Sustainable Finance:Building from the Producer’s

Perspective

Prepared byBenedick Bowie, Benjamin Deljurie, Sunil Subbakrishna

delivered by Lou Munden

at the General Assembly of the World Farmers Organization

June 7th, 2012

COLLABORATORS

Lou Munden1, Peter Holmgren2, Rosalind Reeve34, Peter Riggs5, Ravi Prabhu6 Benedick Bowie1, Benjamin Deljurie1, Sunil Subbakrishna1, Emelyne Cheney2

 1) The Munden Project

2) Food and Agriculture Organization of the United Nations3) Ateneo de Manila University School of Government

4) Chatham House (Associate Fellow)5) Ford Foundation

6) World Agroforestry Centre

This presentation previews a white paper written by the collaborators listed above. The views expressed in that document will be those of the author(s) and do not necessarily reflect the views of the Food and Agriculture Organization of the

United Nations, the Ateneo de Manila University School of Government, Chatham House, the Ford Foundation or the World Agroforestry Centre.

 FINANCIAL SUPPORT

The Munden Project’s initial scoping work for financial mechanisms that drive good climate and development outcomes was supported by the CGIAR Research Program on Climate Change, Agriculture and Food Security (CCAFS). The views expressed in this document cannot be taken to reflect the official opinions of these agencies, nor the official position of the CGIAR or ESSP. 

CCAFS is a strategic partnership of the Consortium of International Agricultural Research Centers (CGIAR) and the Earth System Science Partnership (ESSP). The program is supported by the European Union (EU), the United States Agency for International Development (USAID), the Canadian International Development Agency (CIDA), New Zealand’s Ministry of Foreign Affairs and Trade, the Danish International Development Agency (Danida) and the UK Department for International Development (DFID), with technical support from the International Fund for Agricultural Development (IFAD).

The Munden Project has self-financed its own work beyond the initial scoping phase as a part of its ongoing commitment to finding better financial solutions for real-world resource problems. 2

Along with the collaborators listed in the previous slide, The Munden Project is about to propose a public-private system to deliver investments in sustainable agriculture and forestry. Our proposal’s basic design will be described in a white paper to be released later this month.

This presentation should let you know:

– What our system design looks like so far

– Why we think that design makes sense for farmers

– Why we think it is realistic that investors would be interested in this idea

In doing so, we recognize that we do not have all the answers. Therefore, my collaborators and I are hoping that you will tell us where we can improve this

work. We want to get this right, and your perspective is a key part of that process.

3

Introduction

The System Design:What, How and Why

Sustainable forms of agriculture (and forestry) achieve some very important goals: greater food security, better economic development of rural areas and a positive impact on climate change. Since these are public goods, we think the public should invest in these practices.

Our conversations with governments across the globe have shown that they are indeed willing to do this…but only if their participation creates a sustainable engagement from private capital. This cannot happen through the current global financial system, for three reasons:

1.It does not invest in many developing countries.

2.Where it does offer capital, the terms of investment squeeze farm margins to the point where the farmer has no flexibility to do anything other than maximize yield in the short term.

3.Moreover, it forces farm production to match the needs of large-scale commodity markets, which inherently lack diversity and resilience.

None of these are consistent with the goals described above. Our proposal seeks to address all three concerns – and it starts by viewing investment from the farmer’s perspective. 5

Sustainable Finance: The Basics

Investor

Investor

Investor

Investor

Investor

Investor

Producer

Producer

Producer

Producer

Producer

Producer

Producer

What we need is a system that enables producers by giving them three key advantages:

1.Lower payment amounts to investors. This will help farmers innovate by giving them a margin for error.

2.The flexibility to make those payments on a variable schedule. This will help farmers adopt more sustainable practices that require start-up time or do not cash flow as predictably.

1.Longer amounts of time in which to pay back the investment. In combination with 1 and 2, this will give farmers the capacity to make the investments needed to improve their operations.

This isn’t a giveaway. We also need to make sure this makes sense for investors (otherwise, they won’t commit capital).

We think a network of public and non-profit intermediaries can satisfy both parties by pooling the producers together into portfolios. It starts with three simple steps.

Investor

Investor

Investor

Investor

Investor

Investor

Financial

entity

Producer

Producer

Producer

Producer

Producer

Producer

Producer

Aggregator

Aggregator

1. A non-profit financial entity sells securities to investors. These securities are “backed” by a diverse combination of payments from farms.

2. That money gets invested in a diverse range of producers. The producers pay the financial entity back over time so the financial entity can pay the investors that bought the securities.

