6 strategic ways to foster and consolidate the use of green financing tools.
The world needs more than $6 trillion in annual infrastructure commitment to achieve proper sustainable development by 2050, representing a 50 to 75 percent burden over current budgetary trends. But contrary to widespread remarks blaming insufficient funding for infrastructure development, the problem seems not to reside on the capital investment supply side, but in a lack of bankable projects in which to invest, according to the World Bank article “Mind the Gap: Time to Rethink Infrastructure Finance,” by Daniel Zelikow and Fuat Savas, published in 2022.
Here we focus on “green” finance tools that can leverage infrastructure projects, particularly those of transit-oriented development (TOD). TOD has been adopted worldwide to reduce the use of private vehicles and promote more sustainable and equitable cities through mass transit, walkable city design, and land use plans prioritizing mixed uses and high density. By fostering transit and active ways of getting around such as cycling or walking, TOD is well aligned with the environmental, social, and governance (ESG) goals proposed by the United Nations. (For the sake of simplicity, ESG will also be referred to as “sustainable” and “green” herein.)
Recently, ESG markets have experienced soaring popularity due to three key characteristics: improvement in corporate reputation, market diversification, and long-term risk mitigation. However, despite general enthusiasm for ESG goals, challenges remain to achieving a sufficiently mature market that provides reassurance and security to stakeholders.
TOD is a project type that combines infrastructure, real estate, land use, and urban design features. Despite the wide acclaim for its urban, social, and ecological benefits, rare is the fully fledged TOD project that successfully combines all these characteristics.
Because it involves multiple public and private stakeholders, TOD suffers from its complex governance and intermittent attractiveness for financing: TOD projects often take 10 to 15 years to be developed and even more time to offset capital costs. Therefore, four structures can be broken down to help explain how revenues and securities interact within the complex TOD financial system: financing, funding, de-risking,and policies.
Financing is what leverages future revenues in TOD. As in other infrastructure projects, debt usually represents the largest share of the financing scheme; similarly, hard infrastructure costs represent most of its capital costs. Funding can be broken down into direct and indirect revenues, from which fees, taxes, and commercialization represent the most common means of funding.
Through financial and nonfinancial tools, policies can also encourage or deter the inflow of funding and finance streaming. Finally, de-risking measures can be broken down into three large groups: insurances, guarantees, and fund structuration.
Similarly, ESG tools fit the four structures of traditional TOD financing. The most popular means of green financing are fixed-income debt vehicles such as green loans and green bonds. Green policies are typically represented by carbon taxes and cap-and-trade policies, followed by energy efficiency incentives such as feed-in tariffs and loans. ESG revenues can come from specific operations (e.g., leasing bike racks), commercial premium revenues for green certifications, or specific energy or carbon emission fees.
Finally, the de-risking tools are derived from traditional de-risking measures, with additional ESG disclosures or links to green assets and financial vehicles.
Given the framework of available green tools, strategic guidance for making TOD projects attainable involves six key points.
1. Revenues are the top priority on this list. Linking ESG inflows to the project operation core ensures green accountability and contributes to solving the current global shortage of bankable projects. Green inflow also serves to flag lower risks and future increases in revenues. An example of direct revenue streaming is that of green assets certification.
According to Cushman & Wakefield’s 2021 report Green Is Good: The Impact of Sustainability on Real Estate Investment, Leadership in Energy and Environmental Design (LEED)-certificated U.S. assets have seen a 21.4 percent higher market sales average than their noncertified counterparts. Differences are perceptible among classes: multifamily assets commanded rental and price premiums of 3.1 percent and 9.5 percent, respectively. And class A offices garnered a 25.3 percent premium in urban environments and a 40.9 percent premium for suburban typologies. When context-specific constraints are taken into account, green certifications could be mandated for specific TOD developments and thus increase commercial revenues.
On the other hand, indirect revenues can come from current popular policies such as carbon taxes. For example, Canada implemented a carbon tax in 2019, and most of the streaming revenue was reimbursed directly to citizens in their tax bills. This inflow could be redirected toward environmentally friendly infrastructure projects, such as TODs.
