Scaling up sustainable investment through blockchain-based project bonds

Chen, Yushi; Volz, Ulrich Working Paper Scaling up sustainable investment through blockchainbased project bonds ADBI Working Paper Series, No. 1247 Provided in Cooperation with: Asian Development Bank Institute (ADBI), Tokyo Suggested Citation: Chen, Yushi; Volz, Ulrich (2021) : Scaling up sustainable investment through blockchain-based project bonds, ADBI Working Paper Series, No. 1247, Asian Development Bank Institute (ADBI), Tokyo This Version is available at: https://hdl.handle.net/10419/238604 Standard-Nutzungsbedingungen: Die Dokumente auf EconStor dürfen zu eigenen wissenschaftlichen Zwecken und zum Privatgebrauch gespeichert und kopiert werden. Sie dürfen die Dokumente nicht für öffentliche oder kommerzielle Zwecke vervielfältigen, öffentlich ausstellen, öffentlich zugänglich machen, vertreiben oder anderweitig nutzen. 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If the documents have been made available under an Open Content Licence (especially Creative Commons Licences), you may exercise further usage rights as specified in the indicated licence. https://creativecommons.org/licenses/by-nc-nd/3.0/igo/ ADBI Working Paper Series SCALING UP SUSTAINABLE INVESTMENT THROUGH BLOCKCHAIN-BASED PROJECT BONDS Yushi Chen and Ulrich Volz No. 1247 April 2021 Asian Development Bank Institute The Working Paper series is a continuation of the formerly named Discussion Paper series; the numbering of the papers continued without interruption or change. ADBI’s working papers reflect initial ideas on a topic and are posted online for discussion. Some working papers may develop into other forms of publication. The Asian Development Bank refers to “China” as the People’s Republic of China. Suggested citation: Chen, Y. and U. Volz. 2021. Scaling Up Sustainable Investment through Blockchain-Based Project Bonds. ADBI Working Paper 1247. Tokyo: Asian Development Bank Institute. Available: https://www.adb.org/publications/scaling-sustainable-investment-blockchain- based-project-bonds Please contact the authors for information about this paper. Email: [email protected], [email protected] Yushi Chen is a Doctoral Researcher at the Science Policy Research Unit, University of Sussex. Ulrich Volz is Director of the Centre for Sustainable Finance and Reader in Economics at SOAS, University of London and Senior Research Fellow at the German Development Institute. The views expressed in this paper are the views of the author and do not necessarily reflect the views or policies of ADBI, ADB, its Board of Directors, or the governments they represent. ADBI does not guarantee the accuracy of the data included in this paper and accepts no responsibility for any consequences of their use. Terminology used may not necessarily be consistent with ADB official terms. Working papers are subject to formal revision and correction before they are finalized and considered published. We are grateful for very helpful comments and suggestions received from Ousmène Jacques Mandeng, Cyn- Young Park, Matthias Pelster, Peter Rosenkranz, Grace Tian, and other participants in the September 2020 conference “Fintech to Enable De velopment, Investment, Financial Inclusion, and Sustainability” organized by the Asian Development Bank, the Institute of Global Finance– University of New South Wales, the Asian Bureau of Finance and Economic Research, the National University of Singapore Business School, and the Asian Development Bank Institute; and the 33rd Australasian Finance and Banking Conference hosted by the University of New South Wales in December 2020. The usual disclaimer applies. Asian Development Bank Institute Kasumigaseki Building, 8th Floor 3-2-5 Kasumigaseki, Chiyoda-ku Tokyo 100-6008, Japan Tel: +81-3-3593-5500 Fax: +81-3-3593-5571 URL: www.adbi.org E-mail: [email protected] © 2021 Asian Development Bank Institute ADBI Working Paper 1247 Chen and Volz Abstract This paper explores options for mobilizing domestic savings through fintech solutions to scale up sustainable investment. Most developing and emerging economies face an urgent need to scale up sustainable finance for low-carbon and climate-resilient infrastructure investment, yet underdeveloped capital markets tend to inhibit domestic resource mobilization for infrastructure investment. At the same time, domestic savers in many developing and emerging economies face a scarcity of “safe” assets in the local currency, resulting in the exporting of capital to financial centers in advanced economies. The paper discusses how fintech can help to complement conventional capital markets and mobilize financial resources for sustainable infrastructure investments. It puts forward a proposal for blockchain-based project bonds to raise finance through a digital crowdfunding platform, which is also able to record transparently and certify the use of proceeds, sustainability impact, and revenue streams of projects by combining timestamp, public and private key mechanisms, and smart contract technologies. This approach would not only provide investors of different sizes with the opportunity to purchase local-currency assets and issuers such as municipalities to raise funds for sustainable infrastructure investment. It would also facilitate project management once the project is operational, for example through metering and billing, and create full transparency over the life cycle of the investment, reducing problems concerning the misuse of funds. Keywords: sustainable investment, fintech, blockchain JEL Classification: G23, O16, O18, Q01 ADBI Working Paper 1247 Chen and Volz Contents 1. INTRODUCTION ............................................................................................................ 