Photo: James Wheeler
What can an American economist, ancient Mesopotamia, a Republican senator from New York, OPIC, and MIGA teach us about urgently mobilizing credit enhancement to support massive flows of investment in natural climate solutions?
In 1990, Harry Max Markowitz, an American economist, received the Nobel Memorial Prize in Economic Sciences. Despite his curiosity in physics and philosophy at school, Markowitz specialized in the field of economics at the University of Chicago. For his dissertation, he elected to apply mathematics to the analysis of the stock market. As he explored the field of stock market pricing that largely centered on John Williams’ analysis of stock prices as reflecting their “intrinsic value,” Markowitz realized that the prevailing theory lacked the analysis of the impact of risk. This fundamental insight caused him to develop his recognized theory of portfolio allocation under uncertainty, published in 1952 by the Journal of Finance.
Markowitz’s continued work in the field led to his modern portfolio theory (MPT), or mean-variance analysis, that is a mathematical framework for assembling a portfolio of assets such that the expected return is maximized for a given level of risk. It is humorous to note that the topic was so novel that, while Markowitz was defending his dissertation, Milton Friedman, another economist and statistician, is said to have argued that Markowitz’s contribution was “nice work, but … not economics.”
Markowitz’s contributions not only transformed investment theory but also influenced risk assessment and management practices across various industries, including finance, insurance, and beyond. His important insights provided a structured approach for understanding and managing financial risk, which remains a cornerstone of contemporary finance and risk management strategies. Credit enhancement and investment risk assessment are closely tied within the realm of financial markets, particularly in the context of fixed-income securities and debt instruments.
Credit enhancement is a strategy used to mitigate credit risk, which is a type of investment risk. The concept of credit enhancement has been employed in various forms throughout history, particularly in the context of lending and borrowing. A historical example of credit enhancement was the use of collateral in lending arrangements. Collateral, such as valuable assets or property, has long been used to secure loans and reduce the lender’s risk of default. This practice effectively enhanced the creditworthiness of the borrower by providing a tangible asset that serves as a form of credit enhancement. In ancient civilizations, such as Mesopotamia and Greece, collateral was often used as a way to secure loans and ensure repayment. For example, in Babylon, merchants could use land as collateral for loans, and failure to repay would result in forfeiture of the land.
The concept of credit enhancement has evolved over time with the development of financial markets and instruments. In modern finance, credit enhancement encompasses a wider range of mechanisms beyond collateral, such as guarantees, insurance, and credit derivatives, all aimed at reducing credit risk and enhancing the credit quality of an investment.
Formed in January 1971, the Overseas Private Investment Corporation (OPIC) was borne out of the realization by U.S. policymakers that private investment was a powerful generator of economic development and that there was an appropriate credit enhancement role for government in encouraging private investment engagement. OPIC achieved its mission by providing investors with financing, political risk insurance, and support for private equity investment funds where commercial financial institutions often were reluctant or unable to lend. Impact investing was also a key priority for OPIC, supporting efforts that sought to produce positive social impacts while generating financial returns sufficient to make these projects sustainable. Established as an agency of the U.S. government in 1971, OPIC managed to operate on a self-sustaining basis at no net cost to American taxpayers.
In the words of Senator Jacob Javits (R-NY) during the Congressional debate preceding the establishment of OPIC back in 1969, OPIC was the “first really big initiative that has come along in the foreign aid field almost since it began, which goes back to 1948 and 1949 … this corporation will for the first time apply business methods and business accounting procedures to the business operations of project development, investment, insurance, guarantees and direct lending—that is, to private activities which are sensitively and directly geared into the development of the less-developed areas which we propose to help in the foreign aid program.”
OPIC of course was not without its critics from both sides of the political aisle. Conservative Republicans condemned what they saw as corporate welfare. Liberal Democrats complained that public resources were being used to support investors instead of projects that helped disadvantaged communities. Opposition came from those who were critical of government involvement in private sector activities abroad. These critics believed that the government should not be directly involved in promoting or supporting private investments overseas. They argued that the private sector should operate without government intervention, even in international markets. Others raised concerns about the potential environmental and social impacts of certain projects that received OPIC support. Overall, OPIC was generally viewed as having made a positive contribution to promoting U.S. investments in developing countries and supporting economic growth.