2. De-risking liabilities should help link revenues, financial vehicles, and policies with legal liabilities. The proper inclusion of ESG disclosures should state responsibilities and demands for each stakeholder, asset, and financial vehicle. De-risking measures will significantly affect the project’s life cycle depending on the stage to be covered. For example, some de-risking actions support only the construction stages—as was the case for the Tideway sewage project in the United Kingdom, which was labeled a resilience-oriented project—by promising additional equity and debt in case of construction cost overruns, according to the Organiztion for Economic Cooperation and Development’s 2021 report De-risking Institutional Investment in Green Infrastructure: 2021 progress update.
3. Local policies are significant for TOD’s short-term financial performance. A policy can work to motivate or deter real estate market absorption and development. Positive stimuli could be feed-in tariffs, as have been used in Germany for solar energy adoption at the expense of government grants since 2000. In contrast, a negative motivation could be a mandatory energy consumption cap, such as the Building Emissions Reduction and Disclosure Ordinance (BERDO 2.0) in Boston, which is intended to restrict energy consumption for commercial buildings. However, if implementation of such policies becomes a trend among cities, then building grid-efficient and certified assets for TOD will boost its market absorption because of a relative reduction in operation costs.
4. Governance has direct influence over a project’s financial performance. There is near consensus that private-sector contributions result in lower operational inefficiencies and higher capital costs. In contrast, the public sector is likely to achieve lower capital costs to the detriment of operational efficiencyand innovation.
Now, the issuance of green financing for infrastructure vehicles has been largely driven by public authorities and statutory agencies, such as the Massachusetts Bay Transportation Authority, which was responsible for allocating $99 million in self-designated sustainability bonds in 2017, and the government of Singapore, which recently made public the future issue of $25.4 billion in green bonds for environment-focused infrastructure. However, private-sector innovation may add more value to TOD green leveraging in the future, mainly in those countries where systematic risk is not sufficiently mitigated. This can result in the consolidation of private/public partnerships as the definitive governance structures for TOD.
The preceding four key points are means for developers and policymakers to consider when thinking of green tools for TOD. In contrast, the following key points will play an important role in the long-term impact and consolidation of ESG over TOD market supply.
5. ESG market maturity will come from achievement of a more scalable, transparent, and liquid market. This transition will be driven by a larger consumer sector, endorsement of policies, and nimble coordination of market facilitators. Nowadays, some initiatives are already working to facilitate new sustainability markets, such as Climate Vault and Flowcarbon, which are developing the carbon credits market from both the standardization and technology side.
Of note, prices of carbon credits are expected to rise 10 to 100 times by 2050; such market endorsement could represent substantial future revenues for TOD, according to the 2021 report Future Demand, Supply, and Prices for Voluntary Carbon Credits from Trove Research and University College London and the 2021 report A Blueprint for Scaling Voluntary Carbon Markets to Meet the Climate Challenge by Christopher Blaufelder, McKinsey & Company.
6. ESG finance and asset liabilities refer to the rapprochement of asset and financial standards. Consolidation of asset standards such as the Building Research Establishment Environmental Assessment Methodology (BREEAM) and LEED will contribute to a closer link with homolog financial standards such as that of the Climate Bonds Initiative. For example, the borrower’s capital cost of green loans could be directly linked to the GRESB certification score of the development’s hard infrastructure assets; the higher the score, the lower the capital cost. This reckoning could be automated by simplifying financial and assets standards, followed by the close coordination of future ESG markets.
A flexing point toward urban development paradigms can now be seen. Today’s real estate and road transportation sectors contribute almost 55 percent of greenhouse gas emissions. Sustainable projects for the urban fabric are needed more than ever. This helps explain why transit-oriented development is on the agenda of cities for its social, economic, and environmental benefits.
However, the complexity of its governance structures, high capital investment, challenging revenue structures, and the long-term nature of its financial returns create difficulties in attracting private investors. ESG financial tools could improve TOD’s financial viability by smartly combining assets, policies, financial vehicles, and legal disclosures with ESG policies and markets.
These components are reflected in four simplified structures: financing, funding, de-risking, and policies. Finally, a path of six strategic key points can foster and consolidate the use of green tools. This could secure private investors’ interests in such an urban and transportation project that encourages transit, active mobility, environmental health, and mixed-use cities.
The authors want to thank Siqi Zheng, Juan Palacios, James Scott, Steven La, Kairos Shen, Sara Anzinger, Zachary Solomon, Roger Mann, and Christina Marin for helping us through this research.
This article is based on a full research report, by the same authors, to be released by the MIT Center for Real Estate (CRE). The research was supported by CRE’s Wang Award.
