AMarketforBrownAssetsToMakeFinanceGreenByLauraCeramiandDomenicoFanizzaWP/23/11IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement.2023JANTheauthorwasExecutiveDirectorforItaly,Albania,Greece,Malta,Portugal,SanMarinoatthetimethispaperwasprepared.HeiscurrentlyExecutiveDirectorrepresentingItaly,theUnitedKingdom,andtheNetherlandsattheAfricanDevelopmentBank.©2023InternationalMonetaryFundWP/23/11IMFWorkingPaperOfficeoftheExecutiveDirectorAMarketforBrownAssetsToMakeFinanceGreenPreparedbyLauraCeramiandDomenicoFanizzaAuthorizedfordistributionbyAnanthakrishnanPrasadJanuary2023IMFWorkingPapersdescriberesearchinprogressbytheauthor(s)andarepublishedtoelicitcommentsandtoencouragedebate.TheviewsexpressedinIMFWorkingPapersarethoseoftheauthor(s)anddonotnecessarilyrepresenttheviewsoftheIMF,itsExecutiveBoard,orIMFmanagement.ABSTRACT:Thispaperproposesamarketsolutiontoenhancetheroleofthefinancialsectorinthegreentransition.Developingasecondarymarketfor“brownexposures”canallowbankstodisposemorequicklyofstrandedassetstherebyincreasingtheircapacitytofinancegreeninvestments.Furthermore,newlycreatedinstruments–thebrownassetsbackedsecurities(B-ABS)-canexpandthediversificationopportunitiesforspecializedgreeninvestorsand,thus,attractadditionalresourcesfornewgreeninvestments.Theexperienceofthesecondarymarketfornon-performingloanssuggeststhattargetedpolicyandregulatorymeasurescansimultaneouslysupportthedevelopmentofthesecondarymarketforbrownassetsandgreenfinance.JELClassificationNumbers:G21;G23;H63;Q54Keywords:Greenfinance;financialinnovation;greenium;financialsector;climatechangeAuthor’sE-MailAddress:lcerami@imf.org;d.fanizza@afdb.orgIMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND3WORKINGPAPERSAmarketforbrownassetstomakefinancegreenPreparedbyLauraCeramiandDomenicoFanizza11WewouldliketothankWilliamOmanandZhongxiaZhangfortheirhelpfulcommentsandsuggestions.WealsothankPasqualeLucioScandizzo,theorganizersandparticipantsoftheAnnualConferenceSITES2022,UniversitàParthenope,Naples,Italy,September16-17,2022,fordiscussions.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND4Contents1.Introduction............................................................................................................................................52.Trendsandchallengesforgreenfinance...........................................................................................63.Thecaseforasecondarymarketforbrownassets:asupply-sideperspective.............................74.Thecaseforasecondarymarketforbrownassets:ademand-sideperspective........................104a.Themarketsforgreenbonds…………………………………………………………………….114b.Thegreenium…………………………………………………………………………………………115.Theroleforpolicies…………………………………………………………………………………………...144a.TheEuropeanmarketforNPL…………………………………………………………………….144b.Apolicysimulation………………………………………………………………………………….156.Conclusions…………………………………………………………………………………………………….17References.........................................................................................................................................................18IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND51.IntroductionTheCOVIDpandemichasmarkedaturningpointintheglobalpushtoaddressclimatechange.Thesharpdropofcarbonemissionsrecordedduringtheshutdowns,particularlyinthemostdenselypopulatedandheavilyindustrializedregions,providedastarkpictureoftheextenttowhichhumanactivityaffectedtheatmospheredirectlyand,climatechangeindirectly2.Emissionsreboundedveryrapidlysoonaftertheendofthelockdowns,reachingnearlypre-pandemiclevelswellbeforethefullreopeningoftheeconomy.Thus,itisjustnotpracticaltocutemissionsbyreducingactivityintheindustrialandresidentialsectorsusingtheexistingenergyinfrastructure.Reducingemissionspermanentlywillrequirethetransitionofthesesectorstolow-carbon-emittingtechnologies.ThisconclusionfromthepandemicreinvigoratedthepublicdebatearoundclimatechangepoliciesaheadoftheUnitedNationsClimateChangeConference-COP26Summit(Glasgow,2021),whichconfirmedthecommitment,enshrinedintheParisAgreement(2015),tokeeptheglobaltemperaturerisewellbelow2degreesCelsiusabovepre-industriallevelsandtopursueeffortstolimitthetemperatureincreaseevenfurtherto1.5degreesCelsius.Inaddition,thesignatoriesoftheGlasgowClimatePactcommittedtopublishupdatedplanstocutgreenhousegasemissionsby45percentby2030andtocontributetothenet-zerogoalby2050.Achievingthecommittedglobaldecarbonizationgoalswillrequireasubstantialsurgeininvestmentsabovehistoricallevelsandmostrecenttrends.Currentestimatesrangearoundstaggeringfigures,althoughsubjecttoaveryhighdegreeofuncertaintyreflectingthenoveltyofthemodelsandthelongprojectionhorizons.Forexample,accordingtoMcKinsey(2022),achievingnet-zeroemissionsby2050wouldrequireabout275trillionU.S.dollarsincumulativespendingonphysicalassets,orapproximately9.2trilliondollarsperyear,overthenextthreedecades.IntheEuropeanUnionalone,theinvestmentneedsareestimatedat28trillioneuros(McKinsey,2020).Becauseofthepotentialdownsiderisksfromaclimatestrategyfocusedexclusivelyongreenactivities,thispaperputsforwardamorebalancedapproachthatconsiderstheneedofpromotingboththedismissalofcarbonintensivetechnologies,andthedevelopmentandadoptionofcleantechnologies.Specifically,thispaperproposesthelaunchofasecondarymarketforbrownassetsresultingfromthesecuritizationofbanksexposurestocarbonintensiveactivities,asameansofontheonehand,mitigatingtherisksfromelevatedstrandedassetsandincreasingbanks’availablecapitaltoextendcreditforgreeningtheeconomy,andontheotherhand,providingbetterrisk-returnopportunitiestodedicatedgreeninvestors,andthuspossiblymakingmorefinancingavailablefortheenergytransitionthanotherwise.Theremainderofthepaperisstructuredasfollows.Insection2,wedescriberecentdevelopmentsandcurrenttrendsandchallengesforgreenfinance.Insection3,wepresentthecaseforasecondarymarketforbrownassetsfromthesupply-sideperspective,basedonastylizedbankmodelofexposuresandexploitingtheoutcomeoftheEuropeanBankingAuthority(EBA)’sclimateriskmappingexercise3.Insection4,weexplorethepotentialdemandforsecuritizedbrownassetsfromthepointofviewofadedicatedgreeninvestor.Insection5,weexaminetheroleforpoliciestosupportthedevelopmentofasecondarymarketforbrownassets.2LaughnerJ.L.,NeuJ.L.,SchimelD.,andZengZ.,SocietalshiftsduetoCOVID-19reveallarge-scalecomplexitiesandfeedbacksbetweenatmosphericchemistryandclimatechange.ProceedingsoftheNationalAcademyofScienceUSA.2021Nov16;118(46):e2109481118.doi:10.1073/pnas.2109481118.3EuropeanBankingAuthority(2021).Mappingclimaterisk:MainfindingsfromtheEU-widepilotexercise,EBA/Rep/2021/11,21May2021.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND6Lastly,section6summarizesthemainconclusionsandhighlightsthepotentialbenefitsoftheproposedmarketforbrownassets.2.TrendsandchallengesforgreenfinanceThepublicsectorisexpectedtoplayakeyroleinthegreentransition.SeizingontheopportunitytosupporttherecoveryfromthepandemicaswellasontheneedtostrengthenenergysecurityandresilienceinresponsetotheeconomicfalloutoftheconflictinUkraine,manycountriesareincreasingpublicinvestmentincleanenergyandinfrastructure.InEurope,forexample,themajorityshareofthenationalRecoveryandResiliencePlans,supportedbyEuropeanfunds(NextGenerationEU),willbespenttoacceleratethegreentransition.Theprivatesector,particularlythefinancialsector,willhavetocomplementpublicinvestmentsandprovidethebulkoftherequiredresources.Therange,size,anddepthoffinancialinstrumentstochannelprivatecapitaltowardgreeninitiativeshaveexpandedrapidlyinrecentyears.GreenbondissuancevolumeinEuropeincreasedby90percentfrom2020toreach252billioneurosin20214,onthebackofamoreprominentparticipationofsovereignandsupranationalissuers.Inthesameyear,greenbondsconstitutedabout11percentoftotalEuropeanbondissuance.Thetotaloutstandingvolumeofgreenbondsattheendof2021reachedabout700billioneuros.Thesebondswerepredominantlyissuedbyinvestmentgradecorporatesintheformofplainvanillafixedcouponbondswithamaturityofuptosevenyearsanddenominatedineuros.Therehasalsobeenagrowinginterestinsustainable-linkedandtransitionbonds.Theformersareperformance-basedbondswithpaymentscontingentonkeyperformanceindicatorsalignedwithasustainabilitystrategy.Transitionbondsareproceed-basedlikegreenbondsbuthaveanarrowerscope,astheyaretypicallyissuedbycarbonintensivecompaniestostartgreeningtheiroperations.Finally,thegreensecuritizationmarket,althoughstillsmall,hasalsorecordedaremarkablegrowthin2021,withatotalissuanceofabout4.5billioneuros.Greencapitalmarketsarecomplementedbythesupplyofgreen-linkedloans,whichpartlycontributedtothedevelopmentofgreensecuritization.Despitetherapiddevelopmentofgreenfinance,thefundingshortfallremainsalarminglylarge.In2021,green-likedbondandloanissuancevolumesamountedtoabout450billioneuros,onlyahalfoftheannualinvestmentneedstoachievecarbonneutralityby2050inEurope.BanksremainthemainsourceofexternalfinancingfortheEuropeanprivatesectorandareplayingakeyroleingreenfinancebyissuinggreen-linkedloans,bonds(whoseproceedsareintendedtoextendloansforgreenprojects),andasset-backedsecuritiesresultingfromthesecuritizationofgreenloans.However,accordingtothefindingsofthefirstpilotexerciseconductedbytheEuropeanBankingAuthority(2021)tomapclimateriskintheEuropeanBankingsector,only25percentofthetotalsubmittednotionalexposurecoveredbytheEUtaxonomyareidentifiedasgreen.Moreover,thegreenassetratio,thatistheprimaryindicatorofgreennessproposedbytheEBAforthedisclosurebybanksisestimatedatjust7.9percent.Accordingtothemappingexercise,morethanhalfofbanks’exposures(58%oftotalnon-SMEcorporateexposurestoEUobligors)areallocatedtosectorsthatmightbesensitivetotransitionrisks.Thesefindingsclearlyshowthatgreeningbanks’balancesheetsisstillafardistantgoal.4AssociationforFinancialMarketsinEurope-AFME(2021).ESGFinanceReport,EuropeanSustainableFinance,Q4and2021FullYear.