1 2. DOMESTIC RESOURCE MOBILIZATION FOR SUSTAINABLE INVESTMENT ........ 2 3. FINTECH SOLUTIONS TO ENHANCE SUSTAINABLE INVESTMENT ...................... 4 3.1 Current State of the Discussion ......................................................................... 4 3.2 Blockchain .......................................................................................................... 6 4. A PROPOSAL FOR A BLOCKCHAIN-BASED BOND FOR SUSTAINABLE INVESTMENTS ............................................................................................................. 8 5. CONCLUSION ............................................................................................................. 12 REFERENCES ........................................................................................................................ 13 ADBI Working Paper 1247 Chen and Volz 1 1. INTRODUCTION Countries all over the world are facing an urgent need to scale up their investments in sustainable infrastructure, including renewable energy infrastructure, to foster a low-carbon transition and to align their economies with the Paris Agreement and the 2030 Agenda. The International Monetary Fund (IMF) recently estimated the additional need for annual public investment in infrastructure, low-carbon technologies, and other areas to achieve the Sustainable Development Goals (SDGs) to be more than US$20 trillion over the next two decades (IMF 2020). Especially in developing and emerging economies, finance is a key challenge to the achievement of these investments. Although the international discourse on financing for development—under the catchy slogan “from billions to trillions”—has highlighted the need to unlock domestic resources, much of the discussion has centered on incentivizing private capital from advanced countries to finance investment in developing and emerging economies. While foreign aid and foreign private capital can play an important role in financing development, it is important to acknowledge the limits to the role of foreign investment in financing infrastructure and the financial vulnerability risks associated with foreign lending. It is also important to make better use of domestic savings in developing and emerging economies, many of which invest significant amounts of their savings in low-yielding assets in the financial centers of advanced economies. Strengthening domestic resource mobilization is therefore crucial, and concerted efforts to this effect are necessary. Besides the mobilization of finance, a central problem regarding infrastructure investment is corruption. The IMF (2020, 1) estimated that “one-third of funds for public infrastructure is lost worldwide to inefficiencies.” It is hence crucial to identify ways to reduce this slack if not to eliminate it. Against this backdrop, this paper will discuss how financial technologies—or fintech— and blockchain-based solutions can facilitate domestic resource mobilization for sustainable investments and at the same time improve the implementation of infrastructure projects throughout the entire life cycle by facilitating processes and enhancing transparency. In particular, the paper explores how fintech can help to complement conventional capital markets and mobilize financial resources for sustainable infrastructure investments. It proposes blockchain-based project bonds to raise finance through a digital crowdfunding platform, which is also able to record transparently and certify the use of proceeds, sustainability impact, and revenue streams of projects by combining timestamp, public and private key mechanisms, and smart contract technologies. This approach would not only provide investors of different sizes with the opportunity to purchase local-currency assets and issuers such as municipalities to raise funds for sustainable infrastructure investment. It would also facilitate project management once the project is operational, for example through metering and billing, and create full transparency across the life cycle of the investment, reducing problems involving the misuse of funds. The structure of the remainder of the paper is as follows. Section 2 discusses the requirement to scale up domestic resources for the necessary investment in low-carbon, sustainable infrastructure