A veteran of alternative investment management has started pitching a new type of securitization he says would allow banks to cut the carbon footprint of their balance sheets.

Andrew Hohns, a former managing director at hedge fund Mariner Investment Group who now runs Newmarket Capital, says he’s currently in talks with a number of banks to construct such novel transfers.

For banks, repackaging and transferring the credit risk from their loan books to less-regulated private fund managers is nothing new. The appeal for investors on the other side of such deals is they can get double-digit returns, while banks get capital relief, freeing them up to do more business.

Newmarket, a Philadelphia-based alternative asset manager that specializes in structured credit, is now pitching a similar mechanism for banks to repackage and transfer their so-called financed emissions, which represent the greenhouse gas pollution linked to their lending and investment activities. Banks that channel a lot of capital into the fossil-fuel industry, for example, would have big financed emissions.

The idea is to “transfer the credit risk, but at the same time transfer the so-called emissions risk to a third-party investor outside of the banking system, such as ourselves,” Hohns said.

Such structured products would be the latest in a string of innovations that includes everything from debt-for-nature swaps to novel use of carbon offsets, as the wizards of high finance experiment with new instruments to tackle climate risk. Applying a risk-transfer model to carbon emissions remains experimental, in large part because it’s hard to assign monetary values to such risk and because no rules exist to guide such a construction.

Meanwhile, banks face growing pressure from regulators to slash their financed emissions. In Europe, where ESG regulations are more advanced than in other jurisdictions, the main industry watchdog has already put lenders on notice.

The European Banking Authority said in October it’s revising the framework that sets industry-wide capital requirements — known as Pillar 1 — to incorporate environmental and social risks. The EBA says the change means that banks will need to review the ESG default and loss probabilities in their portfolios, as well as the risk weights that go into determining how much capital they set aside for each client account.

With so-called emissions-weighted risk transfers, banks can use “the same kind of mental models that have been built up on the regulatory capital side to reasonably state that they’ve reduced the emissions intensity of their portfolio,” Hohns said.

The global standard-setter for financed emissions reporting, the Partnership for Carbon Accounting Financials, doesn’t offer guidance for such securitizations. CDP, a nonprofit that advises public and private entities on how to measure and report their carbon footprint, said such transfers don’t address the wider challenge of reducing emissions in absolute terms.

An emissions-weighted risk transfer “isn’t innovation, this is engineering,” said Amir Sokolowski, director of climate at CDP. “The purpose of this financial engineering instrument seems to be to cut the link between emissions and risk,” but the result may “threaten both direct action and the steer of sustainable finance,” he said.

Wolfgang Kuhn, chief executive of Kuhn Advisory & Research and a member of the European Financial Reporting Advisory Group, also voiced skepticism. “The original sin of the global financial crisis was separating origination from risk-taking,” he said. With emissions-weighted risk transfers, the question is whether “we are going to repeat the exact same concept.”

The financial appeal of such instruments, however, has attracted the attention of other structured credit specialists besides Newmarket Capital. Ryan Dunfield, chief executive of SAF Group, a Canadian private credit investor, says he’s also had talks with banks about taking on their emissions risk. Like Hohns, he declined to name the banks because those talks remain private.

Dunfield said demand for such instruments rests primarily on the regulatory landscape. “Ultimately it’s going to be regulators saying we’re going to increase your capital density, and the economics will actually drive [banks] to start hitting those transactions,” he said.

Structures that SAF has discussed with banks include a so-called black carbon pool, Dunfield said. The idea is to create a vehicle into which banks can “move all their emissions-intensive financings,” he said. SAF would then seek to match those with carbon offsets, he added.

Appetite for transferring credit risk, meanwhile, is growing among banks. Deals for synthetic risk transfers reached about $20 billion last year, as banks lowered their exposure on roughly $200 billion of loans. That’s roughly double the level transferred to third parties a decade ago, Hohns estimates.

While European banks like Banco Santander SA, Barclays Plc and Societe Generale SA, as well as Canadian lenders including Bank of Montreal, Royal Bank of Canada and The Bank of Nova Scotia have been the biggest users of synthetic risk transfers in previous years, Wall Street is fast catching up.

BlackRock Inc. has said the market has the potential to grow at about 35% a year, as the instruments gain acceptance and tougher capital rules take hold. Meanwhile, investing giants including Ares Management Corp., KKR & Co. and Blackstone Inc. also are devoting resources to exploring such deals.

As an add-on, the capital relief achieved through emissions-weighted risk transfers would free up banks to channel more funds into green projects, Hohns said.

Newmarket Capital already classifies two types of synthetic risk transfer as impact deals. The first is structured around a green underlying asset, such as a renewable energy project. The other is structured around an underlying asset that’s not green, but for which the bank has pledged to put the freed-up capital toward environmental or social projects.

“Conventional forms of energy are likely going to continue to require financing for the better part of the next century, they represent good credit risk and are important tools for human flourishing,” Hohns said. “We’ll continue to invest.”

This article was provided by Bloomberg News.