Green bonds







Green bonds can mobilize resources from domestic and international capital markets for climate change adaptation, renewables and other environment-friendly projects. They are no different from conventional bonds, their only unique characteristic being the specification that the proceeds be invested in projects that generate environmental benefits. In its simplest form, a bond issuer will raise a fixed amount of capital, repaying the capital (principal) and accrued interest (coupon) over a set period of time. The issuer will need to generate sufficient cash flows to repay interest and capital.
Key words: Climate change; Innovative finance; Private capital; Sustainable investment; Green growth; Impact investment; Debt and capital markets; Municipal bonds
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Green bonds are innovative financial instruments where the proceeds are invested exclusively (either by specifying the use of the proceeds, direct project exposure, or securitization) in green projects that generate climate or other environmental benefits, for example in renewable energy, energy efficiency, sustainable waste management, sustainable land use (forestry and agriculture), biodiversity, clean transportation and clean water. Their structure, risk and returns are otherwise identical to those of traditional bonds. The International Capital Market Association’s Green Bond Principles and the Climate Bonds Initiative's (CBI) Climate Bond Standards help to determine whether a bond qualifies as green or not. Usually, green bonds must undergo third-party verification/certification to establish that the proceeds are funding projects that generate environmental benefits (e.g. the Climate Bond Standard Board has established a procedure for certification, including the nomination of approved verifiers). The four Green Bonds Principles that define a green bond relate to:
Two categories of green bonds have emerged, i.e. green labelled bonds (i.e. certified as green) and unlabelled green bonds (issuances linked to projects that produce environmental benefits). Climate bonds are a sub-category where the proceeds are linked to projects that address climate change. To date, CBI has identified four main types of green bonds:
More recent innovations include greenSukuk, which comply with Islamic Finance standards.
Stakeholders
Potential in monetary terms
The volume of labelled green bonds has grown steadily since 2013, reaching US$221 billion outstanding issuances in 2017. Less strict criteria (unlabelled green bonds) put outstanding issuances at about US$ 895 billion. The landscape is mostly dominated by rail (i.e. clean transport) and renewable energy projects that are not labelled “green” by the issuer. Potential demand from investors is extremely high. Investors with over US$60 trillion of assets under management have made public commitments to make responsible investments, and green bonds can help them to achieve their pledges. The supply of unfunded investment projects is also large with investment in energy supply and efficiency estimated at US$53 trillion.
Green bonds were traditionally demanded by environmentally and socially responsible investors but market opportunities extend beyond this category of investors. Combined with continuing growth in corporate green bonds, The Climate Bonds Initiative believes the labelled green bond market can reach US$300bn of issuance by 2018. China and India have emerged as key markets, with a 73 percent share of green bonds issuances in emerging markets. The Agricultural Bank of China issued the first green bond by a state-owned Chinese bank in 2015, mobilizing a total of US$1 billion. Earlier in 2015, Xinjiang Goldwind Science & Technology (wind energy) issued a US$300 million bond for which it received orders worth US$1.4 billion. The value of each green bond issue varies greatly, from a few US$ million to over US$2 billion
A regulated capital market to govern the issuance of debt must be in place. No specific legal requirement is necessary for issuing green bonds, however. Existing international standards such as the Green Bond Principles or Climate Bond Standards can be recognized/adopted by national financial authorities, issuers and certifying bodies.
The debt market should be sufficiently liquid to sustain daily transactions. The size of the money and bond market and the existence (and competition among) financial intermediaries, credit rating agencies and market indexes can reduce the costs of issuing green bonds. These factors indicate that emerging markets and middle-large countries are in a better position to issue green bonds. Countries with limited financial depth or illiquid markets (e.g. low income or small countries) can issue bonds in foreign markets, including via the intermediation of international and regional development banks. For example, the African Development Bank used proceeds from green bonds to finance the Ithezi-Tezhi Power Project in Zambia, the Kivuwatt Project in Rwanda and the Buseruka Hydropower Project in Uganda, three LDCs.
The bond issuer should be prepared to enter regulated capital markets, which require certain criteria for listing financial products to be met, e.g. number of years in operation, certified budgets, turnover, etc. Beyond eligibility, the issuer should be ready to demonstrate its financial strength and creditworthiness publicly. Other forms of green finance are available for smaller enterprises or individuals (e.g. green mortgages). The price of and interest on the bond is directly connected to the financial standing of the issuer and/or the cash flows generated by the underlying projects.
Consistent income must be generated by the underlying green project. Unlike dividends, coupons are distributed at regular intervals. Companies and entities seeking to issue bonds need to rely on activities that can generate sufficient cash to pay coupons.
