A year after the international agreement in Paris to curb global emissions, the task at hand for the 195 signatories of the COP 21 agreement has not gotten any smaller.
The costs to stem climate change are steep — some put the bill at $12.1tr over the next 25 years, and the United Nations estimates $150bn a year of investment is needed by 2030 to keep the globe from warming more than 2C. After that, the annual requirement could be more than double that, and goes up sharply if that threshold is breached.
The good news is that the green bond market is growing, perhaps not as quickly as some would like, but consistently. Some $41bn in sustainable investment bonds were issued in 2015, and another $45bn so far in 2016. New markets have sprung up in Mexico, Brazil, India, China and even Estonia, among others. The spectrum of credits with access to the market have expanded from triple-A supranationals to high yield — though the bankruptcy of one-time green bond issuer Abengoa in 2016 marked a set back for the growth of sustainable high yield bonds.
Investors have taken notice. In 2014, investors representing $24tr in assets under management (AUM) signed a statement announcing their willingness to invest in climate change solutions. In two years, initiatives like the Institutional Investors Group on Climate Change and the Principles for Responsible Investment (PRI) have grown that commitment to include investors with more than $60tr AUM.
But, with the Climate Bond Initiative (CBI) estimating that $1tr in green bonds a year could be issued by 2020, true scale in the green bond market has yet to achieved.
The first task for market participants that want to scale up the market is definitions. Strides have been made in identifying and defining asset classes and procedures that are appropriate for green financing, but more needs to be done, says Hans Biemans, head of sustainability, markets at Rabobank in Utrecht.
“Scaling up the market requires the Green Bond Principles [GBP] and participants to deliver more or less clear definitions of the kinds of projects that can be included in a green bond,” he says.
Part of the challenge is that science and technology required for a client-friendly infrastructure for a globalised world is still developing. The underlying measurements that gauge a green investment’s climate-friendliness are often disputable — as in the case with measuring carbon emissions avoidance.
As part of the effort to tackle that challenge, the International Capital Market Association (ICMA) updated its GBPs in June, adding to and clarifying its list of green-eligible project categories, among other things. Already, stakeholders are discussing next steps in that process, looking to identify further areas of eligibility and to harmonise impact reporting beyond energy efficiency and renewable energy.
“I think we will see bonds that fund the improvement of production facilities and buildings, and those that fund the development and introduction costs of products that are made from bio-based, recyclable, organic and less environmentally harmful materials and processes,” says Biemans, who is also an ICMA executive committee member on the GBPs.
Harmonising standards for process, impact reporting, definitions of eligible assets are crucial to scaling up the market, as they would reduce the significant cost of resources poured by issuers into preparing their own frameworks for green financing and by investors into evaluating the impact of their investments. Like having standardised accounting practices, standardising the evaluation of a green bond’s ‘greenness’ lowers overall transaction costs and ensures the integrity of the market.
But therein lies another problem. Some stakeholders in the sustainability sector would like to see only the most high quality sustainable assets pass eligibility criteria.
But from a debt capital markets perspective, says Crispijn Kooijmans, head of public sector origination, DCM at Rabobank in Utrecht, “you don’t want guidelines to be too strict as you want to be able to offer a suitable solution for different issuers and situations.”
Kooijmans agrees there must nonetheless be standards, however. “We also need this market to retain credibility, so there must be guidelines and at least some clarity. And investors want those, too.”
Biemans says that ICMA’s GBP committee has considered looking to standards of sustainability and green transitioning that already exist in certain sectors.
“There are a lot of standards followed by different businesses out there,” he says. “Every sector has its own standards, and they are usually on the level of the assets themselves, like LEEDs [Leadership in Energy and Environmental Design] and BREEAM [Building Research Establishment Environmental Assessment Method] in real estate. If you want to scale up the market, starting from these standards is a good place to begin. You have to accommodate normal, existing processes.”
Pooling resources
Defining eligible assets and reporting standards should not only reduce transaction costs but also increase the pool of assets that can be financed by green bonds. In part, achieving scale in the market requires increasing the number of agreed-upon eligible asset types.
But many potential issuers of green bonds don’t have the ability to aggregate enough already eligible assets to back a green bond. Corporates, for example, may always comprise a small portion of green issuance.
“Large corporates have a very different strategy for sustainability from most green bond issuers. They don’t own solar plants or wind farms, they own buildings they operate from,” says Rabobank’s Biemans. Corporations like Apple, Starbucks and Sainsbury’s have indeed issued green bonds, but often for one-off projects or improvements that don’t necessarily need further investment down the line.
Financial institutions, which do have the balance sheet, are where much future growth in the market is likely to come from, then. But much of the sustainable investment they engage in is in the form of loans, not bonds. And once again, aggregating those loans to a capacity that makes bond issuance efficient is a challenge.
That is due, in no small part, to the challenges imposed by infrastructure investment, which comprises a significant portion of the finance needed to stem climate change.
