Bridging the Gap: Elements for a way forward

Financing the Transition — Blog 2.

This is the second of a series of blogs on financing the transformations that our societies need. It is part of our project ‘Re-coding for a civic capital economy’, co-financed by EIT Climate-KIC, and also builds on ideas developed through the EmergenE Room programme with McConnell Foundation, our work with Viable Cities, and the EIT Climate-KIC supported Long Term Alliance. See the first blog here.

Linked to the climate crisis is a huge funding gap estimated to be $6 trillion annually. There is both an opportunity and demand to look at the problem through a different lens, especially as current macroeconomic crisis management tools and unconventional monetary policies, such as Quantitative Easing, may not provide any substantial redress in the time required.

As our previous blog outlined, there is a need to invest in and recognise the value of a new typology of 21st-century infrastructure, a new class of assets, and a new way of managing liabilities — all of which fall outside our existing socio-economic system.

Our work to date reveals two significant features of this new asset class.

1. Typologies: The new asset class includes novel investments such as an urban forest (looking beyond its cost and traditional elements as timber yield value to incorporate its systemic environmental and social services) and intangible assets such as bridging social capital (trust, governance, well-being), which enables societies to handle shocks in an age of long emergencies.
2. Characteristics: The new asset class operates and behaves like infrastructure, where yields are persistent, quasi-monopolistic, and serve as a foundational component of our 21st-century society and economy.

Unlocking this asset class for society-wide benefit requires new capital structuring mechanisms, in order to open up whole new value chains as yet inaccessible or unrealised in the analogue era of the 20th-century and early-21st-century economy. Such an approach is predicated on:

1. The real-time, data-driven coupling of investment instruments and smart micro funding contracts.
2. The capacity to pool liabilities and value flows, turning micro into macro, through smart collective insurance or collaborative procurement and outcomes-buying models.
3. Building what is called ‘sympoietic systems’ of interaction and collaborative value creation. “Sympoietic (collectively-producing) systems do not have self-defined spatial or temporal boundaries. Information and control are distributed among components. The systems are evolutionary and have the potential for surprising change. Since they cannot be identified by boundaries, sympoietic systems must be identified by the self-organising factors involved in their generation.”
4. The deployment of smart market protocols (such as open, micro-transfer pricing) to avoid rent-seeking and monopolistic behaviours and characteristics.
5. A series of interoperable smart elements, that are vital in constructing the contracts of value necessary for transition.

Combined, these conditions catalyse a whole new set of value chains. They can optimise, measure, and contract for investment and value synergies — thus generating co-benefits, managing co-liabilities and externalities in a way as yet unaccountable and impossible to create contracts for. Trees, for example, can be understood as a natural resource but also can be contracted as an infrastructure asset for their carbon-capture capabilities, their means to manage ‘heat island’ effects for energy utilities, their impact on health outcomes for communities, and their sustainable urban drainage benefits for water utilities.

We believe this new way of structuring capital and value has the potential to drive the expansion of what counts as investable infrastructure beyond assets like real estate, transport, and energy to include both civic and nature-based assets: social infrastructure as well as brown (full-street retrofit), green, and blue nature-based solutions, all of which are fundamental to tackling the climate crisis and driving a just transition.

As we outlined in the first blog, this has all been made possible by developments in the application of smart contracts and distributed ledger technologies. When combined, these create almost frictionless means to transact, pool, and aggregate value, and to couple across the ambient, micro, and known emissions of value and their spillovers.

The ability to contractually value and interact with the permutations of these value emissions is what opens up the potential for a new class of investible value models. We can then use a combination of these emissions of value to establish, for example, a much deeper understanding of the holistic value flows of a tree — its direct value to a house, its value within a system, as well as its correlated value to a synthetic benchmark or index.

Once we are able to understand and more accurately describe the value equations of novel infrastructures in this context, we can start to assemble the contractible components and value chains, These value chains are assembled and compounded off the back of a series of universal elemental components which we think are vital to constructing this new civic economy.

A PERIODIC TABLE OF TRANSITION ELEMENTS

Over the course of the last year we have identified a series of elemental transition finance components through various projects, missions and case studies. We think all of these are vital in ‘re-coding’ capital and constructing the civic value chains we need in order to drive the transition. These elements are the foundations of a radically transparent and machine-readable investment ecosystem which, in turn, creates new governance mechanisms. Our work has shown that these value chains can be constructed through a series of discrete ‘machined’ elements. These create the contractible pathways for the flow of value across multiple partners and stakeholders, opening up new possibilities for funding, including the financing of novel infrastructures.

Construction of value in this new economy is based on these elements. The fact that they are digitally machined provides a surge in capacity that would not otherwise exist. In fact, advances in technological capability (computational and API contracting, remote-sensing, data collection and analysis), as well as near-zero transaction costs, have made and will make the development of these new elements possible. The resulting value chains are the combinations of these elements that result in contractual arrangements such as smart covenants (to capture spillover value of novel infrastructure benefiting real estate owners) and comfort-based or outcomes-based contracts for at-scale district retrofitting, smart perpetual financing, and smart carbon treasuries. Together, they form whole new compounds of value that enable financing of the transition.

