Climate Bonds, An Overview
By Sean Penrith, The Climate Trust
April 2014
Background
Issuing of bonds financed infrastructure initiatives over the past century or two to meet environmental and social challenges. These included sewer construction that helped address the blight of cholera in Europe and the development of the national energy grids to fuel the economic growth of the 20th century. These bonds are long-term debt instruments that are repaid at pre-agreed upon rates and guaranteed by governments.
The latest Intergovernmental Panel on Climate Change (IPCC) Fifth Assessment report sends a stark message that it is imperative that the world shifts to a low-carbon and resilient economy now.[1]A 2013 World Economic Forum report projected the need for global investment in the low carbon economy at $5.7 trillion annually by 2020 to avert the most serious consequences of climate change.[2]There is international agreement that to address this investment gap, governments are somewhat limited especially in the light of a recovering global economy and thin public sector balance sheets.
The pressing need to accelerate our climate mitigation efforts has brought a spotlight to bear on targeting private financing. Climate bonds are proving to be a valuable tool in the climate finance arena garnering considerable attention from both investors and environmentalists. A TD Economics special report in 2013 touted them as “Victory Bonds for the Environment.” Richard Kauffman, former advisor to the U.S. energy secretary and now the energy and finance chairman for New York State commented appropriately, “New strategies don’t require going to the lab; they involve applying financing techniques that have already been invented and are used widely in other parts of the economy, but have not yet been applied to this sector.”[3]
Climate bonds fit Kauffman’s definition of a new strategy; they are essentially infrastructure bonds tailored specifically to finance climate solutions. The scope of projects that can be financed is determined by the issuer and can be broad or specific.
Bond Universe
The greatest share of institutional funds is allocated to the global bond market. The value of these bonds as of the end of 2010 was $95 trillion with 72% of those bonds being held by long-term investors such as pension funds, mutual funds, and insurance firms.[4] While conventional investors are waiting for policy signals, others are actively demonstrating their commitment by investing in bonds and other financial instruments that support low-carbon project development at scale. This has set the stage for a market for climate (green) bonds, defined as asset-backed bonds that furnish capital to climate change mitigation projects that yield credible reductions in emissions, or strengthen adaptation measures. The green bond market is currently just 0.4% of the global bond market.
Bonds are ideally suited to funding the long-term environmental infrastructure needed to develop the low-carbon economy. Bonds allow one to borrow against future economic benefits to allow for the investment needed now to deliver those benefits (Figure 1).
Figure 1: Short-term price support for climate friendly projects to achieve economies of scale will result in long term cost savings. Source: Climate Bond Initiative, U.K.
The required upfront investment needs are often balanced by significantly lower operating costs especially in the building, energy, industrial, and transport sectors. Bond financing is being influenced by new financial regulations (e.g. Basel III) which are prompting more capital-market funding of project finance transactions and by changing asset allocation strategies by institutional investors such as pension funds, mutual funds, and insurance firms who need long-term fixed-income investments to match their liabilities.
Outstanding bond totals in 2012 were $174bn and increased to $346bn by the end of 2013.[5]Of this outstanding 2013 bond total, $163 billion were deemed as investment grade bonds (risk, currency, and issue size compatible with institutional investors). The top tiers are dominated by transport ($263bn), energy ($41bn), and finance ($32bn).
In the U.S. the most established government bond programs directed at green investment stem from the American Recovery and Reinvestment Act (ARRA). These include the Qualified Energy Conservation Bonds (QECBs), which typically fund energy efficiency projects in government owned/operated buildings and the Clean Renewable Energy Bonds (CREBs), which fund clean energy projects. There was negligible CREB issuance in 2013, but around $230m worth of QECBs were issued.[6]
Climate bonds typically mature in the 5-10 year range, which is appropriate to climate mitigation project timelines. The fact that the market is seeing multiple issues and reissues in this sector indicates that both the issuers and investors are generally satisfied with these bonds as a credible and growing investment class.
