8. The Development of Green Finance in EU Agriculture: Main Obstacles and Possible Ways Forward

This chapter partially draws from Migliorelli and Dessertine (2018).

Agriculture releases large quantities of carbon dioxide (through the burning of biomass mainly in areas of deforestation and grassland), is responsible for up to half of all methane emissions (livestock alone account for about a quarter of such emissions, while irrigated rice farming accounts for about a fifth of total emissions) and is a key source of nitrous oxide (generated by natural processes, but boosted by leaching, volatilisation and runoff of nitrogen fertilisers, and by the breakdown of crop residues and animal wastes). Source: http://​www.​fao.​org/​docrep/​004/​y3557e/​y3557e11.​htm

In addition, crop and livestock production are the main source of water pollution by nitrates, phosphates and pesticides.

As a matter of fact, the debate on how to foster sustainable agriculture and the bio-economic transition embraces many other disciplines. Aspects regarding effective regulation, technological improvements, scientific research and evolution in the lifestyle (in particular as concerns the types of proteins to be consumed, animal or vegetal) will also determine the feasibility and the speed of the changeover.

Data for 2010–2013. Agricultural factor income represents income generated by farming which is used to remunerate borrowed/rented factors of production (capital, wages and land rents) and own production factors (own labour, capital and land). Source: EC (2015b).

A common, shared notion of green farming practices does not exist in literature or in the agricultural industry. In our analysis, we refer to this expression for any farming practice that may be entitled to be financed via green financing instruments. See further in the chapter on the issue of a lack of definition of green farming practices.

As a matter of fact, to be useful, a proposed financing structure needs to have clear testable implications, so that the underlying paradigms may be supported or refuted by data. To this extent, the present work should be considered only a first step, setting up the theoretical foundations. Further empirical research will be needed to test the effectiveness of the discussed financing structures on the ground.

The share of the CAP within the total EU budget has decreased sharply over the past 30 years despite the successive EU enlargements (from 73% in 1985 to 39% in 2013). Such a trend has been induced by a series of successive reforms, which have mainly had the objective of incentivising a progressive transition towards a more market-oriented system. Nonetheless, in the actual multiannual financial framework (2014–2020), the CAP funds amount to over € 55 billion per year (EC 2015b).

Depending on the country, direct payments (hence excluding other forms of subsidy) may range from 15% or less (Cyprus, Lithuania, Malta, the Netherlands and Romania) to more than 40% (Ireland, Luxembourg, Slovakia and Sweden). Source of data: EC (2015b).

Agri-environment and climate payments are considered within the Rural Development policy. These payments are cofinanced by the European budget and national or regional authorities, which have a large autonomy in designing their own multiannual programmes on the basis of the menu of measures available at the European level. The provider-gets principle states that farmers who sign up for environmental commitments beyond the reference level of mandatory requirements shall receive funds to cover the costs incurred and income forgone.

The SMEs segment represents 58% of the value-added creation and 67% of the employment in the non-financial sector in Europe. Data refers to 2014 (EC 2015a).

Relationship banking can be defined as the provision of financial services by a financial intermediary to the market on the basis of both hard and soft information, the latter obtained through a long-term engagement and continuous interaction with the client (Cornée et al. 2018). Conventionally, cooperative banks and savings institutions are considered as practising relationship lending.

Another factor that can induce small banks to focus on SMEs is the borrowers’ concentration problem that they could suffer by lending to large enterprises.

Financial statement lending, asset-based lending, credit scoring and factoring are some of the most widely used transaction lending technologies.

In more detail, Ashcraft and Schuermann (2008) analysed the specific agency problems at several points in the securitisation chain for subprime mortgages that ignited the Great Crisis, while Migliorelli and Dessertine (2018) focused on a possible securitisation mechanism to be introduced in the EU agriculture to foster environmentally friendly practices.

These include the provisions linked to the mandatory greening direct payments and the agri-environment and climate payments following the provider-gets principle already mentioned in paragraph 8.2.1.

The initiative of the European Commission launched in 2018 and aimed at establishing an EU classification system (or taxonomy) for sustainable activities is a step in this direction. This initiative should result in a Report of the Commission technical group providing a taxonomy for climate mitigation activities by Q1 2019 and a taxonomy on climate change adaptation and other environmental activities by Q2 2019. This taxonomy will not be included in legislative measures. For a more detailed discussion, see in particular Chaps. 6 and 7.

Green bonds may suffer less than other types of financing instruments of the lack of a definition or taxonomy of green activities. This is mainly due to the development of specific methodologies and labels by the financial industry.

This may be particularly so in many East-European countries and, to a lesser extent, in France (see again Table 8.2).

A first initiative to define green loans is dated March 2018 when the Loan Market Association (LMA) published the first Green Loans Principle (GLPs), mainly mimicking the Green Bond Principles (GBPs) initiative. In the framework established by the LMA, green loans are defined as “any type of loan instrument made available exclusively to finance or re-finance, in whole or in part, new and/or existing eligible green projects”. To be recognised as such, the concerned organisations also have to align with the four core management components of the use of proceeds, process for project evaluation and selection, management of proceeds and reporting (LMA 2018).

