Ghana securitized an education tax to improve access to education and a petrol tax to pay off legacy debts in the banking sector.
U.S. utilities are securitizing fees to pay for and prevent future storm damage.
California has proposed to securitize vehicle registration fees to finance electric charging stations and meet its 2035 goal that all new car sales are electric vehicles.
Securitizing taxes and fees – issuing a bond backed by these cash flows and using the proceeds to strengthen climate resilience and adaptation – might help meet the most pressing climate finance need for emerging markets. Such securitization has the potential to raise large-scale financing for urgent needs today, attract private capital by issuing a bond backed by cash flows from established taxes and fees, and create limited or no fiscal pressure for the government.
These approaches are similar to what the U.S. calls “stranded cost securitizations”: securitize cash flows from a surcharge of fees or taxes and raise money to finance urgent needs. They were discussed at a September 2022 Milken Institute panel discussion as a possible tool for financing adaptation.
Africa is one of the most vulnerable places worldwide. An estimated 30% of Africa’s population faces exposure to destructive droughts, floods, and wildfires. Timely action and financing are critical to protect Africa’s economy, agriculture, health, way of life – as is true for many emerging markets.
Yet financing is low and attracting private capital is difficult. Most adaptation actions do not generate business revenues, making them less attractive for private investment. If private money is available, many African and other emerging market governments face tight fiscal constraints that make it highly challenging to borrow for these activities.
U.S. utilities have used stranded cost securitizations since the 1990s. They were introduced to raise financing to purchase new equipment and pay off existing debts – retire stranded assets – in the face of deregulation, growing competition, or changing technology. The securitizations typically result in lower-cost financing, creating cost savings that allow utilities to offer lower customer rates.
These securitizations are finding new life in the sustainability context. U.S. utilities are securitizing fees to pay for wildfire and storm damage and to reduce the risk of future damage.
According to Christian Fong from Rocky Mountain Institute, they’re now being used to help utilities finance their coal-to-renewable energy transitions.
And again there’s California’s proposal to securitize vehicle fees and Ghana’s education tax securitization, both to finance a more sustainable future.
Ghana has shown twice that securitizing taxes can be done in Africa, offering size and long-term funding. Ghana’s 2020 Daakye Bond Program securitized an education tax in a $1 billion local currency-equivalent program that has already shown impactful results, like expanded access to education in rural areas, as discussed by Armah Akotey from Databank and Cecilia Hesse from Temple Investments (Databank and Temple Investments were the transaction’s arrangers).
Ghana’s 2017 Energy Sector Levy Act (ESLA) program securitized a petrol tax to raise $1.6 billion cedi equivalent to eliminate legacy petroleum debts in the banking sector. Both programs allow tenors up to 12 years.
Keys to activation
Several key principles help make these transactions workable, which Markus Papenroth from Fitch laid out. They fall into three broad categories.
Sustainable cash flows. The flows should have a strong payment history and be irrevocable. Ghana put its education and petrol taxes in place years before it securitized them, which created performance histories. U.S. utilities and California’s DMV have years of performance data on their fee receivables.
Irrevocability is key: governments must be prevented from reversing course and taking the cash flows back. According to Fong, the U.S. has legislative guarantees preventing future utility commissions from making changes. In Ghana, the government legally established the education tax as a distinct cash flow so it could be securitized and to raise investor confidence that, even if the government changed, the tax policy on these cash flows would not. Detailed statutes should define the taxes and their ability to be securitized.
Legal protections should ensure that the cash flows are dedicated to paying off the bond, and off-limits to the originator. According to Akotey and Hesse, the assigned part of Ghana’s education tax is paid to a non-government bank which passes them on to the special purpose vehicle (SPV) that issues the bond. There’s also a legal requirement that if the government diverts any cash flows, the entire obligation goes on its balance sheet – a disincentive to tampering with the structure.
Papenroth noted that these are all critical mitigating factors against government interference but sovereign “take-over risk” can never be 100% eliminated.
Protecting the government from responsibility for these exposures. To avoid creating fiscal pressure, laws and regulations must protect governments from having to assume the obligations. Building securitizations on strong cash flows reduces the likelihood of payment shortfalls that a government might be pressured to cover. True Up mechanisms that adjust tax or fee levels to meet bond obligations and re-assessing the sufficiency of cash flows before any new issues, as Ghana does, help reduce these risks.
Assuring workable economics. The tax needs to be designed for a population that can pay it, influenced by the tax level and size and strength of the population it’s applied to. Daniel Bond from MiDA Advisors looked at securitizing fees to help a South African utility pay to convert from coal to renewable energy and found that below market utility rates made it infeasible.
Overall, governments and other originators must be able to design, apply, and manage these programs effectively. A successful track record will increase investor and rating agency comfort.
Not every country can create these securitizations where the economics, motivations, laws, and resources work. But they may help some countries attract institutional investors to financing adaptation. The government’s central role increases the likelihood that funds raised will be used for truly green purposes and that related policymaking will be credible. Reliance on established taxes and fees is a plus. And as with any securitization, it offers opportunities to blend financial resources as needed to create attractive risk and return profiles.
The securitized bonds also will help build green bond markets – a much needed development in most emerging markets. Indeed, government-related green bonds are seen as a key step to accelerate growth.
As countries look to scale climate finance, particularly for adaptation, they should explore the idea of securitizing taxes and fees as an instrument in their toolkit.
Alison Harwood is a Senior Fellow at the Milken Institute. Rizwan Haroon and Mohammad Rakibur Rahman were IFC-Milken Institute Capital Markets Program scholars, from the Pakistan and Bangladesh SECs respectively, interning with the Milken Institute.