According to IFSL Research, climate bonds could be issued each year up to a level of $0.5 trillion for the next 20 years and still not exhaust the capacity of the global market.
30% of the issued bonds yield less than 1% while 40% of them are in the 1-3% range. Around $35bn of outstanding climate bonds deliver 3% or higher. A 2011 report by investment consultant firm, Mercer, concluded that institutional allocation of investment in “climate sensitive assets (infrastructure, agriculture, timberland, and real estate) could help de-risk portfolios from the impacts of climate change compared to a business-as-usual scenario.”[8]
Climate Bond Benefits
Institutional investors are often challenged to support climate friendly financial instruments since many of them come with additional parameters that include alternative coupon payments, liquidity constraints, and variable maturities. These parameters are hard to integrate into existing portfolio frameworks. Climate bonds however, can be structured exactly the same as traditional Treasury-style bonds (marketable, fixed-interest U.S. government debt security with a maturity of more than 10 years) and are thus easily included into institutional investment portfolios.[10]
Since austerity measures in many industrialized countries have severely limited the scope with which governments can use tax revenues to invest in low-carbon projects, climate bonds that attract institutional investments to support a low carbon economy are particularly advantageous. Energy and infrastructure projects often require secure long-term revenue streams to enable the establishment of up-front finance. This has resulted in increased cost of capital for these types of climate friendly projects, and climate bonds could become the key to unlocking the vast potential of the international bond market to bridge the financing gap.[11]
Bond Successes
The European Investment Bank (EIB) issued the first climate bond in 2007. EIB’s program of Climate Awareness Bonds totaled more than a billion euros and was used to fund renewable energy projects. Instead of offering a fixed return or coupon, the bond was held for five years before it was redeemed at face value plus an amount driven by the performance of the FTSE4Good Environmental Leaders Europe 40 index (a 5% minimum return was guaranteed).[12]
2013 saw a “breakthrough for investor awareness of labeled bonds,” according to the Bonds and Climate Change report commissioned by HBC. The International Finance Corporation (IFC) and Export-Import Bank of Korea (Kexim) issued a $1 billion bond and $500 million bond respectively. Both were oversubscribed in just a few hours with 50%-70% of the buyers originating in the US and Europe.
In early November of last year, Ford and Microsoft made their support for climate smart investments clear. They invested in a $1 billion bond for climate projects issued by IFC. The bond transaction was reported to be heavily oversubscribed and had investors from firms such as BlackRock, Deutche Bank, Ford, and Microsoft.[13] The rapid pace of subscription is a common element for climate bond issuances. Earlier this year, the new Canadian Export Development Bank received $500m in bond orders on a$300m bond in 15 minutes.
The New York State Energy Research and Development Authority (NYSERDA) recently took advantage of a bond issuance to finance $24.3 million in loans that support energy efficiency improvements.[14]
Climate Bonds has posted a new item, ‘EIB issues first Sterling Climate Awareness Bond, upsized to GBP500m ($832m). Puts EIB at the top of issuer list for the year – nearly $3bn out in past 3 mths. Go Luxembourg!’
During March of this year, the European Investment Bank (EIB) launched its first Sterling Climate Awareness Bond, a GBP500 million, 6-year bond. EIB was initially targeting GBP350 million, but the issuance was upsized due to high demand primarily from UK SRI investors and major bank treasuries, some of which have dedicated SRI portfolios. The coupon was 2.25%. Investor profiles for this climate awareness bond were:
- Banks = 69%
- Fund managers/ insurance / pension = 12%
- Central banks = 11%
- Building Societies/ Retail/ Corp = 8%[15]
Bond Future
Market observers predict increased uptake in the climate bond arena. The heightened focus and implementation of ESG (environmental, social, and governance) screens of the Principles of Responsible Investment (PRI) to fixed income portfolios will mobilize over 1,000 PRI signatories who represent $32 trillion in assets under management. Pursuing environmental investments enables institutional investors a way to adhere to their mission statements and reduce risk exposure to the potential impacts of rising emissions levels. The California State Teachers’ Retirement System pension fund has a charter to integrate climate risk into their asset allocation and investment strategy. Denmark’s’ ATP pension fund has targeted $1biilion for the investment into climate change areas.[16]This demarcation of climate friendly investment is a growing trend and suits the emerging climate bond instrument.