Such (apparently secondary) a problem may have indeed important policy implication. In fact, it may be expected that a policy intervention defining green farming practices in agriculture (e.g. through a specific taxonomy), and conversely constituting a basis for identifying green financing instruments, may conduct to a wide re-labelling of existing bank loans in green loans, with no significant effects in terms of additionality. For policy initiatives aiming at increasing the financing flow towards green farming practices to be effective, complementary actions would indeed be needed (e.g. in the form of fiscal or regulatory incentives for banks to issue green loans to otherwise not financed projects). See Chap. 7 for a more in-depth discussion on this issue.

In this respect, a promising movement in research, supported by policy makers, is emerging trying to link sustainability risks and financial risks (e.g. by considering that sustainable investments may reduce the frequency and the incidence of catastrophic natural events, thus also reducing their economic consequences). In the long term, and as a measure to further encourage sustainable finance, regulatory provisions for a different prudential treatment of the exposures related to sustainable projects might be introduced to the benefit of financial intermediaries (e.g. in case of more favourable requirements in terms of capital absorption for loans issued to finance sustainable projects). In the EU perspective, a supporting factor is already foreseen in the European Commission plan for sustainable finance (EC 2018). See also Chap. 6.

To this extent, also note that positive externalities linked to environmentally friendly practices are typically not considered in the farmer’s individual investment choice pattern.

This attitude can be explained by the traditional “incremental” evolution of the CAP over time (which inherits at every revision a relevant part of the support schemes used in the past) and by the relative novelty of the green finance discipline (which then requires time to be integrated in a complex policy scheme).

In addition, the effective involvement of institutional investors could result in a more efficient use of public spending. If used in blending instruments (e.g. in the form of a guarantee), public support could become an effective means of leverage for the overall investment levels (in terms of ratio between public participation and the inflow of private resources).

In this respect, relevant financial theory suggests that, in order to be more oriented towards the development of green finance, the public support should be kept in the form of grants or direct payments only when aimed at compensating agricultural producers from carrying out unprofitable but green farming practices. Otherwise, it should be embedded in market-oriented financing structures (e.g. by means of guarantee) allowing a wide range of investors to take part in the financing of green farming practices. A first step in this direction has been recently made with the introduction of ad-hoc financing instruments in the framework of the European Funds for Strategic Investments (EFSI). In particular, since 2015, it is possible to create financing instruments combining funds from the EFSI and funds from the European Agricultural Fund for Rural Development (EAFRD), within the Rural Development (RD) policy. One of the declared objectives of these initiatives is to create a leverage effect with the public funds used (in terms of the ratio between the total amount of the resources mobilised by the financing instrument and the amount of the public support).

In such a case, financing structure backed by public support could even go against the state aid regulation in EU.

This practice is indeed already adopted by EU policy makers in several programmes, through the so-called ex-ante assessments (see for example the Methodological handbook for implementing an ex-ante assessment of agriculture financial instruments under the EAFRD).

In this regard, excess spread (the practice of issuing notes with an overall yield lower than that of the underlying assets) and overcollateralisation (the practice of issuing an amount of notes lower than the available underlying assets) are also used as sources of internal credit enhancement and to cover transaction costs linked to the securitisation operation.

In a true sale securitisation, the ownership of the underlying exposures is transferred or effectively assigned to a securitisation special purpose entity. In contrast, in a synthetic securitisation, the underlying exposures are not transferred, but the related credit risk is transferred by means of a guarantee or derivative contracts.

Despite these advantages, existing literature highlights certain risks linked to securitisation practices. To this extent, a number of works have analysed the effects of the information asymmetries and the moral hazard that may feature the relationship between originator and final investors. In fact, banks and other financial institutions may tend to accept reducing their credit standards and transfer the risk to the market. In this respect, evidence has been documented, in particular for the subprime mortgages in the United States, which have been accused of triggering the financial crisis in 2007. Based on these studies, the absence of skin in the game has been the basis of a misalignment in the incentives between originators and final investors. This phenomenon has eventually caused a sensitive reduction in the quality of the underlying assets (Keys et al. 2009; Mian and Sufi 2009). For this reason, all recent regulation proposals on securitisation have included risk retention clauses concerning the originator. In more detail, the provision of maintaining a minimum nominal value of the first-loss tranche or of each of the tranches sold or transferred to investors is constantly proposed to limit opportunistic behaviours (BCBS 2014; IMF 2015; EC 2015c).

In an originate-and-distribute model, originators (typically banks) issue new loans with the intention to successively securitise them. Nevertheless, in order to avoid opportunistic effects, a characterising feature of the financing structure should be that originators maintain a certain level of skin in the game. In other words, they must keep in their balance sheets a quota of the first-loss tranche or a quota of all the tranches issued by the vehicle.