NOTE: This has to happen across a number of different countries, not just a single one. Without this feature, it will not work properly.

3. If the producers are too small, then the financial entity can interact with an aggregator – such as a farmers’ organization or a large cooperative – in order to achieve scale.

88

We think that interest rates in many countries are so high that they can be lowered while still giving investors a relatively high return. This is because we think the real risk of a pool of these countries is much lower than the returns would suggest.

Below is a simple model showing the difference between $1 billion US invested over 10 years at benchmark rates across two different portfolios: one emerging markets (Portfolio 1), the other developed countries (Portfolio 2).

How Does This Translate into Lower Farmer Payments?

Central bank benchmark rates as of May 29th, 2012

That’s more than 14 times the return from Portfolio 1! Are the Portfolio 1 countries so

much riskier? Of course not, and that’s why we think

there’s ample room to drive down farmer payments while keeping investment returns

competitive.

(Incidentally, this gap could also support

sustainable farming in developed countries by blending higher returns with very low risk. This

would tend to lower payments for emerging

market farmers.)

How Does This Enable Farmers to Pay Back Flexibly?

9

2013 2014 2015 2016 2017 2018 

  Brazilian Réais    None    None   R$ 3,950  R$

11,850  R$ 3,950   None 

  Ghanaian Cedis   None   GH₵

1,892  None   

GH₵ 1,892

 GH₵

1,892 

GH₵ 1,892

  Indian Rupees   165,555₹   220,740₹   165,555₹   None    165,555₹   None 

 Kenyan

Schillings 

85,668Ksh

  None   257,004K

sh  None   

85,668Ksh

 171,336K

sh

 Philippine

Pesos  86,972₱   86,972₱   None    None    43,486₱   86,972₱

  Thai Baht   63,234฿   31,617฿   None    31,617฿   None    94,851฿                                                      Value in USD

   

$8,000.00

 

$8,000.00

 

$8,000.00

 

$8,000.00

 

$8,000.00

 

$8,000.00

A highly diversified portfolio can help farmers pay less, more or not at all depending on the year. Here’s a quick example of how lower or absent

payments can be balanced by higher ones:

In other words, we can offer farmers the flexibility to change the size and timing of their payments to investors by pooling them together.

This can be done in a way that leads to a smooth return for the investor.

Because of this, the more participation we see in this system, the more flexible the system becomes.

Public sector: Enabling environmentPublic sector: Enabling environment

Private sectorPrivate sector

Investor

Investor

Investor

Investor

Investor

Investor

Financial

entity

Producer

Producer

Producer

Producer

Producer

Producer

Producer

Aggregator

Aggregator

Credit enhancement

fundGood governance

4. But this doesn’t handle all the risks. So the public has to offer support for a credit enhancement fund that will cover investors in the event losses tied to specific political factors cause losses.

5. The public also has to offer clear, good governance structures so that investors know their investments end up on the farm and not in the pockets of local officials.

Again, this is not a giveaway. Risk insurance is important, but not designed to cover every loss. We can draw the line between acceptable and unacceptable coverage by asking two questions: 1.Can a normal investor reasonably quantify and understand the risk?2.If so, is the risk so large that a normal investor will be unable to invest?

Let us assume the existence of an investor who specializes in infrastructure: specifically, bridges. The investor targets a specific country in which to build some freight bridges, where the costs are defrayed by tolls levied on goods transported across the bridge.

Now assume that the public needs this new freight bridge to be built in a risky area. In this scenario, public money should be targeted towards taking some of the risks off the table, but not all. If the bridge is in a conflict zone, the public might help by providing protection against it collapsing due to sabotage. On the other hand, if the bridge collapses because the investors squeezed their contractors or used substandard labor, they need to bear that loss.

We can also design the portfolios so they mitigate some risks by themselves. The Appendix provides an example of a major risk – exchange rates – and how that risk is mitigated by our design.

11

Drawing the Line on Risk Protections:The Bridge Analogy

Public sector: Enabling environmentPublic sector: Enabling environment

Investor

Investor

Investor

Investor

Investor

Investor

Financial

entity

Producer

Producer

Producer

Producer

Producer

Producer

Producer

Aggregator

Aggregator

Sustainability

Verifier

Credit enhancement

fundGood governance

6. In return for creating this investment opportunity, the public has a sustainability verifier that ensures it’s protecting investments that are working economically and environmentally. This may include technical assistance where needed.

We are still developing metrics for this, but the basic idea is to verify producer income/assets and biomass in the landscape.

