One of the hottest trends in finance is prepaid muni bonds structured to help local utilities buy decades worth of renewable electricity. They’re good for the environment, but even better for the banks that will profit from cheap financing, trading profits and federal tax breaks.
Socially responsible investing, marketed under the moniker “ESG” (short for environmental, social and governance), is a huge and growing business. In 2015 global ESG-related assets were $2.2 trillion, according to PwC, growing to $9.4 trillion in 2020 and nearly doubling in 2021 to $18.4 trillion. Sustainable bonds are a big slice of this pie. Globally, over the last two years, an average of more than 400 bonds have been issued per quarter, totaling over $1.7 trillion, according to the London Stock Exchange’s Refinitiv group. European issuance is more than double that of the U.S., but a wave of new green bonds is coming here.
One particularly vibrant corner of this market: ESG-certified municipal bonds, such as those designed to help local communities prepay for decades’ worth of green electricity. According to Monica Reid, the founder of Kestrel, which charges “a fraction of a basis point” of a new bond deal’s face value to verify new issues as “social,” “green” or “sustainable,” there have been $85 billion worth of these municipal bonds issued in the U.S. in the last two years. Reid’s Hood River, Oregon–based team of 27 analysts and engineers certified nearly a third of them.
“Not everything is green or sustainable or socially beneficial because it’s financed with municipal bonds,” Reid says. “The muni market is also where coal ash dumps are financed, ports and airports. It’s where turnpikes and toll roads are financed. We are very discerning. Internally we have a do-no-harm criteria. If repayment is from oil royalties or gambling revenues, that’s a problem.”
Like so many environmental trends, this one started in California. Over the past 14 months enormous Wall Street banks such as Goldman Sachs and Morgan Stanley have persuaded ultra-green electric power agencies in Northern California to hand them roughly $2.7 billion, with $2 billion more in the works. The power agencies raise that upfront cash by selling tax-free municipal bonds of the type Kestrel certifies. In return, the banks so far have promised to deliver into the California power grid 2.2 million megawatt hours per year of “green” electricity, sourced from solar, wind and hydropower.
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There are many winners. The banks get cheap loans to spend on whatever they want. Californians, like the residents of 15 other states and the District of Columbia, get to pick their provider and can choose to put their money toward greener power. And investors can hold the bonds comforted by the knowledge that they have invested in something not only green but backed by a big bank’s guarantee.
The loser? Uncle Sam. If Morgan Stanley issued its own similarly structured corporate debt to raise funds, it would likely pay 6% or so interest, subject to federal tax. But when Morgan raises cash via a municipal prepaid green electricity deal at a 4% interest rate, it incurs no federal tax. On $3 billion in green power munis so far, that would equate to some $50 million a year in forgone tax revenue. Maybe it’s worth it. After all, it’s a model that could quickly spread across the nation and help underwrite the development of enormous amounts of greener energy. But it also could add up to billions of dollars in hidden annual subsidies to rich Wall Street banks. That might not play well in Peoria.
California is one of 10 states that have enabled the creation of local electricity-purchasing cooperatives called Community Choice Aggregators. They have names like Marin Clean Energy and Silicon Valley Clean Energy, and were formed to enable Californians to buy power marketed as 100% “green.” In recent years these co-ops have entered multidecade contracts directly with the owners of solar fields and wind farms to buy their electricity output.
But these electric co-ops are utterly unequipped to manage a host of complex contracts with financial counterparties. So last year the Marin co-op joined with sister entities in places like Silicon Valley, Berkeley and Carmel to set up what’s known as a conduit issuer, the California Community Choice Financing Authority (CCCFA), essentially a shell agency with the power to issue tax-free municipal bonds.
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Worldwide, bond buyers snapped up $481 billion in green bonds last year. But buyer beware: “Just because it’s green it’s not inherently a better investment,” warns Eve Lando, who manages billions of munis at Santa Fe, New Mexico–based Thornburg.
In the last 14 months, CCCFA has issued $2.7 billion in three different Clean Energy Project Revenue Bond deals, with tax-exempt coupon rates of 4%, courtesy of Morgan Stanley and Goldman Sachs. The money goes toward prepaying for 30 years of renewable electricity. Prepaying comes with a discount. CCCFA members, for example, expect to save $7 million per year on their electricity purchases.
