceeds (the most common type is a normal fixed-income bond); green use of proceeds revenue bond (linked to income streams); green project bond (linked to a single or multiple green projects) and green securitised bond (collateral and cash flows provided by multiple projects).

“Green bond issuances grew 78% in 2017 to US$155.5 billion, with more than 1,500 issues from 37 different countries, taking the cumulative green bond issuance to around US$350 billion. The year started well, with notable features being Indonesia’s issuance of a US$1.25 billion green sukuk — the first sovereign green bond issued in Asia. However, Bloomberg reports that Hong Kong is planning an even bigger sovereign green bond plan of up to US$12.8 billion, the proceeds of which would be for green public works projects,” says the report.

Social bonds, which differ from green bonds only in terms of their use of proceeds, offer further potential for cities in financing sustainable investments, says the report. Instead of green projects, however, these bonds are used to finance projects that “directly aim to help address or mitigate a specific social issue and/or seek to achieve positive social outcomes especially, but not exclusively, for target populations [economically or socially disadvantaged in some manner]”, according to ICMA’s Social Bond Principles.

The authors of the report acknowledge the potential overlap between green and social bonds and point out that those that intentionally blend both elements are known as sustainability bonds. Another key element of social bonds can be the conditions which may be attached to the payment of the coupon. The coupon is often performance-based, in terms of the performance against a specific social goal.

“For example, private finance is generated by a social bond, which is then provided to a not-for-profit contractor tasked with reducing or eradicating a specific social issue (for example, the number of prisoners reoffending within a certain time frame). The ‘coupon’ can then be paid by the issuer (for example, a government or local authority) to the bondholders based on the performance against certain pre-agreed metrics,” says the report.

Despite smaller growth than green bonds, social bonds are growing very quickly with nearly US$9 billion worth of issuances last year and US$12.5 billion in cumulative issuances, says the report. It adds that social bonds have been a more public sector-centric product with private issuances at a relatively low level.

“As awareness of this interesting new bond class comes through, we would expect growth to be significant, just as it has been in the green bond market. With the potential benefits of sustainable projects in cities, be it ‘environmental’ in nature such as energy, water, waste or transport, or more ‘social’ in nature — relating to education, health or law and order — the applicability of green and social bonds is very clear and we would expect to see urban issuances accelerate accordingly,” says the report.