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND7Environmental,social,andgovernance(ESG)investinghasthepotentialtoacceleratethejourneytoachieveclimatechangegoals,eventhoughtheevidenceisnotconclusive,partlyreflectingtheabsenceofaregulatoryframework,thatmightmitigatetheriskofgreenwashingandincentivizecompliancewithfirms’declaredcommitmentstogreeningtheiractivities5.Fromthisperspective,recentprogresstowardstheadoptionofcommontaxonomiesofgreenactivities,suchastheEUtaxonomy,andrelateddisclosureandreportingrequirementsforthecorporateandthefinancialsectorcanhelpmitigatetheriskofgreenwashing,whichconstitutesamajorobstacletoamorerapidexpansionofgreenfinance.Otherpoliciesandregulatorymeasurescanprovidefurtherincentivestogreeninvestmentsandattractprivatecapital.However,someoftheenvisagedpoliciesortheirspecificdesign,mightalsohavetheunintendedconsequenceofincreasingthecostand,hence,reducingthesupplyofprivatecapitalforgreenprojects.Forexample,asharpincreaseincarbonpricestoachievetheemissionreductiontargetswouldhitfirmsthathaveheavycarbonfootprints,leadingtohigherdefaults,whichwouldresultinimpairedcreditqualityforthebanksexposedtothosefirms6.Thisexampleshowshowclimatepoliciesbynarrowlyfocusingonthegreeneconomyattheexpenseofcarbon-intensiveinfrastructureandactivitiesmightacceleratethedepreciationofbrownassetsovermuchshorterperiodsoftimethanfeasibletoensureasmoothandefficienttransition.Theemergenceoftheso-calledstrandedassetsisachallengingrisktomanageforthefinancialsector,andtodulyconsiderbypolicymakersinthedesignofclimatepolicies.AsfirstunderscoredbyH.-W.Sinninhisprovocativebook,Thegreenparadox(2008),todayitiswidelyacceptedtheviewthatclimatechangepoliciesaimedatcurbingconsumptionoffossilenergycanhavetheoppositeunintendedeffectofacceleratingtheproductionoffossilenergyand,thus,climatechange.Amorepragmaticapproachtomitigation,ontheotherend,mightbemoreeffective.3.Thecaseforasecondarymarketforbrownassets:asupply-sideperspectiveBanksareexpandingtheirgreenassetsportfoliosbutstartingfromaverylowlevel,presumablyonaccountofbothdemandandsupplyconstraints.Onthedemandside,bankablegreenprojectsmightstillbelimited,albeitareexpectedtogrowinresponsetotheglobalpushtoclimateaction,whichhasmorerecentlybeenreinforcedbygrowingconcernsoverenergysecurity.Inthecurrentenvironment,itisreasonabletoexpectalastingincreaseinfossilfuelpricesandaweakeningprofitabilitytrendforbusinessactivitieswithhigh-carboncontent.Publicpolicies,suchascarbonpricing,mayfurthertiltlenders’appetitetowardsgreeninvestments.Onthesupplyside,banksmightbecapitalconstrainedbecauseofstrictcapitalrequirementsandthelegaciesofpastcrises,mostnotablytheunwindingofpandemic-relatedsupportmeasures.However,macroprudentialmeasures,suchastheso-calledbrownpenalizingfactor(i.e.,higherrisk-weightincapitalrequirementsforcarbon-intensiveassets)andconverselyagreensupportingfactorthatadjustscapitalrequirementsforgreenbonds,mayeasebalancesheetconstraints.5Forinstance,Elmaltetal.(2021)findaweakrelationshipbetweenemissionsgrowthandESGscores,withfirmswithbetterscoresdisplayingonlysomewhatsloweremissionsgrowth.6Climatestresstestsconductedbybankingsupervisoryauthoritieshavefoundamaterial,albeitmanageable,impact.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND8Inourmodel,wefocusonsupplyconstraintsandassumethattorebalancetheirportfoliostowardsgreenassets,bankscanonlystoprollingovertheirbrownexposuresandinvesttheproceedsintogreenprojects.Incontrast,greenexposurescomingtomaturityarereinvestedinthesame(rolledover)orothergreenprojects.Ourobjectiveistosimulatethetimepaththatwouldrebalancebanksportfoliostowardsgreenassetsunderthedescribedstrategy,whichwelabelaspassiverebalancing.Tothisend,weassumethatallexposurescanbesplitintotwobroadcategories,greenandbrown,wheretheformersaredefinedinlinewiththeEUtaxonomyasappliedintheEBApilotexercise,whileallotherexposuresareconsideredasbrown.Forthepurposesofoursimulation,wesettheendpointatanequallybalancedportfoliobetweenbrownandgreenassets,intendedasapurelyillustrativeexample.Infact,theoptimalmixwillvaryacrossbanksdependingontheirbusinessmodel,policies,andriskmanagementframeworks.Undertheaboveassumptions,theevolutionofthebrownandthegreenportfolios,canbedescribedbythefollowinglawsofmotion:B(t)=B(t-1)(1+r-δ)(1)G(t)=G(t-1)(1+r)+δB(t-1)(2)Inequations(1)and(2),BandGarethetotalbrownandgreenexposuressubmittedintheEBAclimateriskmappingexercise,andtisthestandardtimevariable.Bothbrownandgreenassetsearnayieldr,thatweassumeequaltothereturnonfinancialassetscalculatedfromtheEBARiskDashboard(September2021).Brownassetsareamortizedattherateδ,whichisproxiedbythequarterlygrowthrateofnetloanstonon-financialcorporationsintheeuroarea(average2018-2021).Weareconsciousthattheassumptionofconstantandequalreturnsforbrownandgreenassetsmightbeveryfarfromthereality,notleastbecauseoftheexpectedimpactofthegreentransitionandpoliciestosupportthistransitionontheprofitabilityofactivitiesandassetswithdifferentcarboncontent.However,fromthisperspective,ourassumptionhastheadvantageofdeliveringaconservativeestimateofthetimerequiredforgreeningbanks’balancesheets.Moreover,theempiricalevidence,althoughlimited,infavorofthe“greenium”doesnotjustifyassumingthatgreenassetsyieldhigherreturnsthanbrownones.Asaninitialcondition,ewecomputegreenexposuresbasedonthetotalexposuressubmittedtotheEBAexerciseandthecalculatedgreenassetratioof7.9percent7.Oursimplesimulationshowsthatitwouldtakeabout40yearstobringthegreenassetsratiofromtheinitialvalueof7.9percentto50percent,underthepassiverebalancingstrategydescribedbyequations(1)and(2),asshownbythesolidlinesinfigure1.ThesimulationstartsfromthesnapshotofEuropeanbanks’balancesheetssubmittedtotheEBAclimateexercise.7IntheEBAexercise,thegreenassetratioiscalculatedastheratioofEUtaxonomy-alignedexposurestotaxonomy-eligibleexposures.