What is sustainable finance?
If that sounds like an easy question to answer, consider the hypothetical case of a lender backing a scheme to retrain adults as computer programmers, or accountants in a city like Katowice, the capital of the Polish region of Silesia
Superficially, that may not appear to qualify as sustainable finance. But the wider metropolitan region of Katowice, which will be hosting the COP24 summit in December, accounts for more than half of the 82,000 jobs that rely on coal production in Poland.
Like scores of other cities across the world, if Katowice is to build a just and sustainable economy, it will need to create employment opportunities for thousands of workers who for generations have depended on an industry that is causing extensive environmental harm. Creating alternative jobs for the coal workers of Katowice will therefore be every bit as important for long-term sustainable growth as financing a wind farm or installing a handful of solar panels.
The need to balance environmental and economic sustainability is one of the definitional challenges that faces lenders committed to supporting the wider Sustainable Development Goals (SDGs) outlined by the UN in September 2015. The agreement on this framework means that rather than focusing narrowly on climate change and the environment, lenders are being called upon to extend their financing to comply with 169 targets enshrined within the 17 SDGs.
Some of those targets may appear to be in direct conflict with others. Finance for a wind farm or solar power installation, for instance, is sustainable — but not if it is harmful to biodiversity without compensating for the impacts. Loans supporting rail and inland water transportation may traditionally have been regarded as more sustainable than those supporting car production. That is no longer necessarily true if the cars in question are super-efficient electric-powered vehicles.
Strengthened Climate Finance Definitions
It is against this backdrop that the world’s leading multilateral development banks (MDBs) convened last month in Washington DC to begin working towards the establishment of a strengthened set of definitions on climate finance, which is generally the first category included under Sustainable Finance, although not the only one. This work is quite challenging, explains Nancy Saich, Chief Climate Change Expert at the EIB, who represented the bank at the week-long Washington discussions.
These definitions, she says, are unlikely to be radically different from those that the MDBs developed and have used for their reporting since 2012, which are recognised as the gold standard. But it is essential that they are updated in order to take account of technological changes in high-emissions sectors and other options for tackling climate change not previously captured. “Our ambition has to be stepped up, whilst still providing clarity and comparability, which are prerequisites if sufficient flows of investment are to be driven towards underpinning long-term sustainable growth.”
There are at least two compelling reasons for this urgency. The first is that, according to the European Commission, if the EU is to achieve the 2030 targets agreed in Paris, including a 40% cut in greenhouse gas emissions, it will need around €180bn of additional investments a year.
If the financing requirement is extended to take account of the broader global SDGs, it would rise to an eye-watering $6tr of new investment each year, according to the United Nations.
The daunting volume of financing necessary tells only part of the story. The equally unnerving part of the narrative is that the planet is fast running out of time if it is to prevent catastrophic and irreversible environmental damage. “If we pass certain tipping points on climate change, the consequences for the world our children and grandchildren will live in will be disastrous,” says Saich. “So the urgency is overwhelming.”
The magnitude of funding required, coupled with the speed with which it needs to be mobilised, means that no single institution can hope to address even part of the challenge alone, no matter how well-resourced it may be.
“Multilateral financial institutions like the EIB have a vital role to play to help channel private capital towards the energy transition and sustainability objectives that are needed to reach the Paris Agreement and the Sustainable Development Goals. But no single entity can achieve enough in isolation,” says Werner Hoyer, President of the EIB.
“The world is just too interconnected and complex, and the amounts of money needed to deal with the issues are so vast that they can be addressed only if we work in partnership together. Partnerships and co-operation are also becoming increasingly critical in the green capital market, where the EIB has acted as a pioneer ever since it launched the world’s first green bond in July 2007. Since then, the bank has maintained its leadership position, issuing more than €23bn of climate awareness bonds (CABs).”
But aside from the liquidity it has injected into the green capital market via its direct issuance, the EIB has also been at the forefront in encouraging continuous dialogue between issuers, intermediaries and investors in the green bond market.
A Common Standard
Much of this dialogue has been aimed at establishing common standards and an agreed taxonomy understood and observed by all market participants.
As with the broader sustainable finance market, it is essential that common definitions are observed in the green capital market to give investors the confidence they need to commit large allocations to green bonds in the primary and secondary markets.
The range of definitions circulating is illustrated in the latest Climate Bonds Initiative (CBI) report on the state of the market, which notes that the total volume of outstanding climate-aligned bonds reached $1.45tr by mid-September 2018. Of this total, however, less than a third ($389bn) is accounted for by more narrowly defined green bonds.