In 2019, under the BUILD Act the United States International Development Finance Corporation (DFC) was established as a development finance institution following the merging of OPIC with the Development Credit Authority (DCA) of the United States Agency for International Development (USAID). The DFC now carries on the work of OPIC with a $60 billion agency portfolio (up from OPIC’s $29 billion) and also operates with the intention of achieving financial sustainability through the fees and returns generated by its investments and financing activities.
The Build Act transferred the Development Credit Authority from USAID to the DFC. The DCA offers direct loans and guaranties (typically 50%, but as high as 100%) of up to $1 billion for tenors as long as 25 years. These guarantees are intended to encourage private lenders to extend financing to underserved borrowers in new sectors and regions. In 2014, the DCA guaranteed USD 134 million of commercial loans that the Althelia Climate Fund issued to support forest conservation and sustainable land use, helping to remove 100 million tons of carbon—the equivalent of 18.5 million cars—from our atmosphere. This guarantee enabled the flow of private capital to finance sustainable land use models that delivered livelihood improvements, ecosystem uplift, and climate change mitigation outcomes.
OPIC’s slice of the market had declined in recent years, with investors turning increasingly to the World Bank Group’s Multilateral Investment Guarantee Agency (MIGA) that has substantially less restrictive eligibility requirements.
MIGA is the other player in the credit enhancement field. As an international financial institution MIGA also offers political risk insurance and credit enhancement guarantees. MIGA promotes foreign direct investment by providing political risk insurance and credit enhancement to investors and lenders against losses caused by noncommercial risks. MIGA was established in 1988 as an investment insurance facility to encourage confident investment in developing countries. MIGA insures long-term debt and equity investments as well as other assets and contracts with coverage lasting up to 15 years with a possible five-year extension depending on a given project’s nature and circumstances.
MIGA too has faced some negative sentiment from those that argued its impact has been hindered by regulatory bottlenecks, corruption, and inadequate infrastructure. Others have voiced equity concerns coupled with transparency issues on the assessment of potential environmental and social impacts of projects. That said, MIGA has successfully managed to promote direct private sector investment in countries that might be considered riskier due to political or economic instability. MIGA’s guarantees have helped mitigate risks for investors, making investments in these regions in sectors that include infrastructure, energy, agriculture, and financial services which are crucial for economic growth and development. MIGA has also developed innovative products and tools to address emerging challenges in investment, such as environmental and social risks.
Results from a 2010 survey that MIGA conducted found that political risk is the most important deterrent of long-term foreign direct investment in developing countries, even more than economic uncertainty and poor public infrastructure.
When we examine the deterrent that inhibits achieving a total investment in nature of $8.1 trillion between now and 2050 called for by the 2021 State of Finance for Nature report for us to have a chance at addressing our global climate, biodiversity, and land degradation challenges, it is imperative for companies and financial institutions to participate by sharing the risk and increasing investments in nature-based solutions. The mobilization of private capital for natural climate solutions is a key challenge over the coming decade. For context, the private sector delivered investment in nature-based solutions to the tune of $18 billion in 2018. The report found that using 2020 data, approximately $133 billion/year currently flows into natural climate solutions space, with public funds making up 86 per cent and private finance 14 per cent of that total.
One cannot dismiss the financial risks facing the intrepid impact investor wanting to marshal the resources to support natural climate solutions. In contemplating mitigation solutions such as reforestation, afforestation, sustainable land management, soil carbon sequestration, and the preservation of ecosystems like wetlands and mangroves impact investors have to navigate long payback periods, uncertainty on returns, regulatory and policy risks, and the vagaries of emerging nature-based markets that don’t have the benefit of track records, clear monetization pathways, and transparent pricing mechanisms.
To succeed at our goal of tripling investments in nature-based solutions by 2030 with 60% – 70% coming from the private market, we need to venture where others won’t. Specifically, we need to learn from others that blazed a path in the field of foreign aid, such as OPIC, DFC, and MIGA but for nature this time. This critical mission needs to be accomplished in a manner that crowds in private capital, creates innovative financing mechanisms, promotes public-private partnerships, and serves as crucial risk mitigation mechanism for our planet.
P.S. We have ideas….