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND9Figure1.Greeningbanksportfolios:passivevsactiverebalancing(timetobalancebrownandgreenexposures)Ournextstepisallowingthebankstooffloadaportionoftheirbrownexposuresthroughtheirsecuritizationandsaleinthesecondarymarketforbrownassets.Bankscannowdisposeoftheirbrownassetsonthemarket.Therefore,wefocusonthedynamicsofanalternativerebalancingstrategy,whichwedefineasactiverebalancing,wherebybankscanincreasetheirgreenexposuresbyinvestingtheproceedsfromthesaleofsecuritizedbrownassetsinadditiontothosefrommaturingbrownexposures.Undertheactiverebalancingstrategy,thedynamicsofthesharesofbrownandgreenexposurescanberepresentedasfollows:B(t)=B(t-1)(1+r-δ-s)(3)G(t)=G(t-1)(1+r)+(δ+s)B(t-1)(4)wheretheonlynewvariable,s,istheshareofbrownassetsdisposedonthemarket.Thepotentialbenefitofthemarketforbrownassetsasameansofacceleratingthegreeningofbanks’balancesheetsand,hence,increasingtheresourcestofinancethetransitiontoagreeneconomy,willcriticallydependontheevolutionofthismarketanditsdepth.Inthisrespect,itisimportanttonoticethatthenewinstrumentsbackedbybrownassetsarenotintendedtoprovidefreshfinancingtobrownactivitiesbuttosupportthephase-outoftheexistingcapitalstockthatreliesondirtyorbrowntechnologiesanditsreplacementwithgreencapital.BasedontheexperiencefromthesecondarymarketforItaliannon-performingloans(NPL),weassumethatbanksmightbeabletodispose10percentoftheirtotalbrownexposuresonanannualbasis.ThislevelcorrespondstotheaverageshareofItalianNPLsoldovertheperiodfrom2006,thefirstyearoffulloperationofthemarketforNPL,to2014.Weexcludethemorerecentyearsbecause2015markedasharpaccelerationofactivityinthemarketforItalianNPL,followingtheenactmentofpolicyandregulatorymeasurestoacceleratethereductionofNPLofItalianbanks.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND10Undertheseassumptions,ourresultssuggestthattheintroductionofthesecondarymarketforbrownassetscouldcuttherebalancingtimetoabout6to7years,asshownbythedottedlinesinfigure1.Assuming,morerealistically,thattheshareofbrownassetsdisposedinthesecondarymarketwillgraduallyincreaseovertime,from2percentto10percent,wouldimplyaslightlylongerrebalancingtimeof8years,thatisstillwellbelowthetimerequiredabsentthesecondarymarketforbrownassets(seefigure2).Figure2.Greeningbanksportfolios:passivevsactiverebalancing(timetobalancebrownandgreenexposures)4.Thecaseforasecondarymarketforbrownassets:ademand-sideperspectiveThissectionexploresthepotentialdemandforsecuritizedbrownassetswhich,althoughlinkedtocarbon-intensiveassets,donotfinancenewcarbon-intensiveprojectsbut,onthecontrary,areintendedtofacilitatethetransitiontoagreenereconomybyexpandingtheopportunitiesforsharingthefinancialrisksofthetransitionamongabroaderpoolofinvestorswhilerisingthefeasiblereturns.Fromthisperspective,securitizedbrownassets-brownassetsbackedsecurities(B-ABS)-canbeconsideredasahybridinstrumentthatofferstodedicatedgreeninvestors,whoarecommittedtosustainablefinance,theopportunitytosupportthetransitionindirectlyontopoffinancinggreenprojects(directsupport).Toassessthecurrentandprospectiveinterestamonggreen-concernedinvestors,weexaminethestructureofthemarketforgreenbonds.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND114a.TheMarketforGreenBondsCurrently,greenbondsareissuedbysupranationalorganizations(e.g.,EuropeanInvestmentBank,WorldBank),sovereigns,andcorporations.Privatesectorissuerscomprisebothfinancial-mainlybanksandrealestateinvestmenttrusts(REITs)-andnon-financialcorporations(renewableenergy,utilities,manufacturing).Greenbondsdifferfromconventionalcorporatebondsbecausetheissuercommitstousetheproceedstofinanceorrefinance“green”projects,assets,orbusinessactivities8,9.Issuerstypicallyoperateintheenergy,transport,andbuildingssectors,followedbywater,waste,landuse,industry,andICT10.However,itisimportanttonotethatgreenbondstypicallydonotfinancenew"green"assetsbutareusedforrefinancing(Ehlersetal.,2020).Acrosscountries,thereistypicallynoauditingorcompulsoryverificationofgreenbonduseofproceeds.Onthedemandside,thegrowthofgreenfinancialmarketsislargelydrivenbytheincreasingnumberandactivityofglobalESGfunds.TotalassetsoffundswithanESGmandateexceeded6trillionU.S.dollarsin2021(AFME,2021).Whileequityfundsconstitutethelargestportion,fixedincomefundsaregrowingfastandaccountnowfor22percentofthetotal.Theincreasinginterestinsustainableinvestmentisconfirmedbyasurveyamongissuers,whichrevealedthat66percentoftheirdealswereallocatedtoinvestorsdescribingthemselvesasgreenorsociallyresponsible11.4b.TheGreeniumTheroleofconsciousinvestorshasbeenconsideredasapossibleexplanationoftheso-called“greenium”,i.e.,thenegativespreadobserved,particularlyatissuance,withrespecttotheyieldsofcomparableconventionalbonds.Accordingtothisexplanation,greeninvestorsarewillingtopayahigherpriceforabondatissuance,whichmeanstheyacceptaloweryieldinexchangeforanenvironmentalbenefit.Thisimpliesthatissuersmaybeabletoattracthigherdemandfortheirdebtbyissuinggreenbondsasopposedtoconventionalbonds.Alternatively,thegreeniummayreflectanexcessofdemandoversupplyofgreenbonds,ascorporationsareslowlyadaptingtoclimatechangeandadoptingcleantechnologies.Theempiricalliteratureontheexistenceandthesizeofthegreeniumhasproducedmixedresults,reflectingbothidentification(intheabsenceofacomprehensivedatabaseofESGbonds)andmeasuringchallenges.Furthermore,theresultsexhibitahighvariabilityacrosssectorsandindividualissuers,reflectingamongotherfactors,theirgreencontentandcredibility.8Intheabsenceofaregulatoryframework,thecommitmentisnotsubjecttocompulsoryverificationoftheuseofproceedsforgreenpurposes.Thisshortcomingcanbeasourceofreputationalriskfortheissuer,ifunabletoprovethattheproceedshavefundedprojectswithpositiveandadditionalimpact.Furthermore,theriskthattheproceedsarenotusedfortheirintendedpurposes(so-called“greenwashing”)canbeamajorimpedimenttothedevelopmentofthegreenbondmarket.9AccordingtotheInternationalCapitalMarketAssociation(ICMA),greenbondsare“anytypeofbondinstrumentwheretheproceedsoranequivalentamountwillbeexclusivelyappliedtofinanceorre-finance,inpartorinfull,newand/orexistingeligibleGreenProjects[…]andwhicharealignedwiththefourcorecomponentsoftheGreenBondPrinciples,”withICMAuseofproceedsspecifyingthat“theutilisationoftheproceedsofthebondforeligibleGreenProjects,whichshouldbeappropriatelydescribedinthelegaldocumentationofthesecurity.AlldesignatedeligibleGreenProjectsshouldprovideclearenvironmentalbenefits,whichwillbeassessedand,wherefeasible,quantifiedbytheissuer.”Therefore,theonlynotabledifferencebetweengreenbondsandstandardbondsisthecommitmentmadebytheissuerontheuseofproceeds.10AccordingtodatacollectedbytheClimateBondsInitiative,thefirstthreecategoriescontributed81%tothetotalissuancein2021(SustainableDebt,GlobalStateoftheMarket,2021).11ClimateBondsInitiative,GreenBondPricinginthePrimaryMarketH22021.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND12Somestudies,usingamatchingproceduretoestimatetheyielddifferentialbetweenasmallsampleofgreenbondsandacounterfactualofconventionalcorporatebonds,havefoundanegativegreenium,whileothershavereachedtheoppositeconclusionbutforspecificmarketsegments.Forinstance,Zerbib(2019)findsasmallnegativepremiumfortheentiresampleandmorepronouncedforfinancialandlow-ratedbonds.Similarly,anegativepremiumisfoundbyEhlersandPacker(2017),butexclusivelyfortheprimaryandnotforthesecondarymarket,whileLarckerandWatts(2020)findidenticalpricingforgreenandnon-greenissuesintheUSmunicipalsecuritiesmarket.Theresultsalsodependontheobservationtimeframe,withLiberatiandMarinelli(2021)findingstrongevidencefortheexistenceofthegreeniumandforitsincreasefollowingtheCovid-19shock.Consistentwiththisresult,Yousafetal.(2022)findthatgreenbondsaretheonlyassetthatservedasasafehavenagainstlargestockmarketfluctuationsduetotheCOVID-19pandemic;further,usingportfolioanalysistheyshowthatsupplementingconventionalstockportfolioswithgreenbondsduringtheCOVID-19pandemicresultedinthehighestrisk-adjustedreturns,comparedtothosesupplementedwithotheralternativeassetsinthesample.TangandZhang(2018)findevidencethatstockpricesandliquidityimproveaftertheissuanceofgreenbonds.Finally,Scatignaetal.(2021)findapositiverelationshipbetweenthecarboncontentofbusinessactivitiesandfirms’fundingcosts,withdebtfromentitieswithahighercarbonfootprinttradingatmarginallyhigheryields.Mostmarketwatchersexpectdemandforgreeninstrumentstocontinuetooutstripsupplyoverthemediumtermamidststronginvestorssupport,which,inturn,isexpectedtopushmoreESGfundstocomplywiththerequirementsoftheEURegulationonsustainability-relateddisclosuresinthefinancialservicessector(Regulation(EU)2019/20881,SustainableFinanceDisclosuresRegulation-SFDR)12.Ontheonehandastandardtaxonomyanddisclosurerequirementscansupportthedevelopmentofgreenfinancialmarketsbyreducingtheriskofgreenwashing;ontheotherhand,itcanbearguedthatasfunds’mandatesbecomemorebinding,deliveringsatisfactoryperformancebecomesmorechallenging.Infact,bynarrowingthepoolofeligibleinvestments,strictsustainablemandatesconstrainbothdiversificationopportunitiesandpossiblereturns.Aspredictedbytheportfoliotheory,greensecuritiescanimprovethetotalexpectedreturnofaportfolioforagivenlevelofrisk,byholdingassetsthatarenotperfectlypositivelycorrelated,therebyreducingtheidiosyncraticriskassociatedwiththeportfolio.However,byrestrictingtheuniverseofinvestmentsexclusivelytogreenassets,aspecializedgreeninvestmentfundwillbesubjecttoextraconstraintsintheconstructionoftheefficientfrontierofinvestments,which,asaresult,willofferaSharperatioinferiortothatofalessconstrainedfund.Fromthisperspective,thedevelopmentofthegreenassetmanagementindustrymightreachahardlimit,whentheperformancegap,intermsofrewardtovolatility,comparedtodiversifiedfundsbecomestoolargetocontinuetoattractinvestorswillingtoacceptlowerriskpremiumspervolatilityforenvironmentalbenefits.Toillustratetheopportunitycostofastrictgreeninvestmentmandate,wefirstconstructahypotheticalefficientfrontierofinvestmentsrepresentativeofthemarket,usingthehistoricalpricingdataofalltheindividualcomponentsoftheDowJonesIndustrialAverage(DJA),andthenconsideralternativefrontiersusingsubsetsoftheDJA,asshowninfigure3.12Regulation(EU)2019/2088oftheEuropeanParliamentandoftheCouncilof27November2019onsustainability‐relateddisclosuresinthefinancialservicessector(OJL317,9.12.2019,p.1).IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND13Figure3.Introducingbrownassetsbackedsecurities:potentialbenefitsforinvestorsTheportionsofthefrontiersthatlieabovetheminimum-varianceportfoliosrepresentthebestrisk-returncombinations(optimalportfolios)availabletoinvestors.Theblackfrontier,labeled“market”,representsthepossibleoptimalportfoliosavailabletoan“unconstrained”investor(diversifiedfund).Restrictingeligibleinvestmentstogreensecuritiesshiftsthefrontierinward(greenline).Asaresult,agreenfundmanagerwillonlybeabletoofferlowerexpectedreturnsforanyacceptedlevelofriskor,conversely,higherriskforanytargetedexpectedreturn.Byofferingadditionalinstrumentswithdifferentcombinationsofexpectedreturnsandvolatilities,theproposedB-ABS(bluestars)mayenablegreenfundsmanagerstoshifttheirefficientfrontieroutwardand,thus,attractadditionalinvestors13.Graphically,thepotentialbenefitsofB-ABScanbeillustratedbytheintermediatefrontier(dottedblueline),thatliesbetweenthetwosolidlines.ThedottedbluelinehasbeenconstructedbyaddingtheB-ABStothegreensecurities,i.e.,usingalargersubsetoftheDJA,therebyshiftingthefrontierbacktotheleft,althoughpartially.Obviously,thisoutwardshiftassumesthatgreeninvestorswillbewillingtobuyB-ABS.Tothatend,itwillbekeytoensurethatthepotentialbenefitsofamoregradualandsmoothtransitionarefullydisclosedandclearlycommunicated.Inthemostbenignscenario,(brownfield)brownassetswillcontinuetogenerateapositivestreamofreturnsduringthetransitionuntiltheyarefullyconvertedtoorreplacedbygreenassets,therebyminimizingthecostsofthetransitionthroughbroaderrisksharingand,mostimportantly,morefundingwillbeavailableforthegreeneconomy.13NoticethatB-ABSareintendedtoincreasethesetofefficientinvestmentsand,thus,areexpectedtoallowforgreaterrisksharingandreductionratherthantoincreasesystemicriskbyleadinginvestors(inourcase,banks,andgreenfunds)toholdincreasinglysimilarportfolios(C.DicembrinoandP.L.Scandizzo,2012).IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND145.TheroleforpoliciesIntheprevioussections,wehaveintroducedthesecondarymarketforbrownassetsasamarketsolutionforthemanagementofthefinancialrisksfromthetransitiontothegreeneconomyand,hence,forpromotinggreenfinance.Risksmanagementconsiderationsprovideincentivestoboththesupplyandthedemandsidesofthepotentialnewmarket.Well-definedclimatechangepolicieswithclearobjectives,measures,andtimelines,aswellasregulatoryframeworksforfinancialrisksfromclimatechangewouldsetthebestconditionsfortheactuallaunchofsuchamarket.Moreover,thecorrectpricingofthenewfinancialinstrumentwouldbecritical,suggestingthatitwilltakesometimebeforethemarkettakesoff,asbanks,specializedpurposevehicles(SPVs),andinvestorsbuildtheirvaluationmodels,facilitatingthepricediscovery.Inthiscontext,targetedpoliciescanalsoplayarole.5a.TheEuropeanMarketforNPLTheexperienceoftheEuropeanmarketforNPLisinstructive.ThesecuritizationofNPLhadbeenaroundfordecades,butthesharpriseofNPLinsomeEuropeancountriesintheaftermathoftheglobalfinancialcrisis(GFC)renewedinterestinthismarket.ThedirectsaleandthesecuritizationofNPL,infact,emergedasthemosteffectivetoolstospeedupthereductionofNPLinbanks’balancesheetsandfacilitatetheirresolution.ThehighersupervisoryscrutinyofNPLforcedbankstomanagetheseloansmoreactively,includingthroughsecuritization.TheactivityinthesecondarymarketforNPLincreasedfurtherfollowingtheenactmentoftargetedpoliciestofacilitatetheresolutionofNPLandtosupporttheirsecondarymarket.Forinstance,inItalyafirstsetofmeasuresfocusedonreformsofdebtenforcementandinsolvencyregimeswiththeaimofshorteningresolutiontimesandimprovingrecoveryrates.Inaddition,thetaxtreatmentofloanlossesandwrite-downswasmodifiedtofacilitatethetimelyrecognitionofcreditlosses(DeferredTaxAssets-DTA).Othermeasureswereintroducedtosupportthesecuritizationmarketmoredirectly.Theseincludedthereformofthemainsecuritizationlaw(D.L.n.50/2017amendingL.n.130/1999)andtheintroductionofagovernmentguaranteeschemeforNPL(GaranziasullaCartolarizzazionedelleSofferenze-GACs,2016).ThisschemeallowsforthemostseniortrancheofthesecuritizedNPLtobeguaranteedbythegovernment,contingentonobtaininganinvestment-graderating,thesaletoprivateinvestorsofthemajorityofthejuniortranches,andthattheguaranteeisremuneratedatmarketprice.AsimilarschemewaslaterintroducedinGreece(HerculesAssetProtectionScheme-HAPS,2019).Despitethehighercoststothebankscomparedtonon-guaranteedsecuritizations,governmentguaranteeschemeshavemadeamaterialcontributiontothedevelopmentofthemarketforNPL,withtheItalianGACSaccountingforoverhalfofallNPLexposuressecuritizedinEuropebetween2017and2021andtheGreekHAPSaccountingforanother25percent14.Similarly,theregulatorytreatmentoffinancialinstrumentscanhaveanimportantbearingontheirsuccessorlackthereof.UnderBaselIII,arevisedframeworkhasbeenintroducedforsecuritizationexposureswithspecial14BoudiafI.A.,MirandaF.G.,AnEmpiricalStudyofSecuritisationsofNon-PerformingLoans,ECBOccasionalPaperNo.2022/292,May2022.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND15provisionsforthoseresultingfromNPL,reflectingtheirdifferentriskdriverscomparedtosecuritizationsofperformingassets(BCBS,2020)15.InEurope,morerecentchangestotheregulatoryframeworkforthesecondarymarketforNPLhavebeenintroducedthroughamendmentstotheEUSecuritisationRegulation(EU2021/557),theCapitalRequirementRegulation(EU2021/558),andthenewNPLSecondaryMarketsDirective(EU2021/2167),withtheviewtofacilitatesalesofNPL,partlyinanticipationofthepredictedincreaseinNPLasaresultoftheimpactofthepandemic16.Theseexamplesshowhowtargetedpolicies,includingtaxes,andregulationscanalter–eitherbystrengtheningorweaking–thedriversofprivatemarkettransactions.Forinstance,similarlytowhatobservedinthecaseofNPL,banksmayincurlossesduringtheoffloadingperiodofbrownassets,andtheselossesmightbemitigatedthroughad-hoctaxmeasures,thatshiftpartoftheburdentothepublicsector.Carefuldesignandcalibrationofanymeasuretosupportthedevelopmentofthesecondarymarketforbrownassetswouldbeneededtoensureconsistencywiththeprimarygoaltoacceleratethetransitiontoagreenereconomy,whilesafeguardingpublicdebtsustainabilityfromfiscalrisksandclimate-relatedcontingentliabilities.5b.APolicySimulationTogaugethepotentialroleforpolicies,weanalyzethedevelopmentsoftheItaliansecondarymarketforNPLintheyearssincetheintroductionofthefirstpackageofmeasurestoacceleratethereductionofNPLinbanks’balancesheets.Undertheincreasedscrutinyofthesupervisoryauthority,bankshadalreadysteppeduptheireffortstoimprovetheirassetsquality,includingbysellingtheirNPL.In2014,Italianbankssold30percentoftheirNPL,upfromanaverageshareof10percentovertheperiodsince2006.Nevertheless,theactivityinthesecondarymarketforNPLincreasedmuchmorerapidlyinthefollowingyears.Aseriesofsupportivemeasureswereintroducedfrommid-2015to2017,withacompoundingimpactonthemarket,wheretheshareofNPLsoldrosetoanaverageofabout50percent,registeringanincreaseof67percentfrom2014.Ifwerepeatthesimulationexerciseofsection3toaccountforthepotentialimpactoftargetedpolicies,“equivalent”tothoseusedforNPL,theaverageshareofbrownassetsdisposedinthesecondarymarketrisesfrom10to17percent,halvingthetargetrebalancingtimeforgreeningbanks’balancesheetsto4years(seefigure4).15BaselCommitteeonBankingSupervision,Capitaltreatmentofsecuritizationofnon-performingloans,November2020.16CliffordChance,Non-performingloans:theevolvinglandscape,March2022.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND16Figure4.Greeningbanksportfolios:activerebalancingpre-andpost-policies(timetobalancebrownandgreenexposures)Theseresultsneedbeinterpretedwithcaution,astheconditionsthatledtotheadoptionofabroadrangeofmeasurestofacilitatethesaleofNPLwereverydifferentfromthosepresentedheretojustifythecaseforpolicyactiontofosterthedevelopmentofamarketforbrownassets.InthecaseofthemarketforNPL,thepolicygoalwastobringdowntheelevatedNPLratiosreachedaftertheGFC,andindeedthemeasuresenacted,alongwithbanks’activemanagementoftheirNPL,provedinstrumentalinbringingtheaverageNPLratiotosingledigit.Inthecaseofgreenassets,thepolicygoalwouldbetoraisethegreennessofbanksexposuresfromthecurrentlowlevelestimatedatjustabout8percent(i.e.,thegreenassetratiofromtheEBAexercise).Forthisreason,wehaveconservativelyassumedaninitialrebalancinggoalof50percentofbanksassets.Thus,boththestartingpointandthegoalofoursimulationexerciseareverydifferentfromthecaseofthemarketforNPL.However,astheeconomytransitionstoagreenermodel,banksmayconsiderincreasingtheirgreenexposuresfurther,pushingforwardtherebalancinggoalabove50percent.Furthermore,thegreennessofexposuresisquiteheterogenousacrossbanks,andthosemoreheavilyexposedtobrownassetswillneedmoretimetorebalancetheirloanbooks.TheseconsiderationssuggestthatthereisacaseforasecondarymarketforbrownassetsbeyondtheextremelyshorthorizonsimulatedbyassumingforcefulpolicymeasureslikethoseintroducedtofacilitatetheresolutionofNPL.