and to meet other sustainable investment needs. It also examines the problems facing developing and emerging economies in mobilizing these resources locally for domestic investment. Section 3 then reviews the solutions for raising local savings and enhancing sustainable investment that fintech applications make possible, paying particular attention to blockchain solutions. Subsequently, Section 4 puts forward a proposal for an integrated blockchain-based fintech solution. Section 5 concludes. ADBI Working Paper 1247 Chen and Volz 2 2. DOMESTIC RESOURCE MOBILIZATION FOR SUSTAINABLE INVESTMENT The IMF (2020) estimated the additional annual public investment needs in infrastructure, low-carbon technologies, and other areas to achieve the SDGs to be 1.3% of the world GDP (Figure 1). Cumulated over the period 2020–2040, the estimated additional investment needs would exceed US$20 trillion in current US dollars. To scale up finance for the SDGs, multilateral development banks (MDBs) have advanced the “billions to trillions” agenda to “unlock, leverage, and catalyze private flows and domestic resources” (African Development Bank et al. 2015, 2). The idea is to use official development assistance, or “blended finance,” to mobilize private capital for investment in sustainable development. Figure 1: Global Investment Needs for Infrastructure, Climate Change, and Other SDGs (Percentage of Annual Regional GDP; Trillions of US Dollars, Right Scale) SDGs = Sustainable Development Goals. Note: The blue bars show the current investment levels across regions as of the end of 2017. The estimates for additional global investment needs are, on average, 1.3% of the global GDP per year during the period 2020–40 (exceeding US$20 trillion in current US dollars) and comprise infrastructure (0.5% of the GDP), other SDGs (0.2% of the GDP), and low-carbon investment (0.6% of the GDP). The right panel shows the cumulative investment needs in trillions of US dollars (constant 2019 prices and exchange rates) over the next two decades. Sources: IMF (2020), drawing on data from Global Infrastructure Hub; Oxford Economics; and IMF staff estimates. Critics of blended finance have voiced concerns about the financial stability risks associated with “the escorting of international capital by multilateral development agencies into frontier and emerging market settings” (Carroll and Jarvis 2014, 540). A fundamental problem of initiatives aiming to leverage private investment by “de-risking” is that the risk itself does not disappear but merely shifts to public balance sheets (Mazzucato et al. 2018). In particular, critics have raised concerns that issues around the “complexity, accountability and transparency” of blended finance (Mawdsley 2018, 194) and the growing risks of related financial innovation and over-financialization in developing economies (Akyüz 2017) may contribute to debt crises. Financial stability risks may also arise from the fact that both development finance institutions and private financiers usually provide finance only in international currency, which leaves ADBI Working Paper 1247 Chen and Volz 3 borrowers with foreign exchange risk.1 The United Nations Conference on Trade and Development (UNCTAD) (2019, viii) stated that “the focus of the development finance agenda on complex – and mostly non-transparent – new financial instruments and on securitized finance, does not bode well for its ability to deliver reliable financing at the required scale to where it is most needed.” Instead of trying to lure international capital for blended finance solutions—which has not been very successful to date, as the small volumes and low leverage ratios reflect (Attridge and Eigen 2019)—efforts should concentrate more on mobilizing domestic resources without creating complex financial structures. While foreign capital in the form of direct investment or foreign aid has played a role in the economic development of many countries, historically no economy has developed its infrastructure and financed its development primarily through foreign finance. Mobilizing domestic savings for local investments is hence a crucial part of economic development. The good news is that, for many countries, especially middle-income countries, domestic savings are not the main bottleneck. In fact, many developing and emerging market economies, especially in Asia, are net capital exporters, as reflected in their current account surpluses. Even countries that do not record current account surpluses tend to invest parts of their savings at low or negative returns in the financial centers of advanced countries, only for these countries to reinvest them in their home countries, typically at higher returns, which then benefit the foreign investors. This phenomenon is known as round-tripping of capital. There are different reasons for investing domestic savings abroad, including macroeconomic instability at home, international portfolio diversification, and tax evasion. Two important reasons to invest savings abroad (which motivate this paper) are the better financial services abroad and the lack of safe financial assets in the domestic economy due to underdeveloped capital markets. The reliance on foreign currency borrowing to finance domestic investment has been associated with two major problems: currency mismatches and maturity mismatches (Goldstein and Turner 2004). Financing long-term projects that yield returns in domestic currency with short-term foreign-currency credit creates financial vulnerabilities that can contribute to financial crises. The currency crisis literature has highlighted the importance of developing local-currency bond markets to overcome “original sin”—the problem that most emerging markets in the past were unable to borrow in domestic currency, even domestically (Eichengreen, Hausmann, and Panizza 2003)—and avoid the financial vulnerabilities associated with currency mismatches (Burger and Warnock 2006, 2007; Burger, Warnock, and Warnock 2012). Since the emerging market crises of the late 1990s and early 2000s, countries have made progress in developing local-currency bond markets (Burger et al. 2012; Berensmann, Dafe, and Volz 2015; Dafe, Essers, and Volz 2018). Nevertheless, these are in part still highly dependent on foreign investors. The large-scale withdrawal of international capital from emerging economies’ bond markets in March 2020 has once again highlighted the vulnerabilities associated with a shallow domestic investor base and heavy reliance on international portfolio investors (Beirne et al. 2020; Hofmann, Shim, and Shin 2020). There is clearly a need to develop local-currency capital markets further with a strong domestic investor base. An important question in this context is the following: can fintech help by mobilizing domestic savings and channeling them into sustainable investments? 1 For a discussion of the shortcomings of blended finance in leveraging private capital, see Attridge and Engen (2019). ADBI Working Paper 1247 Chen and Volz 4 3. FINTECH SOLUTIONS TO ENHANCE SUSTAINABLE INVESTMENT 3.1 Current State of the Discussion Emerging financial technology has already had significant impact on financial development and holds great potential to advance the sustainable finance agenda (Chishti and Barberis 2016; Jeucken 2010). The G20 Sustainable Finance Study Group highlighted the emerging practice of applying digital technologies to sustainable finance (G20 SFSG 2018). As shown in Figure 2, the Sustainable Digital Finance Alliance (SDFA) identified several challenges to connecting the financial sector with the real economy and highlighted the potential of digital finance for improving information and efficiency in the financial sector through better systems and data and for fostering inclusion and innovation in the real economy by broadening sustainability choices and providing new sources of finance. It is possible to develop and apply digital technologies to leverage sustainable finance by facilitating better use of sustainabilityrelated data for financial decision making and by supporting nascent business models by enabling better access to funding. Digital finance can help to address the barriers that limit the scalability of sustainable finance, such as the lack of local community power and asymmetrical information between investors and other stakeholders. Consequently, digital finance can help to promote goals such as financial inclusion and energy justice, both of which are key issues in the sustainable transition (Demirguc- Kunt et al. 2018; Aboushady and Gowaid 2019; Arner et al. 2020; Volz et al. 2020). Figure 2: Implications of Digital Finance for Sustainable Development Source: Authors’ compilation based on SDFA (2018). The UN Secretary General’s Task Force on Digital Financing of the SDGs recently emphasized the development of financial inclusion into citizen-centric finance as one of the transformational opportunities that digitalization offers (Digital Financing Taskforce (DFTF) 2020). Citizen-centric finance is not only about the financial return but also represents an aggregation of influence through different channels and organizations (DFTF 2020). ADBI Working Paper 1247 Chen and Volz 11 An example would be a community-based renewable energy project, in which investors can also play the role of consumers. A community ownership model would allow a “pay-as-you-go” approach, whereby the developers are the utility companies that sell, for example, electricity services through a pre-paid model. By recording the investor profile in the blockchain network, consumers can leverage their ownership of the project to use electricity and even trade with each other, that is, to become “prosumers”—producers and consumers at the same time. This is a suitable solution for adopting a net metering policy for microgrid or other renewable projects, enabling investors to become prosumers (Stoutenborough and Beverlin 2008; Hwang et al. 2017). Blockchain also provides the option of documenting the environmental or carbon impact, which