Sustainable infrastructure investments, of which the CBI estimates $6.2tr by 2030 is needed, are often smaller than traditional infrastructure projects. That makes it difficult for banks, which have the balance sheet other potential green bond issuers like corporates do not, to aggregate enough to back securitizations or covered bonds. But the small scale of investments, such as residential energy efficiency, are also a benefit, since loan pool granularity is among the top attractive qualities of securitizations and covered bonds to investors.
Nonetheless, green project investment can often be riskier than comparable traditional investments, as the relative newness of the technology and its rapid evolution introduces unknown risks like potential obsolescence. The relatively low risk-return on offer for investors in some cases, then, is a hurdle for some potential issuers.
There have been some successes, though. Dutch mortgage originator Obvion this summer became the first ever issuer of a green residential mortgage-backed security.
Rachelle Rijk, head of funding and balance sheet management at Obvion’s treasury, says that among the big challenges in green securitization is finding out what investors will accept in a pool, as it is a new market.
“Different green investors have different ideas about the definition of ‘dark green’, or even what type of assets are best for a green pool,” Rijk says.
“What we’re working on now is what level of improvement investors want to see; where the sensitivity lies. So not just what percentage of the pool is on improvement loans, but also how much the improvement has to be. Can it be from a ‘C’ to a ‘B’, or does it need to be ‘C’ to ‘A’, for example.”
A portion of the pool underlying the Green Storm RMBS transaction, which was increased in size following high demand, was on such improvement loans, she adds. “So that’s a positive signal that these types of loans are eligible for green bond-labeled RMBS funding.”
From Rijk’s experience, it’s clear that part of the solution to scaling up green securitizaton and covered bond issuance comes back to standardization, this time of the loans underlying the bonds. Loan comparability has always been a fundamental necessity for large scale investment in both securitization and covered bonds.
Once that comparability has been established, CBI says the public sector should step in to ensure dealflow is consistent. Two ways of doing that are by providing credit enhancement or warehousing eligible loans, as the state of Pennsylvania in the US does with its Warehouse for Energy Efficient Loans programme.
Spring cleaning
Banks already have unknown billions of sustainable assets on their balance sheets that could be used to back securitizations, covered bonds or even senior unsecured pools. Green Pfandbriefe, private placements (PPs) and Schuldschein have all either been successfully executed or are in the works.
The problem, bankers say, is that many banks don’t have systems in place to identify those assets and segregate them out for green bond portfolios.
“I’d say that 70%-80% of the financing in the sustainability sector is done by bilateral loans, project loans, rather than the capital markets. So the banks are doing quite a bit on that side,” says Mike Koerkemeier, European head of high grade DCM for ING in Amsterdam.
Some have already embarked on initiatives to identify eligible assets, flag them, and educate employees on sustainable financing to encourage further supply. Some bankers have reported that the act of issuing a green bond itself has aided that process, as client-facing employees begin to approach their treasury departments with questions about green assets and plans to pitch green bond eligible projects to clients.
But many banks with existing sustainable assets need encouragement to come to market, especially in jurisdictions whose banks have generally higher risk profiles.
Sovereign duty
There are many ways for the public sector to get involved in scaling up the market, like providing tax incentives or reducing risk weights for holdings of eligible assets at financial institutions.
“You have to point to China as the leader and to India as a government that is also very active and has distinguished itself by promulgating national frameworks for issuance as well as taking policy actions,” says Jonathan Weinberger, head of capital markets engineering at Société Générale in London.
But there are reasons to be wary of too much public sector involvement since politicians are often too slow to act and are prone to being fickle on policy matters over time.
“A number of governments have used fiscal policy to support the market,” Weinberger says. “The problem is that occasionally a government will change its mind, as Brazil did in 2014 when they removed tax exemptions for wind turbine manufacturers.”
And, of course, the possibility of regulating the sector, which could aid in its harmonization, nonetheless could threaten to stifle the creativity required to develop the market properly.
One of the most potent ways for the pubic sector to get involved is to actually issue bonds themselves. Top-rated supranationals like development banks helped kick start the green bond market by issuing. And while multilateral development banks will likely continue to be big players in both green-infrastructure lending and green bond issuing, sovereigns themselves can play a big part too.
But no sovereigns have yet issued green bonds, at least not with a CBI green-bond label, despite last year’s COP 21 agreement setting legally binding requirements for states’ sustainability goals. France is said to be among those racing to be the first sovereign green bond issuer, and municipalities in the US and Europe have increasingly used the market. And with COP22 in Morocco coming up in November, the pressure will surely be on governments to begin financing their ambitious plans for the transition to sustainability.
But where sovereign issuers are perhaps most needed are in emerging market countries. Among EM sovereigns reportedly looking to tap the green bond markets is Nigeria — another strong signal that the green bond sector is gaining traction globally. But more emerging markets sovereigns are needed.
EM banks, which have generally lower credit ratings and often sporadic access to bond markets, do often have green assets on balance sheet. But having the confidence to put in the effort and resources, and to take the risk of issuing, can require some encouragement. That’s where their sovereigns can help.
Having top-rated sovereigns enter the market could help give confidence to potential market participants to enter. That’s not just because they could provide standards issuers and investors could compare the private sector to, but also because it would help to signal that the green bond market is here to stay.