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND17Finally,itisimportanttorecallthatweareassumingthatallnon-greenexposuresofbanksarebrown.Thisisasignificantsimplificationbutongoingworktoimprovetheenvironmentaltaxonomyofactivitieswillallowtorefinetheanalysisusingmoregranulardataontheenvironmentalcategorizationofbanks’exposures17.Despiteallthenecessarycaveatsfordrawingconclusionsapplicabletoahypotheticalsecondarymarketforbrownassets,thelessonsfromtheexperienceofthesecondarymarketforNPLshowthatwell-designedpoliciescanplayanimportantsupportiverole.Inprinciple,thissupportcouldbeconceivedastemporarytoreflecttheexpectedlifeofthepotentialmarketforbrownassets.Infact,asmoreeconomicactivitiesbecomeenvironmentallysustainableandthewholeeconomyachievescarbonneutrality,themarketforbrownassetscanbeexpectedtovanish.Asactivityinthismarket“naturally”declines,supportmeasureswillalso“automatically”ceasetobeused,ifbasedonmarket-pricing,astheywillnolongerbeattractive.Alternatively,supportmeasuresmaybeaccompaniedbyappropriatesunsetclauses.6.ConclusionsThesimulationspresentedinthispapersuggestthattransferringbrownassetsfrombanks’balancesheetstotheportfoliosofdedicatedgreeninvestorscanhelpraiseprivatecapitaltofinancethetransitiontoacarbonneutraleconomy.Theproposedmarketforbrownassets(i.e.,theB-ABS),ontheonehand(supplyside)mayallowbankstooffloadpartoftheirbrownexposuresand,thus,freerisk-basedcapitalthatcouldbeusedtofinancenewgreeninvestments;ontheotherhand(demand-side),thenewmarketcouldexpandtheinvestmentopportunitiesavailabletogreenassetmanagersbeyondtheconstraintsmandatedbyenvironmentallyconsciousinvestors.Asaresult,greenassetmanagersmaybeabletooffersuperiorrisk-returnprofilesand,hence,attractmoreresources.ThepotentialbenefitsofthemarketforB-ABSstemfromgreaterrisksharingamongmarketparticipantsaswellasriskreductionthroughdiversification.Creatingamarketforbrownassetscouldbepossiblebyleveragingonthesesupplyanddemandfactors,reinforcedbytheglobaleffortstothegreeneconomytransition.Nonetheless,theexperienceofthemarketforNPLdemonstratesthattargetedpoliciescanplayadecisiveroleinfosteringmarketdevelopment.17TheEUtaxonomyiscurrentlylimitedtodefininggreenactivitiesconsideredasenvironmentallysustainablefromtheperspectiveoftheobjectivesofclimatechangemitigationandadaptation.However,thereisanongoingworkbytheplatformonsustainablefinance,establishedbytheEuropeanCommission,toproposeapossibleapproachfordefiningnegativeimpacteconomicactivities(‘browntaxonomy’)andnoimpactactivities(‘neutralactivities’).Whilethisworkisinanearlystage,itwouldeventuallyprovideacompletecategorizationofthefullspectrumofeconomicactivitiesfromanenvironmentalperspective.IMFWORKINGPAPERSAmarketforbrownassetstomakefinancegreenINTERNATIONALMONETARYFUND18ReferencesAlbamonteD.,Lenuovenormesullacartolarizzazionedeicrediti,Bancad’Italia,NotesonFinancialStabilityandSupervision,N.10,July2017.AssociationforFinancialMarketsinEurope-AFME(2021).ESGFinanceReport,EuropeanSustainableFinance,Q4and2021FullYear.BaselCommitteeonBankingSupervision,Capitaltreatmentofsecuritizationofnon-performingloans,November2020.BNPParibas,ItalianbankDTAs:non-performingloans,regulationandtaxrules,EcoFlash,13November2017.BoudiafI.A.,MirandaF.G.,AnEmpiricalStudyofSecuritisationsofNon-PerformingLoans,ECBOccasionalPaperNo.2022/292,May2022.BrodiE.,GiacomelliS.,GuidaI.,MarcucciM.,PischeddaA.,ProfetaV.,SantiniG.,Newmeasuresforspeedingupcreditrecovery:aninitialanalysisofDecreeLaw59/2016,Bancad’Italia,NotesonFinancialStabilityandSupervision,No.4,August2016.Caramichael,JohnandAndreasRapp(2022),TheGreenCorporateBondIssuancePremium,InternationalFinanceDiscussionPapers1346,BoardofGovernorsoftheFederalReserveSystem.CliffordChance,Non-performingloans:theevolvinglandscape,March2022.ClimateBondsInitiative,GreenBondPricinginthePrimaryMarketH22021.ClimateBondsInitiative,SustainableDebt,GlobalStateoftheMarket,2021.DicembrinoC.andScandizzoP.L.,CanPortfolioDiversificationincreaseSystemicRisk?EvidencefromtheU.SandEuropeanMutualFundsMarket,CEISTorVergata,ResearchPaperSeries,Vol.10,Issue8,No.240–July2012.EhlersT.andPackerF.,GreenBondFinanceandCertification,BISQuarterlyReviewSeptember2017.EhlersT.,MojonB.,andPackerF.,“Greenbondsandcarbonemissions:exploringthecaseforaratingsystematthefirmlevel,”BISQuarterlyReview,September:31-47,2020.DalyaE.,IganD.,andKirtiD.,LimitstoPrivateClimateChangeMitigation,IMFWorkingPaperNo.2021/112,April2021.Ernst&Young,ItalianNPLsandUTPs:ConversionintotaxcreditsofDeferredTaxAssetsassociatedwithtaxlossescarriedforwardandotherdeferreddeductions,TaxNewsUpdate,March18,2020.EuropeanBankingAuthority,RiskDashboard,dataasofQ32021.EuropeanBankingAuthority(2021).Mappingclimaterisk:MainfindingsfromtheEU-widepilotexercise,EBA/Rep/2021/11,21May2021.FaticaS.,PanzicaR.,Sustainableinvestingintimesofcrisis:evidencefrombondholdingsandtheCOVID-19pandemic,EuropeanCommission,JRCWorkingPapersinEconomicsandFinance,2021/7.FischettoA.L.,GuidaI.,RendinaA.,SantiniG.andScottodiCarloM.,Badloanrecoveryrat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