How green bonds can drive low carbon economy after Paris

First issued by the World Bank in 2008, green bonds have been a growth story in the last eight years. Analyst forecasts predict strong future growth, fueled by demand, environment-friendly projects and the adoption of the Paris Climate Change Agreement last December.

Green bonds are no different from regular bonds in their nature. Both types of securities offer a predictable return to investors in the form of a fixed coupon yield, in exchange for medium to long-term funding for economic activities. By definition, the mission of a green bond is to finance projects that bring environmental gains, which requires a credible method of assessment over the life of the investment.

The requirements needed to ensure the credibility of green bonds are, however, still a work in progress. Misuse of proceeds can damage reputations, if not the market itself. For this reason, investors are calling for robust, transparent standards for the investment community.

But while there are question marks and problems to solve, the future of green bonds is promising. The road set of national plans to take climate action which underpin the Paris Agreement are expected to  accelerate government and business investment in large-scale climate-friendly projects with known returns, providing a fertile field for the issue of more green bonds.

A New Twist to Known Securities

Bonds are used by organizations to borrow money at cheaper rates than bank loans. Once labeled green, their proceeds spur renewable energy, energy efficiency, sustainability, biodiversity and clean infrastructure.

Institutional investors buy the bonds to increase their exposure to green assets and diversify their portfolios. SEB, a Swedish bank, says that so far more than 250 institutions have at least one green bond in their portfolios.

The market’s growth is undeniable. Only USD$3 billion of bonds were sold in 2002. Between 2013 and 2014, the market trebled in size, reaching USD$36.6 billion according to the Climate Bonds Initiative.

Moody’s ratings agency expects sales to exceed $50 billion this year, in comparison with $42 billion in 2015. HSBC bank is even more optimistic, predicting an increase to reach $55 billion and as high as 80 billion. This would raise the total outstanding green bonds issuance to a range of $133 to 158 billion.

The challenge and the opportunity are highlighted in the fact that these numbers however represent only 0.06% of a global bond market that was worth around $87 trillion at the end of the third quarter, 2015, according to the Bank for International Settlements.

Green bond issuance was largely dominated by multilateral banks and the World Bank until 2012. But two years later, a third of issuances were made by companies in the energy, utility, consumer goods and real estate sectors, according to the Gearing Up for Green Bonds report published by the KPMG auditing, tax and advisory firm.

National development banks are also joining the market.  In January, China approved two bonds worth $15.2 billion from the China Industrial Bank and Shanghai Pudong Development Bank.

The public sector had also joined the fray. States and local governments in the United States have issued $7.5 billion in green bonds since 2010, according to Bloomberg data.

In February, the New York Metropolitan Transportation Authority (MTA) issued $500 million in green bonds to finance infrastructure renewal and upgrade. The MTA also launched a targeted ad campaign to sell the bonds to individual New Yorkers.

Meanwhile, in the corporate sector, Apple entered the market in February, issuing $1.5 billion in green bonds to run clean energy projects. The mobile devices maker makes securities a part of its environment strategy and it pushes suppliers to adopt clean energy. For its part, HSBC has pledged $1 billion for a portfolio of green, social and sustainability bonds focused on renewables, energy efficiency, clean transport, adaptation and related sectors. Toyota was the first carmaker to issue a green bond in 2014. In June 2015, the Japanese company sold more than $1.2 billion of these securities.

This broad-based interest in green bonds from multilateral to national and private sector banking, from cities and regions to companies has now, therefore, established a strong platform for further growth.

 

A Tool to Implement the Paris Agreement

But the green bond market is not just growing, it can also act as a tool to implement the Paris Agreement, says Andrew Whiley, Communications Manager at the Climate Bonds Initiative.

Mr. Whiley expects these securities to be parts of the conversation at the next UN climate change conference, COP22, in Morocco, in November because countries need large-scale financial instruments to fund sustainable development and peak and reduce their greenhouse gas emissions.

“The connection between bonds and climate finance was not always as obvious as it is now. They had a marginal role to play but they were not as widespread. They were a niche method in the past, but there has been a realization that green bonds could be a major path to the conversion of INDCs” into climate action,’’ he said.

Michael Ridley, Director, Green Bonds and Corporate Credit at HSBC, agrees on the impact of the agreement. “The successful climate change talks in Paris last December should prompt agencies, banks and companies to identify further green projects requiring finance.”

Mr. Ridley also says that the financial community has caught up with the concept. “The Moody’s credit-rating agency is to start assessing new green bonds. This should stimulate green-bond issuance from the second half of 2016, particularly with US issuers and clients. Many US institutions are not familiar with the European organizations that currently provide independent opinions and verifications.”

Will all investors understand the purpose and join in?

Andrew Whiley believes that New York’s MTA provides a good example of concrete, day-to-day activities. After all, more than 8.5 million people travel on its network every day, helping to avoid emissions. “People do not need to be super smart to put money in those bonds. They are a safe investment and people can understand [the development of public transport]”.

Defining Green

Raising money with green bonds must come with environmental strings. Projects financed by the bonds will be scrutinized. Will they be green enough to avoid allegations of greenwashing?

This is why two sets of standards currently define green bonds.

The Green Bond Principles have been adopted by 50 large issuers, underwriters and investors. They set disclosure criteria and where the money can go. An external consultant can provide a second opinion on the bond structure and on the projects financed.

The United Nations also back green bonds that help refinance Clean Development Mechanism (CDM) projects at lower interest costs. The bonds give investors access to verified low-carbon projects in developing economies. The mechanism has been responsible for more than $138 billion of financial flows to climate-friendly projects.

The Climate Bonds Standards, for their part, have been put forward by the Climate Bonds Initiative. They provide a model currently covering solar, wind, low carbon buildings and transport. They make assurance by independent audit professionals mandatory. Reports have to be submitted to the Climate Bond Standards Board.

But KPMG believes that the engine that drives standards can still be fine-tuned, labeling the private green bond market as the “Wild West”. Reputations are on the line. Do issuers have unsustainable core businesses? Are projects bringing environmental benefits, if any?

“Standardized criteria for what makes a bond green are critical for the future credibility of the market, says Wim Bartels, Global Head of Sustainability Reporting and Assurance at KPMG. If too many issuers have the green credentials of their bonds challenged, this could affect the growth of the market by discouraging both future investors and issuers”.

KPMG expects more issuers to publish annual reports and disclose the outcomes of their investments. They need to show that environmental benefits have been achieved.

“In the meantime, adds Mr. Bartels, my advice to issuers is to only issue green bonds that meet tested criteria, that avoid below-market environmental efficiency improvements that relate closely to the major environmental challenges we face such as climate change and water scarcity, and that do not fund controversial projects.”

If there are risks to address, green bonds have been a welcome addition to climate finance and they are becoming a true vehicle on the road to a low carbon economy.