The retail and consumer segments also find appeal in climate bonds since these investments support their environmental goals, local communities being impacted by a changing climate, and the diversification of their portfolios.
A secondary influence on this market is the guidelines regularly issued by the Global Investor Coalition on Climate Change to asset managers commanding $22 trillion in assets. These institutional investors are attempting to proactively position themselves favorably ahead of the 2015 climate agreement to be held in Paris.
The growing climate bond market is now able to present governments with a range of policy options to stimulate private investment into low-carbon projects. Governments could support the market further through preferential tax treatment, or through the provision of partial guarantees.
There may however be a time constraint on the popularity of climate bonds. In this prevailing low interest rate environment, climate bonds are appealing with their higher return rates compared to government benchmark bonds. These low interests rates will trend higher over time and the higher yielding government instruments may evenutally offer competition to climate bonds.
While still a nascent market, the climate bond universe offers considerable promise. Attracting private sector investment to help bridge the climate finance gap, and to sign up for debt instruments that finance environmental capital projects is a viable solution. The current small scale of the bond market offers tremendous scope for growth. While increasing environmental awareness will buoy demand, only structure and return will govern the successful outcome of these investment vehicles.
[1]IPCC Fifth Assessment Report (AR5), http://www.ipcc.ch/report/ar5/index.shtml
[2]Unlocking Private Climate Investment, http://www.wri.org/blog/unlocking-private-climate-investment-two-lessons-opic-and-ex-im-bank
[3]Clean Energy Finance Through the Bond Market, http://www.brookings.edu/research/reports/2014/04/16-clean-energy-through-bond-market
[4] Climate Bonds – the investment case http://bit.ly/1m1jctP
[5] Bonds and Climate Change State of the Market 2013 http://www.climatebonds.net/files/Bonds_Climate_Change_2013_A3.pdf
[6]The green bond market takes off in 2013, Bloomberg New Energy Finance
[7]http://www.climatebonds.net/files/Bonds_Climate_Change_2013_A3.pdf
[8] Climate Change Scenarios: Implications for strategic asset allocation http://bit.ly/1i9PrmB
[9] http://www.climatebonds.net/files/Bonds_Climate_Change_2013_A3.pdf
[10]Green Bonds: Victory Bonds for the Environment, http://www.td.com/document/PDF/economics/special/GreenBonds_Canada.pdf
[11]Climate bonds – the investment case, http://www.climatebonds.net/wp-content/uploads/2012/05/Will-O-Climate-Bonds-Chap16-1.pdf
[12]Green Bonds: Fixed Returns To Fix The Planet, http://www.investopedia.com/articles/bonds/07/green-bonds.asp
[13]Ford and Microsoft invest in $1 billion bond for climate projects, http://www.greenbiz.com/blog/2013/11/08/ford-microsoft-invest-green-bond
[14]Clean Energy Finance Through the Bond Market, http://www.brookings.edu/research/reports/2014/04/16-clean-energy-through-bond-market
[15]Climate Bonds Initiative alert, http://www.climatebonds.net/2014/03/eib-issues-first-sterling-climate-awareness-bond-upsized-to-gbp500m-832m-puts-eib-at-the-top-of-issuer-list-for-the-year-nearly-3bn-out-in-past-3-mths-go-luxembourg/
[16]Green Bonds: Victory Bonds for the Environment, http://www.td.com/document/PDF/economics/special/GreenBonds_Canada.pdf