Minimum investment required and running costs
Public and private entities incur various costs when they issue bonds. Depending on the value, complexity, number of markets, taxes, risk profile of the issuer, etc., the issuance of a green bond might cost from thousands of US dollars to millions. Fees are usually calculated as a share of the face value of the emission. Depending on the number of services bought, service fees can exceed 1 per cent of the face value. For smaller and riskier emissions the sum of fees and taxes can reach 5 per cent of the face value. The lead financial institution usually charges a fee that comprises structuring, placement, legal and underwriting services. The level of complexity of the deal is a primary determinant of the fee, a plain vanilla bond, for example, being one of the cheapest products. In certain developing countries it might be cheaper to issue a bond abroad. Amortization and deferred payments are used to budget issuance costs across the maturity. The cost structure of green bonds is for the most comparable to traditional bond issuances. Additional costs unique to green bonds relate to the third party verification (which could cost from US$5,000 to US$50,000) and the monitoring and reporting system (the cost of which is dependent on existing frameworks).
Use in appropriate time and context
Green bonds offer direct access to regulated debt markets. Therefore, all considerations related to the use of debt finance apply (e.g. leverage, liquidity, cost, maturity, currency etc.). Their appropriateness versus other instruments (e.g. stocks etc.) has to be assessed on a case-by-case basis. Green bonds are usually best suited to large-scale projects such as low carbon transportation, sustainable water management and renewable energy, which generate cash flows over a long investment horizon. Governments can attract sizeable investments for infrastructure that are green and climate resilient. For instance, Nigeria, as the first African nation, issued a US$30 million sovereign bond to finance low-carbon projects. Sovereign green bonds have grown steadily in most recent years, both amongst developed and developing nations.
Participation of sub-sovereign governments and affiliated entities in the green bond market is on the rise. The municipal bond market is particularly attractive for green bonds given that responsibility for overseeing water, waste and transport services is often devolved to local authorities. For example, Cape Town issued a green municipal bond for Rand1 billion (US$77.2m) to finance public transportation and water infrastructure in a period characterized by severe droughts. Municipal bonds can help cities to finance large-scale infrastructure in the context of climate adaptation and resiliency. However, issuing government securities is a complex undertaking, particularly by sub-national entities with limited capacities. Recourse to capital markets can have a radical impact on the budget of a local authority, thus calling for strict oversight to prevent the generation of uncontrolled public liabilities, given that municipal bonds are generally implicitly or explicitly guaranteed by the national state. Prerequisites include credible governance, sound budget and audit records, relevant legal, tax, and regulatory frameworks, and viable arrangements for settling disputes.
The issuance of green bonds should never be abused as a means to greenwash a company’s operations or to deceive investors and consumers.
Cons
Risks
The growth of bond markets provides increasing opportunities to finance the implementation of the SDGs and green economy projects. Moreover, green bonds can help to promote Environmental and Social Governance in the financial sector. They can stimulate financial, regulatory, and economic policy reforms to boost green growth and can help countries make the transition towards becoming low carbon economies.
The direct impact of green bonds on the environment largely depends on the quality and performance of the underlying projects financed by the proceeds. The World Bank provides data on the estimated impact of its portfolio, e.g. two energy saving projects in China expect to save 12.6 million tons of CO2 equivalent annually through US$400 million of financing from green bonds. Multilateral development banks have established a harmonized framework for impact reporting on renewable energy and energy efficiency projects financed by green bonds proceeds that with time should allow a more stringent measurement of impact.
The quality of the projects can be strengthened through the deeper integration of environmental and climate factors into the project design (e.g. achieving multiple environmental benefits). With time, markets can provide incentives for doing so, but transparency, agreed standards, Measurement, Reporting and Verification (MRV) and oversight are required. The work of regulators, investors and intermediaries to improve transparency and reporting should continue along with the establishment of complementary financial products, such as green indices, mutual funds and ratings. Making mandatory the publishing and third party verification of information presented to investors and the public will help green bonds to graduate into a more recognizable product.
In an effort to build verification systems, countries are beginning to set standards and create coordination bodies. For example, China is in the process of creating a Green Bonds Standard Committee, a regulatory supervision body that oversees the practices of bond verifiers. Additionally, the EU is exploring the possibility of developing EU green bond standards as well as creating an official EU Green Bonds Label. These steps certainly help formalize the green bond market however, variability in standards across regions carries its own risks. As the market matures, harmonizing regional systems into a clear set of international standards would be advantageous.
While green bonds, by definition, should have a positive impact on the environment, additional steps can be taken to improve their social impact. Interested parties should not only progressively enhance the Green Bond Principles to better address environmental impacts and concerns but also to introduce reporting on social outcomes according to international standards.
Guidelines
Case studies