For a more detailed analysis on how an origination-and-distributesecuritisation mechanism can be introduced in agriculture, see Migliorelli and Dessertine (2018).

The expected reduction in the funding cost for agricultural producers is directly linked to the incidence of the public guarantee on the risk-profile of the notes issued by the securitisation vehicle.

In addition, securitisation has been blamed for contributing to the explosion of the subprime mortgage crisis in the United States and igniting the financial contagion worldwide. In particular, the negative view was due to the observation that securitisation had probably incentivised lax credit policies and poor asset quality standards. For these reasons, in the aftermath of the financial crisis, securitisation operations have registered historically low levels of issuance both in Europe and in the United States. Policy makers and international organisations have recently reacted by proposing amendments to existing regulations in an attempt to contrast the misalignments observed in the securitisation chain and give new impulsion to the market. In Europe, the ongoing reform aims, in particular, to identify criteria for simple, transparent and standardised securitisation (STS).

Critics of these financing structures usually highlighted the problems associated with low levels of additionality (even new loans awarded under these schemes might have been obtained without support), high administration costs and an often limited leverage effect (calculated by the ratio of total loans issued on the amount of public support).

As already underlined, a definition of green farming practices (e.g. through a specific taxonomy) will ease this task.

The leverage ratio for initiatives in the EU of guarantee funds can be expected to be between 4.0 and 6.0. As a comparison, the expected leverage ratio for financing structures backed by securitisation mechanisms may reach 15.0.

This second feature, even though it can increase the overall size of the fund by opening to market contribution, is not mandatory.

In some cases, venture capital and private equity funds can also enter in the management of the firm, potentially bringing benefits in terms of additional competencies and market knowledge.

In some industries, the entrance of venture capital and private equity firms is the capital of a company often accompanied by the issuance of new debt.

This is linked to the investment strategy of the venture capital or private equity funds that are remunerated by the sell-off of their quota when the firm has reached the expected growth potential.

Even in this case, a standard definition of green securities issued by funds of funds is currently not developed or in use.

See Bijman and Iliopoulos (2014).

In some cases, cooperative banks have experienced exceptional growth. As a consequence, those financial institutions have reached high levels of hybridisation and have been substantially transformed into universal banks (e.g. Crédit Agricole in France or Rabobank in the Netherlands).

For more details, see Migliorelli and Dessertine (2018).

In many instances, banking institutions that follow the same organisational pattern (e.g. a decentralised decision-making) may exhibit quite a similar behaviour in their lending practices. This is especially the case for other stakeholder-oriented banks such as community banks and savings banks.

The notion of a repository of the soft information we refer to is the one discussed by Berger and Udell (2002).

Nevertheless, it should be argued that the systemic relevance of this issue has to be evaluated country-wise. In fact, both the composition of the farming industry and of the banking sector (the latter in particular in terms of the presence of transaction lending technologies specialising in SMEs lending) may play a significant role in determining the final marketability of the loans and their average amount. In countries in which the average farm size is higher and the access to debt for farms is easier, the transaction-based banking channel could be expected to be fairly effective in financing green farming practices. This can be the case for countries such as Denmark, the Netherlands or the United Kingdom. On the other hand, in countries in which the farmland is dispersed and agricultural firms rely on the personal wealth of the farmer or the family more than on debt, there is the likelihood of a reduced outreach while using transaction-based lending increases. This may be particularly so in many East-European countries and, to a lesser extent, in France (see Table 8.2).

In the cooperative intermediation scenario, some inherent risks may exist in the case of an explicit or implicit hierarchical link between cooperative operational entity and cooperative financial entity. Such a situation may occur, in particular, in the case of large agricultural cooperatives or federations of cooperatives controlling a financial institution with the aim of serving their members. In such a case, conflicts of attribution may materialise between the operational and the financial entities. Furthermore, a dominant operational entity would tend to impose laxer credit standards and reduce the monitoring of the borrowers. In the mid-term, this would probably produce a deterioration of the quality of the loans issued and securitised. To limit systemic risks due to the transfer of the loans to the market through securitisation, a rigid governance structure assuring the decisional independency of the financial entity would have to be put in place and clearly communicated to the market. As a matter of fact, this is the typical case of captive financial institutions operating within larger industrial or commercial groups and that might be replicated in the largest agricultural cooperatives or federations of agricultural cooperatives.

A wider discussion on these issues is given in Chap. 6.

In terms of standards and labels for green financial products, the European Commission has mainly focused its attention on green bonds, with a Report of the Commission technical expert group on a standard for green bonds expected by Q2 2019. In addition, an assessment of applying the EU Ecolabel to financial products is also ongoing as of Q2 2018. Nevertheless, green labelling criteria for securities issued by structured finance vehicles (e.g. securitisation or funds of funds) are not yet under specific discussion. A wider analysis of these issues is given in Chap. 6.