This is not to belittle the continued impressive growth of the green bond market, where issuance volumes this year look set to chalk up a new record in excess of $180bn. Appropriately, given its role as a pioneer in the market, it was the EIB which took green bond issuance volumes for 2018 above the magic $100bn mark when it launched its maiden Sustainability Awareness Bonds (SABs) in early September.
Sustainability Awareness Bonds
Eila Kreivi, Head of Capital Markets at the EIB, describes the new Sustainability Bonds as siblings to the CABs. In other words, the SABs are intended to complement rather than replace the bank’s existing funding programme by bringing greater specificity to the use of proceeds in the broader green and social bond market.
Kreivi adds that whereas the CABs are allocated exclusively to climate change mitigation, SABs are intended to address distinct themes specified in the SDGs, with water identified as the first sector to be targeted by the new bonds. “The framework for the SABs is identical to the CABs, but the use of proceeds is wider, because they mix green and social projects,” says Kreivi.
The SAB programme will in time be extended to other sectors, such as health and education, once detailed reporting frameworks are in place, building on the global success of green bonds by ensuring that socially responsible investors are offered market-leading standards of reporting.
“The key words for us are transparency and accountability,” Kreivi says. “We don’t believe you can build a sustainable financial system if you simply expect investors to take your word for how the proceeds of green or social bonds are used. Our philosophy is to be entirely transparent and then let investors judge for themselves whether it matches their requirements in terms of sustainability.”
Investors responded warmly to the €500m seven year transaction. The issue was exhaustively roadshowed and priced in line with the EIB’s existing CAB curve, generating demand well in excess of €1bn from more than 50 investors.
Thomas van Gilst, acting head of the water division at the EIB’s Project Directorate, says that the water sector was an obvious one for the first SAB issue. “It was a pragmatic choice, given that water is a relatively simple sector which is very clearly aligned with the sustainability goals,” he says.
Because the water sector is also relatively large, he says it is ideally suited to a €500m benchmark. The EIB lends about €3bn annually to the water sector, according to van Gilst, of which about 20% (roughly equivalent to the proceeds of the first SAB) is allocated to high impact water projects.
An example of this would be the extension of a water network to the peri-urban communities of Malawi’s rapidly growing main cities of Lilongwe and Blantyre which previously had no access to clean water.
It is a mistake, however, to assume that funding raised through the first SAB is earmarked exclusively for water projects in developing countries outside Europe. As van Gilst says, there are still plenty of areas in Europe where leakage rates are very high due to ageing networks, including pipes that can be well over half a century old and in urgent need of replacement. Projects addressing deficiencies of this kind, he says, are still very much in line with the SDGs.
The most recent example of the role the EIB has played in helping to foster closer partnerships and comparability in the green capital market is its support for the Global Green Bond Partnership (GGBP), which was launched at the Global Climate Action Summit (GCAS) at San Francisco in September. There, the members of the GGBP partnership reaffirmed their commitment to work together to scale green bond issuance primarily by sub-national entities and corporates through “targeted technical assistance, capacity building, de-risking, investing, and underwriting support.”
The GGBP is also committed to supporting the development of innovative funds and other financial vehicles to mobilize investor capital. But the EIB recognizes that there is still much to be done if the potential of global institutional resources to support sustainable investment is to be harnessed more effectively.
Risk-sharing Guarantee Initiatives
This, says Maria Shaw-Barragan, head of the EIB’s Global Partners Department, is why the EIB is looking to develop risk-sharing guarantee initiatives for cash-rich institutional investors such as pension funds.
Mechanisms of this kind will be a prerequisite for unlocking institutional money that is tied up in unproductive, low-yielding government bonds or money market instruments and redirecting it towards productive long-term support for sustainable infrastructure projects, for example.
“When you speak to institutional investors about this, they say they can generally live with regulatory and political risk,” says Shaw-Barragan. “What they are much less able to tolerate is the short-term liquidity risk arising from non-payment from public sector off-takers.”
Efficient risk-sharing mechanisms, she adds, would help to stimulate more public-private partnerships (PPPs) that have already proved their worth as a means of supporting sustainable infrastructure investment in several emerging economies.
“There have already been some very striking success stories in the application of PPP, especially in the energy sector, in countries such as South Africa, Ghana and Kenya, and we’re beginning to see it emerge in Cameroon,” says Shaw-Barragan. “But we need to see progress across many other regions if more institutional money is to flow into these projects.”