Will Climate Bonds Become the New Way to Finance Sustainable Development?

Because these instruments provide the payback security institutional investors desire but are still targeted toward environmentally positive endeavours, they are becoming increasingly popular and could become a major new force in the green investment world.   

Institutional investors in search of quality yield and positive environmental impacts quickly snapped up last month’s $1 billion green bond offering of the International Finance Corp’s (IFC) for its climate-smart projects in developing countries. The bond offering, which was heavily oversubscribed, was sized to address the growing demand from an increasing number of investors interested in climate-related opportunities. 

The IFC now plans to issue at least US$1 billion in green bonds a year to support private sector investment in renewable energy and climate-friendly sectors in emerging markets for projects that reduce greenhouse emissions. 

[stextbox id=”custom” float=”true” width=”200″ bcolor=”add3d5″ bgcolor=”add3d5″ image=”null”]”Climate change is one of the most urgent development challenges of our time and only markets can mobilize the investment necessary for mitigation and adaptation. We are ramping up our Green Bond program to meet the growing demand for this asset class and enable investors to support climate-smart investment in developing countries.” IFC chief executive officer Jin-Yong Cai. [/stextbox]

The IFC is not alone in this financing space. Last month the European Investment Bank (EIB) priced its first Climate Awareness Bond (CAB) transaction for 2013 targeted to fixed income investors to support EIB lending for renewable energy and energy efficiency. 

As one of the largest financiers of projects to tackle climate change (over EUR 13bn worldwide in 2012 alone) the EIB uses CABs to attract private sector or institutional investors to its climate action program by virtue of its excellent credit standing. 

The World Bank is also a major player in the Green Bond market. Indeed, the Green Bond concept as originally developed by the World Bank in 2007/2008 has become a preferred method to encourage and coordinate private and public sector activities to address climate change. Proceeds from the Bank’s green bonds are credited to a special account that supports World Bank loan disbursements on qualifying projects in client countries. 

The appeal of this product lies in its simplicity – the credit quality of the bonds is the same as that of other World Bank triple-A rated bonds, it is a ‘plain vanilla’ structure, a liquid instrument that can be traded as easily as other ‘plain vanilla’ bonds issued by the World Bank, with a market competitive return. 

With these characteristics, it fits the requirements of core portfolios of large fixed income investors seeking to support activities that have a positive impact on climate change. 

Other key financial institutions have entered the field. In February the Export-Import Bank of Korea (Kexim) issued its first “green” or climate friendly bond, the first benchmark-sized bond marketed as a green bond outside the multi-lateral development banks. See GLOBE-Net article (Korean Exp-Imp Bank Green Bond Issue Oversubscribed). 

Not only was this seen as a big step forward and a big contribution from Korea, touted as the standard-bearer of green growth government, it was a positive signal from the marketplace that ‘green’ is not a barrier to mainstream investors, but rather an attractor.  

A Growing Market

Over US$3.3 billion worth of the triple-A rated bonds have been issued by the World Bank since 2009, managed by firms such as Skandinaviska Enskilda Banken (SEB), as well as JP Morgan, Deutsche Bank and Daiwa Securities. (See GLOBE-Net article “Green Bonds: The Next Market-Based Mechanism to Tackle Climate Change“) 

Over the past 18 months, the global market for these types of bonds has nearly doubled, from US$5 billion to some US$9.5 billion, according to SEB, who partnered with the IFC on its first green bond offering. However, the total green bond market may be much larger, according to HSBC Holdings and the Climate Bonds Initiative, a London-based nonprofit. 

The International Energy Agency estimates that US$5 trillion of investment will be needed worldwide by 2020 in renewable power, energy efficiency, and cleaner transportation to contain rising global temperatures. Most of this capital will come from the private sector. 

Sean Kidney, Chair of the Climate Bonds Initiative, predicts climate themed bonds backed by credit worthy financial institutions or governmental agencies could become the preferred vehicle to attract this level of investment from private or institutional investment sources. 

