Institutional investors are starting to wake up to the potential of the debt market for projects that tackle climate change, writes MIKE SCOTT.
When you build a power plant fuelled by coal or gas, the actual plant is only half the story. You then have to factor in the price of the fuel that will run the facility for the next four decades. As we have seen in recent years, this price can be extremely volatile but it is not included in the initial cost of the project because it is operating expenditure rather than capital expenditure.
With renewable energy, the financing profile is completely different. All the cost is up front capital expenditure on new equipment – if you’re building an offshore wind farm, there’s not just the foundations, turbine towers, blades and nacelles to think of, but also the undersea cabling, onshore transformer stations and – because it is an industry that remains in its infancy – even the ships that will install the turbines. But once they are installed and commissioned, the costs of running wind farms are minimal. There is, of course, a certain amount of maintenance and repair, but the fuel itself – the wind in this case – is free. The same applies to solar power.
With many renewable technologies still relatively new and unproven, investors have been reluctant to commit funds despite the pressing need. According to the International Energy Agency, “in order to limit global warming to 2 degrees Celsius and avoid the worst effects of climate change, investments in low-carbon energy technologies will need to at least double, reaching $500 billion annually by 2020, and then double again to $1 trillion by 2030”.
INVESTMENT IN CLEAN ENERGY FELL IN 2013
Yet according to Bloomberg New Energy Finance, in 2013 investment in clean energy fell 11 per cent to $254 billion, far short of what the science tells us is needed. While part of the fall was due to the massive drop in the price of solar power equipment which meant that more power was being generated for less money, there is still a massive clean energy investment gap, says Mindy Lubbers, CEO of Ceres, the US-based sustainable investment organisation.
Today, the leading providers of capital to clean energy are primarily commercial banks, national and multilateral development banks and electric utilities. But these sources alone are insufficient to double annual global clean energy investment by 2020 and quadruple it by 2030, according to a recent Ceres report, Investing in the Clean Trillion: Closing the Clean Energy Investment Gap.
Clean energy projects need new and additional sources of capital, while banks and utilities need to be able to sell out of projects once they have been developed so they can invest in new capacity. The largest potential providers of funding are institutional investors such as pension funds, insurance companies, sovereign wealth funds, endowments, foundations and investment managers. Globally, these institutional investors collectively manage about $76 trillion in assets.
The key to harnessing these investors and their capital to the cause of decarbonising the economy is the market for green bonds, or climate bonds as they are also known. These debt instruments are ideal for financing renewable energy projects because they can provide upfront the capital that the project developers need while also giving investors the long-term returns that they are looking for and fulfilling their desire to improve their green credentials.
“The issuance of green bonds is being driven both by the capital needs of issuers as well as the commitment of institutional investors to climate finance and responsible investment,” HSBC analysts wrote in a recent research note.
FROM THE NILE DELTA TO THE GREAT BARRIER REEF
The Climate Bonds Initiative defines such bonds as debt instruments that raise finance for climate change solutions. “These might be greenhouse gas emission reduction projects ranging from clean energy to energy efficiency, or climate change adaptation projects ranging from building Nile delta flood defences to helping the Great Barrier Reef adapt to warming waters,” the organisation says.
The market for green bonds has been slow to take off, for a number of reasons. Partly, there have not been enough bonds available. Clean energy is still a relatively young sector that is still scaling up, while bond investors need large projects to invest in. This relative youth also meant that green bonds were seen as a risk, simply because there was no track record for investors to benchmark issuance against.
But 2014 could be green bonds’ year to break through to the mainstream. HSBC has said that the market should more than double this year to $25 billion, having tripled in size to about $11 billion in 2013. “The era of green bonds has arrived. We see increasing use of bond markets to raise capital for the lowcarbon economy,” the bank said in a research note earlier this year.
The market looks set to grow as investors get used to the concept and are reassured by the performance of previous issues and the fact that green bonds have not been priced at a premium to other bonds. In addition, as the market grows, the necessary market infrastructure is being put in place to reassure investors and encourage them to commit their cash.
GREEN BOND PRINCIPLES
One important development in this regard is the creation of the Green Bond Principles, backed by some of the world’s biggest banks, including Bank of America Merrill Lynch, Goldman Sachs, BNP Paribas, Deutsche Bank, Citigroup and JPMorgan Chase. Their aim is to encourage transparency, disclosure and integrity in the development of the market, according to Ceres.
“The development of a robust and liquid market for green bonds is an important progression for debt markets,” adds Suzanne Buchta, global co-head of green debt capital markets at Bank of America Merrill Lynch. “In co-authoring these principles we attempt to help standardise the product and we hope to catalyse investment into environmentally sustainable projects, something to which our firm is very committed.”
