The current strains in the financial sector highlight once more the importance of sound risk-management practices in banking. Understanding potential balance-sheet risks arising from holding specific assets is paramount. That’s why,
Last month, the World Bank issued a five-year outcome bond that aims to provide clean drinking water to around two million school children in Vietnam. A lack of clean drinking water causes an estimated 9,000 deaths a year in Vietnam, and children are especially vulnerable to parasitic waterborne diseases.
Outcome bonds like this one blend the World Bank’s triple-A credit rating with direct exposure to specific project results. The World Bank Group has been developing these bonds to respond to the enormously challenging conditions facing many developing countries. Inflation, conflict and resulting refugee and internal-displacement crises, and the increasingly visible impacts of climate change are all reducing economic growth and reversing years of hard-earned development gains. At the same time, countries face high debt, depressed budget revenues, and eroded fiscal buffers that are unable to support investment in growth and development.
Outcome bonds offer one pathway to achieving this. Investors are guaranteed their principal by the Bank, but they agree to give up the coupon on the bond in favor of contingent future payments that are linked to development project outcomes. The foregone investor coupons are instead channeled to a project.
In the case of Vietnam, the $50 million proceeds are used to support the Bank’s sustainable development activities globally. The coupons that would have gone to investors are instead provided by the Bank to the water purifier project in Vietnam. The investors receive payments related to the issuance of verified carbon credits from the project that represent the reduction in greenhouse gas emissions. The more of those credits that are generated, the higher the payment to the investors, subject to a cap of roughly 5% per year.
By reducing the need to burn biomass to boil water, the project is estimated to reduce deforestation, improve air quality and health, lower fuel costs and reduce greenhouse gas emissions by almost three million tons of carbon dioxide over the life of the bond. The transaction will finance the manufacture of 300,000 water purifiers and their distribution to 8,000 schools and other institutions.
The structure of this bond builds off the $150 million, five-year Wildlife Conservation Bond (also known as the “Rhino Bond”) the Bank issued in March 2022. The outcome payments depend on growth in the rhino population, calculated and verified by an independent agent, and financed through a conditional grant from the Global Environment Facility.
The Bank is also tapping private capital for the benefit of developing countries through catastrophe bonds. These instruments increase a country’s financial resilience against disasters by providing them with funds in the immediate aftermath of an event.
For example, the Bank issued a catastrophe bond that provides Jamaica with $185 million of insurance cover for severe hurricanes. Donor funds from the U.K., Germany and the U.S. were used to finance the insurance. Investors earn a coupon that includes an insurance premium component, and risk losing some or all of their principal if the disaster event occurs. (That amount would instead be transferred as an insurance payout to the insured country).
Although development-project outcomes and natural-disaster risks can be exotic variables for the capital markets, a growing number of investors believe these sorts of risks are worth taking when they are properly managed, modeled and well-understood.
It is key that we continue to innovate in this area and bring increasing amounts of funding from capital markets and donors to solve global challenges.
This op-ed was originally published in Barron's on March 18, 2023.
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