Of course, large prepayment for future commodity purchases is a Wall Street banker’s dream. A close look at the California bond documents reveals an impressive feat of financial engineering involving a maze of entities, commodity swaps and derivatives that effectively transform billions of green bond proceeds into a tax-exempt source of funding and trading profits for Morgan Stanley and Goldman Sachs.
Says Joann Hempel, a vice president and senior credit officer at Moodys, “The banks can use the funds for whatever they want.”
On Wall Street, tax-free prepaid revenue bonds have long been associated with natural gas. In fact, nearly 95% percent of the estimated $60 billion that has been issued since the 1990s has been to purchase that fossil fuel. The idea was that small municipalities in places like rural Wilcox County, Alabama, or Omaha, Nebraska, would band together to sell tax-exempt bonds and use the proceeds to reserve a supply of natural gas at the same discounted prices that large city power systems paid.
In 1999, the IRS investigated the practice. The agency wanted to make sure traders weren’t using the bond deals to dodge taxes by using munis to acquire more gas than they needed, then selling the excess at a markup. In 2003, the IRS ruled that prepaid structures were kosher as long as 90% of the gas or electricity delivered went to the muni’s regular customers.
Enron’s bankruptcy in December 2001 was a setback for prepaid gas deals. The Houston energy firm had fraudulently boosted its cash flow by entering into numerous prepaid commodity swaps with banks like JP-Morgan and Citibank. In these circular deals, Enron would get billions in upfront payments from the banks in return for promising to repay the funds with gas deliveries. According to forensic investigators, Enron tended to repay these round-trip borrowings not with physical molecules of gas but with the proceeds of additional prepaid swaps, à la Charles Ponzi.
Although there were no municipal bonds involved, the Enron revelations chilled the market until the 2005 Energy Policy Act gave safe harbor for munis to get back into the prepaid business. “They got the IRS to sign off on a tax exemption. That’s when it exploded,” Hempel says.
Two of the biggest issuers of prepaid natural gas municipal bonds are Jackson, Alabama’s Black Belt Energy, a not-for-profit set up to purchase gas for residents of local cities and for companies operating in the area, including Boise Cascade, BASF, Louisiana Pacific and Main Street Natural Gas of Kennesaw, Georgia. According to The Bond Buyer, Black Belt, whose name derives from the dark, rich soil of this former cotton plantation region, was the third-largest issuer of municipal debt in the southeastern United States in the first half of 2022, raising $1.5 billion in prepaid natural gas bonds. That’s in addition to some $5 billion in gas-revenue bond deals it has floated since 2016.
Georgia’s Main Street Natural Gas issues gas bonds mostly on behalf of the Municipal Gas Authority of Georgia. It counts 79 cities and towns as its members. Since 2006, Main Street has issued no less than $10 billion in municipal prepaid gas bonds with a host of Wall Street partners including Merrill Lynch, JPMorgan, RBC and Citigroup.
Here’s how a recent Black Belt Energy bond deal worked. In October, Goldman Sachs and Stifel issued $383 million in 5.5% tax-exempt bonds, which were eagerly snapped up by fund managers including Vanguard, BlackRock and TIAA-CREF. After accounting for debt service reserve and other costs including 1% in issuance fees, some $377 million was handed over to a limited liability company called Aron Energy Prepay 13 LLC. That LLC was set up by Goldman Sachs’ commodity trading subsidiary, J. Aron, which has the ongoing responsibility of securing 30 years of physical gas deliveries as the project’s “gas supplier.”
Aron Energy Prepay 13 then delivers the money to Goldman Sachs, effectively as an unsecured loan, at lower tax-exempt rates. Then both sides hedge their exposures; because the revenue that Black Belt’s utility customers receive from selling gas is variable (based on the market price of gas) but the payments owed to bondholders are fixed, Black Belt and Goldman enter into commodity swaps contracts ensuring that no matter what happens with gas prices, those bonds will get paid.