The graphic above shows an initial periodic table of elements which we have started to define as they emerging from our work. We do not believe this to be either exhaustive or complete, but it is a start. We expect this list to be added to and augmented by ourselves and others over the course of the coming year.

A key feature of these elements is that they can be compounded to build rich complex systems of value, and the contracts provide the capacity for these elements to be structured as value flows. Therefore, bundles of these elements would create new contracts and functions, such as smart covenants and smart comfort or outcomes contracts. Such contracts facilitate the interaction between micro, ambient, and known flows of value and liabilities. Below are some examples of these contracts with examples of how they are used in creating value chains:

CONTRACTS & FUNCTIONS — Examples

These contracts can be aggregated to create new functionalities such as a Carbon Treasury.

A Carbon Treasury would involve management of an accreting (gradually accumulating over time) legal liability of a local authority (e.g. municipalities have a legal responsibility to be carbon neutral by 2050 or before). It could do so through an asset-backed approach as opposed to a traditional revenue based approach (i.e paying ever-higher insurance premiums or carbon offsets). So, rather than buying carbon credits to offset its net emissions (which would effectively be leaking money out of the local economy), the local authority could take the net present value of the future liability and use that to set up and invest in a civic infrastructure asset like a network of urban forests, or renewable energy infrastructures and whole-district retrofits. The authority could then issue index-linked perpetual notes which pay coupons algorithmically based on a carbon price or outcomes index, or on the closing price of CO2 offsets on a recognised exchange on the coupon payment dates.

This form of compound transaction results in the trading of an accreting liability for a civic asset. The table below illustrates how the local authority effectively buys a collective outcomes contract with locked-in value flows within a circular economy.

It is important to note that the Carbon Treasury proposed is an example of a compound element as opposed to a value chain, in that it is essentially about managing carbon liabilities through a series of elements. It is of course an integral part of value-chain construction especially when viewed through a carbon sequestration lens as in the case of an urban forest, or the potentially rapid carbon emissions reductions through holistic district energy retrofits.

Value chains are the results of contracts and functional elements being combined to construct decarbonisation deals that maximise value creation and, therefore, making them eligible for investment. Without the technological advancements in value capture mechanisms, it would not be possible to structure deals such as street or district retrofits and TreesAsInfrastructure (a project which aims to demonstrates how urban trees can be used to offset carbon locally in cities), as well as other nature-based solutions like the soil regeneration initiative undertaken by our partners MIS in Montreal.

Value Chain Models

The following two examples are used to illustrate the potential of the elements we describe and new value construction they offer.

The Highline as smart commons

As we analyzed in a previous publication, there is a fundamental link between investing in an urban greenspace infrastructure like the Highline in New York (or the proposed highline in the London Borough of Camden) and the uplift of land value and revenue yields adjacent to it. Historically, this link has been uncontractible and untransacted, leaving civic assets like a new public green amenity largely uninvestable even though they generate a large quantum of value — from well-bein and local business growth to biodiversity. If these civic assets are invested in by the public/state, the financial value generated is currently largely captured by a minority real estate owner economy.

We believe that a sustainable value chain can be structured for such civic assets, on the basis of a collateralised Smart Covenant-backed Perpetual Bond. This is an asset-backed security collateralised through a smart covenant contract, which captures the value flows in the deal — i.e. land value uplift and retail revenues, containing an option to receive fixed and variable annuity streams (the coupons).

The smart bond can also be contingently structured to contain elements of price uplift that are relative and proportional to the aggregate uplift notional value, and also proportional to the location of each micro-asset holder in the overall highline perimeter. The bond could equally be structured with capital call features, allowing bondholders’ capital to be called when needed in line with the various development phases of the Highline project. Bondholders could also be given voting rights over future restructurings, or rights of first refusal in subsequent financing rounds. In this way, a new financing approach emerges for the green infrastructures that our cities need but find hard to fund though traditional budgets.

FutureFit: whole-street or whole-district retrofitting

The retrofitting of whole blocks, streets and districts in an integrated manner present us with a system-scale option for meeting climate transition targets. If undertaken in a holistic manner, benefits don’t just include energy efficiency, energy bill savings and job creation, but also human health, social cohesion and industrial innovation, with correlated benefits at the national level.

However, up until now the complexity of interactions and transactions, ambient and micro spillovers of value, a misaligned ecosystem of incentives and nonlinear benefits, have all served to maintain this holistic at-scale retrofitting as a rarely realised designer’s dream.

Whole-system ‘FutureFitting’ is a good example of the transposition of output financing (energy units only) to outcomes financing that creates a type of synthetic risk arbitrage between the change in energy utilisation and comfort value. The model is predicated on the collateralisation of the delta (change) between the value of the energy reduction (of future energy demands) and the energy bills paid by the customer that contribute to the retrofit.