In other words, “sustainability” is more than just about food security or the climate – it’s about producers being strong enough to deliver these outcomes over time.

13

It sells securities to a diverse pool of

investors via a public entity, at a higher return than what

those investors get at home.

It makes investments in

producers across a wide range of countries and farm types.

It does so in a way that helps

sustainable practices by offering real

flexibility at a lower cost.

It uses public support to handle some forms of risk and offer technical

assistance. In return, the public imposes sustainability standards as a condition of

investment.

AA

BB

CC

(Farmers Organizations could provide these

aggregation services.)

The Result: A Virtuous Cycle

In order for this to really translate into results, we and our collaborators need something else:

TO HEAR FROM YOU AND YOUR MEMBERS

Until now, we’ve worked on the very basic questions related to financial design, sustainability requirements and governance. But applying this in the real world requires real-world knowledge that we don’t have.

You and your members do. If you think there’s appeal in the concept of flexible, sustainable finance that drives higher income for producers and better environmental outcomes, we want to hear from you. Talk to us today or write us at:

ag@mundenproject.com 14

What Now? More Specifics: We Need Your Help

Appendix Example:Currency Risk

Investors presented with this opportunity will immediately realize two things:

– They have their own investors, who give them money in “hard currencies”:• Euros, US dollars, British pounds, Japanese yen

– But the farmers that are giving them payments do so in a “local currency”, which can be anything from a Colombian peso to a Kenyan schilling to an Australian dollar

For an investor from the US, this is a problem when the dollar appreciates against something like the Indian rupee or Mexican peso – because the payments stay the same amount in rupees or pesos, but the exchange rate change means less dollars for the investor. This is kind of like the fertilizer or fuel cost problems many of you face, only in reverse.

The essential point is that we need to figure out a way to help investors manage this risk. This can’t all be done by governments, because of limited public funding capacity – so what do we do?

16

Addressing Currency Risk

17

How to Judge the Risk

We can show this using Value at Risk (VaR), which is the maximum loss potential of

investments in 99% of cases across a simulation.

VaR practitioners are very interested in where

this red line falls.

(That’s because past the red line [the area under TVaR], things become very unpredictable and dangerous.)

1818Reflects interbank trading data from February 22nd, 2012

Currency risks are unacceptably high when VaR is up here…

Let’s see why this matters so much by looking at a simple set of charts. The values on the left are VaR scores (x axis) and we’ll show

them across a 5-day window (y axis)

1919Reflects interbank trading data from February 22nd, 2012

1.25 1.50 1.75 2.25 3.25

Investors can define desirable risk scores over time so they know where to put their money.

The objective is simple: find currencies that keep the VaR as close to these five green boxes as possible.

2020Reflects interbank trading data from February 22nd, 2012

1.25 1.50 1.75 2.25 3.25

We picked some random currency data from a few months in 2011-12 to

show this.

As you can see down there at the bottom, the Colombia Peso (COP)

offered low risk. All the scores are well within the investor’s desired

range.

But they can’t invest all their money in Colombia!

2121Reflects interbank trading data from February 22nd, 2012

So they can consider other places, like Thailand (THB), Kenya (KES) and the Philippines (PHP). These were all well within the acceptable risk levels we set earlier.

2222Reflects interbank trading data from February 22nd, 2012

But this approach excludes important countries – and not just those who have major civil strife or huge levels of poverty.

We found it can also apply to investments in Brazilian reaís (BRL) and Ghanaian cedis (GHS).

2323Reflects interbank trading data from February 22nd, 2012

Not only that, but investors have key concern about currency risk in emerging markets.

When these countries go bad, they can go very bad, very quickly, which means the real risks that would ruin an investor aren’t down here…

2424Reflects interbank trading data from February 22nd, 2012

…they’re up here, where an investor can lose 10 percent of the investment in a single week (just because of the currency, much less harvest problems, fuel costs, etc.)!

Investors have found it impossible to predict which currencies will reach this level of risk, so all emerging markets and developing countries are deemed suspicious.

In other words, lowering risk means finding a way to handle this problem.

2525Reflects interbank trading data from February 22nd, 2012

2626Reflects interbank trading data from February 22nd, 2012

The solution is the same as we saw in the portfolio: blend the investments.

When we ran a simple model, we saw that pooling these currencies into a PORTFOLIO that blends Colombia, Thailand, Kenya, the Philippines, Brazil, Ghana and Malaysia…

…gets the risk down to where we need it, which will drive lower payments for

producers while retaining flexibility!

Thank You