[stextbox id=”custom” float=”true” width=”200″ bcolor=”add3d5″ bgcolor=”add3d5″ image=”null”]The concept of theme bonds is not new. They are similar in principle to railway bonds of the 19th century, war bonds of the early 20th century, or the highway bond of the 1960s.  [/stextbox]

While in principle, green bonds might be used to address a wide variety of environmental matters to date the main focus has been on climate change mitigation. That may be changing. 

The State of Massachusetts plans to sell $1.1 billion of new and refunded general obligation bonds next month.  According to a Reuters report, the bond offering will be similar to World Bank Green Bonds, except there will be no third party review of the inclusion criteria, a prescribed feature of the World Bank’s offerings.  (When SEB was mandated to underwrite and place the World Bank’s green bonds, the bank commissioned an independent audit of the product’s environmental claims as part of its labelling due diligence.)

Nor will the proceeds all go to investments related to climate change. Projects to be funded will span clean water and drinking water initiatives; energy efficiency and conservation in state buildings; land acquisition, open space protection and environmental remediation projects; and river revitalization and preservation and habitat restoration works.

This could be indicative of a new way to finance sustainable development at the state or national level of governments. Indeed, as U.S. states look for new sources of clean energy finance, a group of public and private investors, policy makers, and industry practitioners have banded to explore new ways to scale up clean energy investment financing using bonds.

A proposal recently published by the Clean Energy and Bond Finance Initiative for Congress to consider would bring together public infrastructure finance agencies, clean energy public fund managers and institutional investors across the country to raise capital at scale for clean energy development through a new State Clean Energy Finance Initiative.

The proposed initiative would be housed at the U.S. Department of the Treasury but program development and project financing approvals would be conducted by state governments. This is seen as a way to preserve government financial support for the adoption of clean energy technologies, but through a variety of credit enhancement tools designed to leverage private capital. 

[stextbox id=”custom” float=”true” width=”200″ bcolor=”add3d5″ bgcolor=”add3d5″ image=”null”]”The State Clean Energy Finance Initiative is designed to assist the clean energy industry in accessing affordable capital through an innovative and efficient program structure,” Lew Milford, President of Clean Energy Group.[/stextbox]

As noted in a report by Sean Kidney as private sector players and other shareholders enter the market, the question of agreed and credible definition becomes more urgent. The Climate Bonds Initiative believes an international standard labelling scheme using a transparent ‘transition’ model for the labelling of issuance by companies that have both sustainable and non-sustainable assets in their portfolios.

Kidney cites a UNEP paper on investors and climate change that more precisely defines a climate bond and relates it to green bonds.

“A climate bond is an extension of the green bond concept. Green bonds are issued by a government or corporate entity in order to raise the finance for an environmental project. The issuing entity guarantees to repay the bond over a certain period of time, plus either a fixed or variable rate of return. Climate bonds would be issued by governments (or others) to raise finance for investments in emission reduction or climate change adaptation.”

A new Asset Class?

While socially responsible investment (SRI) was something of a niche area of financing in the past, recent moves by both institutional investors and government Treasuries to invest in bonds that target climate change mitigation  initiatives and other environmentally focused initiatives could become a major feature of the green financing landscape. 

Indeed, the World Bank is already considering using triple-A rated credit instruments to more precisely channel funds to mitigation and adaptation projects in the portfolios of the largest investors. 

It believes green bonds could develop from a simple, high-grade product to a more complex array that appeals to investors with different risk habitats – those looking for high-grade products (with credit-enhancements) and others searching for higher yield potential, taking on more credit risk.

According to the Bank’s 2010 handbook, products such as ‘rainforest bonds’ or ‘energy efficiency bonds’ with different risk characteristics and tranches could be issued or credit-enhanced by multilaterals or governments to support specific climate change activities. 

The Bank reasons that more private capital can be mobilized if products are designed that fit the risk/return characteristics, offer portfolio diversification, or provide liquidity and give investors opportunities to benefit from the success of projects that address climate change.

‘Sustainable Investment ‘ will be a major topic at GLOBE 2014, the next in the celebrated GLOBE Series Conferences on the business of the environment taking place in Vancouver Canada, March 26-28, 2014. Reserve your place now. Check here for more details.