The complex prepaid deals work out well for Black Belt’s gas customers, who lock in low prices, but they’re even better for Goldman Sachs, because the bank gains access to cheap funding. J. Aron is also a big winner, because it gets a long-term captive natural gas buyer for its commodity traders. In fact, J. Aron is one of the largest sellers of physical natural gas in North America. According to Natural Gas Intelligence, during the first six months of 2022, J. Aron delivered an average of 3.8 billion cubic feet of natural gas per day, roughly 3% of total consumption in the United States, to approximately 400 different municipal utilities.
Thanks in part to some $24 billion in prepaid muni bond gas deals over the last five years, and commodity markets roiled by the war in Ukraine, energy trading is booming on Wall Street. Goldman’s Global Markets division, powered by J. Aron’s traders, generated $22 billion in net revenue in 2021, its highest level in 12 years. Other firms active in prepaid bonds include RBC, Toronto Dominion, Morgan Stanley, Citigroup and JP-Morgan. Billionaire Ken Griffin’s flagship Wellington and Kensington hedge funds are the latest to jump on the prepaid muni bandwagon. In Janu-ary Griffin’s Citadel teamed up with JPMorgan to issue $626 million in tax-exempt bonds via Georgia non-profit Main Street Natural Gas.
For investors, prepaid energy bonds, renewable or fossil-fuel, are a no-brainer. Because the bonds are ultimately backstopped by the banks, investors get the rock-solid credits but with the higher yields typically associated with investing in the tax-exempt bonds of conduit issuers. And although these are 30-year bonds, they’re structured to allow issuers to call the bonds and reprice them within seven years, so they trade as if they have shorter duration—which is great when interest rates are rising.
“When you can buy a high-quality intermediate investment and pick up as much spread as you do in this sector, it’s a good place to be,” says one mutual fund manager.
And despite their small-town façade, issuers like Alabama’s Black Belt are operating far from their home markets, selling their cheap muni-financed gas as far away as Philadelphia, Arizona and L.A. There is nearly no risk in these deals, and what little there is rests squarely on the shoulders of their bank guarantors. Prepaid bonds have a stellar reputation. The only big bust was roughly $700 million in gas bonds issued by Main Street Natural Gas via Lehman Brothers. In 2008, when Lehman went belly-up, Main Street had to scramble to rearrange gas supplies, while bondholders ended up recovering only 80 cents on the dollar six years later.
It’s only natural that the banks and promoters see renewable energy as the next lucrative frontier for prepaid deals. The federal Inflation Reduction Act contains $270 billion to extend for 10 years generous tax incentives like those that enable investors in solar and wind projects to book up to a third of their costs as federal tax credits.
“[Renewables bonds are] creative and could be just as popular as gas. Right now, it’s a supply issue,” says Eve Lando, a portfolio manager at Santa Fe, New Mexico–based Thornburg Investment Management, which handles $40 billion, including $6.8 billion in muni bonds.
It’s possible that even natural gas deals could one day get the green stamp of approval. In July, the European Union added the fossil fuel—along with nuclear power—to its green, or climate-friendly, list. “Natural gas is a savior of sorts when it comes to bringing down emissions. Converting from coal to gas is a huge positive,” asserts Black Belt CEO Matthew McKinley, who says Black Belt is considering renewables, including methane, which can be captured from landfills or extracted from bovine “emissions” in dairies. Such “biogas” sources are considered carbon-negative because methane is a far worse warming gas than CO2, and capturing it prevents it from wafting into the atmosphere.
Bankers will win with “green” natu-ral gas or renewables like wind and solar. Some Wall Street giants have already gone upstream and gained expertise developing wind, solar and battery systems, incentivized by generous federal investment tax credits. Over the past five years, Goldman Sachs Renewable Power has built an enormous portfolio of 850 renewable energy projects that generate 2,300 megawatts and $300 million a year in revenue. In June Goldman spun off the division as MN8 Energy, which now is planning an IPO.
Goldman declined to comment for this story, but the bank’s California customers are enthusiastic. “We are looking to retool this solution to bring down the cost of renewable energy,” says Michael Callahan, associate general counsel of Marin Clean Energy and general counsel of CCCFA. “Prepayments in electricity is an extension of gas prepayments, and a bigger opportunity.”
By , Christopher Helman & Matt Schifrin, Forbes Staff
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