The deal construction can also be viewed as a derivative; a Total Return Swap (TRS) where the receiver leg of the swap (beneficiaries) is comprised of various returns including a comfort contract in return for a series of payments (energy bills) that are capped or linked to, for example, a consumer price index CPI. From the beneficiary’s perspective, it is trading (swapping) energy capacity for comfort value through the contract. In this case, the householder (a beneficiary) receives the direct well as correlated benefits of a whole street retrofit — the comfort value. The comfort contract is linked to energy usage and the energy bill that is linked to the individual. Health savings is an additive component and not linked at the individual (micro) level but at the societal (health service) or systems level.

The seed capital required to fund the retrofit is the aggregate notional value of the amount of energy reduction (¤/KWh). As the seed capital will only partially fund the retrofit, other parties (e.g. Health, Environment) will also need to contribute to the overall required funding amount for the whole street / whole city retrofit.

The total seed capital available could be pooled and warehoused to originate syndication deals involving senior-secured bank or private capital, or alternatively through a Smart Perpetual Bond with structured coupons linked, for example, to an applicable spread (e.g. the notional value of the energy unit reduction) and/or to a customised index of environmental and social constituents. These are just some examples of financing alternatives to consider when structuring output-to-outcomes financing. However, the Public Interest Institution performs key functions in the scaling and execution of this value chain model.

The Public Interest Institution (PII) would oversee:

• Aggregation of all deltas of the projected energy requirements.
• Pooling of energy savings with savings from other budgets.
• Achievement and verification of outcomes objectives.
• Participation of other stakeholders and counterparties.
• Construction and operation of secondary pooling mechanisms.

The PII would pool the energy savings potential at street level, and use that as a density function to determine excess spread required between energy units saved and the energy bill guaranteed for the consumer. Once this is established, the PII would sequentially invite outcomes buyers such as public health, then utilities and insurance (reduced flooding risk), and perform these additive functions as each contract and outcome buyer (liability holder) is separate.

Density Function: In probability theory, a probability density function, or density of a continuous random variable, is a function whose value at any given sample in the sample space can be interpreted as providing a relative likelihood that the value of the random variable would equal that sample.

The strategy also requires us to not only break down the contract into granular elements of specific performance, procurement, and comfort but also manage the nesting of the contractual elements between all contracting parties (this is a vital issue and challenge for parametric smart contracts). Further, the sequencing and execution of the various contractual arrangements is essential as the transaction contains execution risk owing to the nested and specific performance in the contractual arrangements between multiple counterparties, including retrofitters and energy suppliers who must commit to providing the seed funding for the transaction.

Trust, legitimacy, transparency, new forms of market design and novel consumer rights are required to mitigate gamification risks in these arrangements. The governance of the energy bill guarantee, therefore, is key. Contract governance and execution of the retrofit strategy is the keystone to constructing these futures. As such, this needs to be orchestrated via a Public Interest Contract, and a third-party contracting agency that would design, create and adjudicate the public interest contracts between energy providers, retrofitters, and citizens, requiring all parties to commit to full transparency and disclosure.

Conclusion

We see the examples of green infrastructure and retrofitting as demonstrative illustrations of how value is structured using the emerging ‘periodic table’ of transition finance elements we have outlined. The key feature of these elements is that they can be compounded to build rich complex systems of value. Digitally enabled contracts provide the capacity for these elements to be structured as value flows at the known, micro, and ambient levels. Technological advancements have made it possible to capture value at micro-massive scales, in order to structure the new value chains

Together, these elements in the new ‘re-coded’ and ‘machined’ finance economy can be used to create whole new forms of civic assets and institutions as we make the transition.

We recognise that our illustrations and conclusions are interim. We will continue to optimise our approach and the development of these novel infrastructures over the course of the next year together with our partners and collaborators, and welcome your thoughts.

The next phase of this journey for us and our many partners is to develop on-the-ground experiments and to gather evidence in order to test and validate our investment hypothesis. We will openly share what we discover and learn.

If you want to find out more about how to engage with this mission, please contact Indy Johar, Anastasia Mourogova Millin, Raj Kalia, Joost Beunderman or Chloe Treger at info@darkmatterlabs.org.

We have been supported in this mission by our close partners, Dominic Hofstetter and Thomas Osdoba at EIT Climate-KIC, Viable Cities, The Long Alliance, and Emergence Room Alliance in Canada. Dominic Hofstetter’s excellent stage-setting for Transformation Capital Framework has been fundamental in guiding our thinking. Our collaboration with the Emergence Room on the future of Canada has been generatively vital to the development of this agenda.

A big thank you to the many people who have knowingly and unknowingly contributed to this thinking and work — Dominic Hofstetter, Jayne Engle, Olga Kordas, Rupesh Madlani, Stephen Huddart, John Brodhead, Tim Draimin, Michael Lewkowitz, Alex Ryan, Patrick Dubé, Thomas Osdoba, Riyong Kim, Robin Parker, Lucy Geoghegan, Peter Reekie, Andrew Chunilall, John Uttley — Thank you

Also a massive acknowledgement to all the many people at Dark Matter who have made this possible.