Innovation is needed in the green bond market
The market for socially responsible investments is flourishing, but only at the top. Corporate and emerging market borrowing, which the world sorely needs, is still conspicuously scarce. Financial innovation is required to broaden participation.
The green bond market has raised $42bn so far this year, fully half of last year’s total. The Climate Bonds Initiative (CBI) predicts there will be $150bn by the end of 2017.
It’s an impressive figure for a market that, in 2013, raised only $11bn but, again according to the CBI, the market must reach $1tn by 2020 if it is to play a part in hitting the targets set at COP21. That increase must come from borrowers further down the credit spectrum than the typical green bond issuer.
The market remains largely the preserve of SSA borrowers. Much of it is simply a relabelling of funding that could have been raised by conventional means, accomplishing projects that lie within the borrowers’ mandates.
Even in triple-A rated funding, there is scope for creativity to bring new capital into the sector. The International Finance Corporation partnered with BHP Billiton to sell a Forests bond in 2016. IFC spent the proceeds on its normal activities but investors had the option to receive a coupon in the form of carbon credits from a Reducing Emissions from Deforestation and Degradation project. Billiton guaranteed the purchase of a certain volume of credits.
The absence of lower rated borrowers in green bonds does not stem from a lack of buyers. Investors say growth in demand for green assets offering more generous yield is outstripping supply.
The public sector is beginning to embrace what is its most useful role as a facilitator, allowing lower quality borrowers to access the market by providing credit support and anchor investments for emerging market borrower deals.
But even with this assistance, other obstacles remain.
The barrier for entry is undeniably high. To issue a green bond benchmark, borrowers must have about $500m in eligible assets to fund — a steep hurdle for issuers smaller than sub-sovereigns or blue chip corporates. Private placements offer the opportunity to raise more manageable amounts of cash but borrowers swiftly run into the economic realities of providing expensive impact reports on sub-benchmark sums.
Bonds, though a vital part of capital markets architecture, are an expensive way of raising large amounts of money. What the market needs is a plethora of ways of raising small amounts. These could be aggregated into larger assets, or invested in directly by green bond funds.
One small company with socially responsible aims recently raised $250,000 with a revenue backed financing scheme.
Some might say that smaller prospective borrowers should avoid the debt markets and simply rely on government grants for their socially responsible financing. However, the delays this entails, and the restrictions and horizons governments tend to impose on grant recipients, are often too restrictive to allow them to engage in long-term projects such as green infrastructure investment.
And if government money is to be used, it should be employed more efficiently than simply ploughing capital into projects and taking the risk of failure. Governments should consider wider use of the pay-for-performance model used most commonly to incentivise issuers.
So-called social impact bonds allow investors to assume the risk associated with project outcomes, providing the up-front capital, borrowed against a government pledge. If the project meets the government’s standards of success, then it pays investors back with a return. If it fails, the investors lose their money and the government gets to fund a more successful project elsewhere.
The proliferation of funds dedicated to socially responsible investing indicates an encouraging change in the mindset of financial markets.
The expansion of the types of projects that fall under its umbrella is also welcome — why, after all, should social aims be excluded from the rising tide of money with a conscience? But without creativity and open minds, neither of these trends will bring small, high yield, emerging market borrowers into the market. And it is their participation that will make the difference.