could, for example, enable the receiving of carbon credits through carbon emission trading schemes. The issuing entity can leverage blockchain to build an impact investing information platform, which incentivizes asset managers and customers in the space by quantifying the carbon certification or emission reductions, or any other positive impacts—be they ecological or social—that the project may have. Automated proof-of-impact reporting can deliver near real-time information on the sustainability impact, providing investors with assurance on the “greenness” or sustainability of their investment. It is possible to configure our proposal in multiple ways to suit different situations. The main goal of this proposal is to leverage the strength of a decentralized governance model with the support of blockchain to achieve project-level financial inclusion. Through the blockchain-based project development platform, the issuing entity can engage with retail investors who would like to own parts of the project, such as a micro-grid project, by equity crowdfunding. Retail investors may receive deductions on their utility bill as part of their bond interests. Furthermore, by replicating this approach, it would be possible to aggregate multiple projects to create a larger portfolio that would be attractive to institutional investors, including impact investors. Figure 4: Technical Structure of the Proposal Source: Authors’ compilation. Figure 4 illustrates the different layers and elements of the technical side of our proposal. This figure includes a digital crowdfunding platform for the funding as the main application in our proposal; technological features such as timestamp, public and ADBI Working Paper 1247 Chen and Volz 12 private key mechanisms, smart contract, and other technologies that we mentioned in the text are part of the blockchain network. These technological features enable the process of registration and certification in the blockchain network and data life cycle management for using blockchain to mobilize information on (i) the use of proceeds, (ii) the construction/realization of the project, (iii) the operation of the project and its environmental/social impact, (iv) metering/billing, and (v) revenue streams. 5. CONCLUSION In this paper, we explore how fintech can complement conventional capital markets and help to mobilize finance for sustainable infrastructure investments. Based on an analysis of the interests of relevant stakeholders, it puts forward a proposal for blockchain-based project bonds aiming to finance sustainable investments. It involves the use of a digital crowdfunding platform to raise finance, while the blockchain is able to record transparently and certify the use of proceeds, sustainability impact, and revenue streams of the project. The suggested approach would not only provide investors of different sizes with the opportunity to purchase local-currency assets and issuers such as municipalities to raise funds for sustainable infrastructure investment. It would also facilitate project management once the project is operational by offering easy technical solutions for metering and billing. Last but not least, this approach would create full transparency across the life cycle of the investment, reducing problems of misappropriation of funds. This in turn should increase the attractiveness of the underlying project. Municipalities, for instance, could issue the proposed blockchain-based project bonds to finance local infrastructure, such as energy utilities, that would generate returns that they could use for payments of coupon and principal. Multiple applications to suit different situations would be possible, including community ownership structures, using the strength of a decentralized governance model with the backing of blockchain. While this approach is applicable to smaller investments, it would also be possible to aggregate smaller assets into bonds that would also be of interest to larger institutional investors. Development finance institutions could play an important role in implementing such investments. Through their involvement, they could also enhance the confidence of potential investors. To our knowledge, such an approach remains unexplored in practice. With support from the UNDP and UNCDF, the UN Secretary General’s Task Force on Digital Financing of the SDGs has recently launched a Pathfinder Initiative with the Government of Bangladesh to explore how to use digital technology to mobilize small amounts of domestic savings for sustainable infrastructure investment (LightCastle Partners 2020). Very much in line with our proposal, this initiative envisages the transformation of micro savers into micro investors and the reduction of the need for international borrowing, using blockchain as a technical backbone to improve the accountability of the funds and returning the dividends from infrastructure investment to the Bangladeshi citizens (LightCastle Partners 2020). 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