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Green bonds can help plug the climate finance gap

Public sector support is crucial to drive the growing market in green bonds, write Sean Kidney and Beate Sonerud

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Financial centres will need stronger green bond markets to scale up low carbon financing and move from the 'billions' to the 'trillions' (Image by jpellgen)

Climate change mitigation and adaptation present huge challenges for both policy makers and markets. Converting national and international policy into effective action requires enormous financial commitments from both public and private sector pools of capital. Global infrastructure provides an easy understanding of the numbers involved. 

The annual allocation required for infrastructure investment in a low-carbon scenario is US$6.2 trillion. Investment to make infrastructure resilient to the changing climate adds at least another US$150 billion to the yearly bill, consistent with a 2C warming outcome.

It is generally recognised that there is an investment shortfall with an annual infrastructure investment gap of more than US$1 trillion. 

Moreover, only 7-13% of current infrastructure projects are estimated to be low-carbon and designed to deal with the additional impacts of a changing climate. 

For physical assets with multi-decadal operational life - power, energy, water, data transport and communication networks - future climate impacts move from being a theoretical to an actual risk.  

New sources of capital with a longer-term investment horizon will need to be sourced to close this gap. Global asset owners and managers - including pension funds and insurance companies - have both the necessary capital and a professed interest in lifting their exposure to climate based investments. 

However, to entice investors to allocate their capital to climate-friendly assets, these must offer competitive financial risk-adjusted returns. Green bonds offer one way to leverage increased capital towards tangible investment by offering financially competitive investment opportunities where the environmental benefits are a bonus, not a sacrifice.

Bonds, especially to finance infrastructure, can offer long-term maturities. These are a good fit with institutional investors’ long-term liabilities, and allow asset-liability matching. They can also provide much-needed diversification and more attractive yields, particularly in markets with a limited supply of bond instruments and a high concentration of investments in government securities. At the same time, bond returns are relatively stable and predictable when compared with equities, an important feature for some institutional investors.

The green bond market has grown rapidly, with issuance tripling from US$11 billion in 2013 to US$36.6 billion in 2014. Around US$50 billion of issuance is expected in 2015. Labelled green bonds are ones whose proceeds are used for green projects, most usually climate change mitigation and adaptation, and are labelled accordingly. If an entity can issue a bond, it can issue a green bond, as the ‘green’ label depends upon the specific type of projects funded, not the environmental credentials of the issuer. So labelled green bonds can be issued by a wide range of entities, including larger, well-known corporations with high credit ratings that account for a sizable share of institutional investor portfolios. 

Labelled green bonds have been issued in emerging markets, including China, India Brazil and Mexico as well as in developed economies, and there is a strong appetite for them amongst investors. 

Whilst large global asset managers and owners as a group ‘stand ready’ to commit, the policy frameworks and market structures around green bonds are not yet robust enough to move the market from billions to the trillions. At The Climate Bonds Initiative, we estimate that US$1 trillion of green bond issuance is required by 2020 to build the climate-aligned infrastructure needed. 

From billions to trillions

Current barriers to growth include education of market players; lack of bankable green projects and robust green project pipelines; lack of standards for what is green; risk-averse investors with limited capacity to analyse green investments and lack of aggregation mechanisms for relatively small investments.

A central market-driven action to address the barriers to green bond growth is the development of green bond guidelines and standards. Green bond standards reduce transaction costs for both issuers and investors in ensuring the climate benefits of the green bonds are measurable, transparent, disclosed and in line with the latest climate science. 

Currently, the only standards available in the market are the Climate Bonds Standards. They cover both the green bond issuance process and what is green and are developed by scientists and technical experts and overseen by a board of investors with US$34 trillion of assets under management. 

Market-led actions are an important starting point, but given the urgency of the climate challenge, public sector support is crucial to can accelerate the market-driven actions to address these barriers and act where the market has yet to do so. 

China: a global green bond leader 

China is a leader in moving from interest to action on green bonds. In April 2015, the People’s Bank of China (PBOC), in association with the UNEP Inquiry into the Design of a Sustainable Financial System, published a range of policy proposals for kick-starting a Chinese green bond market, including tax incentives and preferential risk weightings. The PBOC is soon to publish official guidelines for green bonds.

The first renminbi-denominated green bond from a Chinese issuer came to market in October 2015, when Agricultural Bank of China issued in the London markets. The precedent is now set for others to follow.

Hints as to the levels of capital required are emerging. PBOC chief economist Ma Jun was quoted in the Shanghai Daily newspaper on November 4, saying China needed 2 trillion yuan (US$315 billion) of “green” investment annually for the next five years. Private funds in these areas will be encouraged, with new rules to nurture the market for green bonds and stocks.

In a recent report, called China Heads to a Low Carbon Future, the London-based Energy and Climate Intelligence Unit (ECIU) said China’s 13th Five Year Plan is expected to confirm the need for increasing environmental and climate based investment. The ECIU highlights the opportunities that will arise for institutional investors as China seeks a low carbon growth path that first slows, then stabilises emissions. 

With strong government support given to green bonds and the massive investment needs in China for green infrastructure over the coming years, the Climate Bonds Initiative expect China to be the largest green bond issuer globally by 2018.

Bonds are one of the financial tools needed to meet the climate finance challenge. We may yet find that East leads West in its drive for low carbon infrastructure investment and climate friendly development.

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