The Principles are an important development, says Sean Kidney, chief executive of the Climate Bonds Initiative, not least because in essence they define what a green bond is. Transparency is central to the green bonds market because issuers need to disclose the nature of the assets being funded so investors know the bond qualifies as green. Often, the exact nature of the assets or activity being funded by a bond can be somewhat opaque, as evidenced by the financial crisis, which was triggered by sub-prime mortgage bonds.
“The best way to ensure that finance is truly addressing environmental challenges is for each bond to meet clear, transparent (publicly available) environmental impact criteria in order to be called ‘green’ or ‘climate’,” Kidney says. “Such criteria (and whether the issuer meets them) should be determined by independent experts and academics rather than by issuers or investors.” The Climate Bonds Initiative has been developing one such scheme, the Climate Bonds Standard.
IT IS ABOUT THE ASSET
One of the key features is “that it’s about the asset, not the company,” Kidney stresses. “The bond is linked to the asset and we don’t really care if the company has strong ESG (environmental, social and governance) criteria. We just want a wind farm to be built. If an oil company issues a bond to build a wind farm, the company itself may not meet a fund manager’s ESG criteria for investment, but the bond should.”
To date, the overwhelming majority of green bonds have been issued by national or multinational development institutions such as the World Bank or its offshoot the International Finance Corporation, whose involvement, sturdy balance sheets and AAA ratings gave investors confidence that the bonds would provide a return. The very first bond specifically labelled as green was issued in 2007 by the European Investment Bank (EIB) – a “Climate Awareness Bond whose proceeds were specifically linked to renewable energy and energy efficiency,” says the Climate Bonds Initiative’s Bridget Boule.
While these multilateral institutions continue to dominate the market, 2013 saw a surge in issuance with the first instruments from private companies coming to market. EdF, the French utility, issued a €1.4 billion ($1.9 billion) bond linked to its renewable energy assets while Bank of America Merrill Lynch debuted a $500 million issue that will fund renewable energy and energy efficiency projects and Swedish property group Vasakronan raised SEK 1.3 billion (€147 million/$202 million) to finance new green buildings and energy efficiency refits.
“All of these issuers are expecting to issue more green bonds,” Kidney says. “EdF was extremely happy with the reception for its issue, which was heavily oversubscribed. In fact, we have seen significant and consistent oversubscription. The corporate green bond market will grow in response to that demand.”
GREEN MUNI BONDS PROVE POPULAR
And in addition to an increase in the corporate market, the market for green municipal bonds is also expected to grow following offerings last year from the city of Gothenburg, which offered bonds based on investments in green property and energy efficiency, and three French provinces that raised money to fund green social housing, renewable energy and energy efficiency projects. Indeed some investors appear to prefer these “green muni” bonds – as the state of Massachusetts found last year when it issued a $100 million green bond alongside regular bonds with exactly the same yield. The state hoped to raise $1 billion from the regular bonds, but found that it could only sell $575 million, while the green bond was 30 per cent oversubscribed. It also found that the green bond attracted a whole new set of institutions, helping it to diversify its investor base.
While it is western markets, along with Japan and Korea, that are the centre of demand, the flood of interest is not confined to the USA and Europe. At the recent C40 Cities Mayors’ Summit in South Africa, the City of Johannesburg announced it is in talks about issuing a green bond to fund new green buildings and retrofits of existing buildings.
Another driver for the consolidation of the market will be the “unlabelled” market – bonds that are not specifically tagged as green but which qualify as such. There are a number of bonds in the market for projects ranging from solar farms to railways that have a beneficial impact on carbon emissions but that have not been sold on that basis. Kidney estimates that the unlabelled market is much bigger than the labelled market at around $72 billion. Reclassifying such debt under the green bond label will further demystify the market and show investors that it is not as exotic as they think.
And he is bullish on the future for the sector. “We’ve seen about $2 billion of issuance this year already. There’s no doubt that the market will at least double this year. The only question is exactly how much it will grow.”
However, the standards are important because you quite quickly encounter grey areas. “We wouldn’t define as green a project to improve the energy efficiency of tar sands, for example,” he points out. “It’s good to make tar sands exploitation more efficient but to meet our climate targets we need to stop using tar sands entirely because they are so polluting.
For the same reason, railway lines to coal mines would also be excluded, while only certain types of investment in biofuels would qualify as some lead to deforestation or compete with food crops for land and water while others such as sugar-based ethanol or second-generation biofuels offer genuine environmental benefits, he explains.
Nonetheless, the green bonds market looks like it is here to stay after UN Secretary General Ban Ki Moon called on investors to “increase finance flows into low-carbon energy and climate-resilient infrastructure, including through setting portfolio targets and increasing the deployment of climate bonds” at the World Economic Forum in Davos.
The bigger the market, the cheaper it will become to fund green projects, says Michael Liebreich, chairman of Bloomberg New Energy Finance. “It is clear that mainstream debt providers are discovering the virtues of clean energy, and that is going to make a difference. A continuing surge in green bond issuance in 2014 will add further downward pressure on lending costs.