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Green bonds
- 1. Green Bonds: Definition, Developments and Drivers Jacqueline Tao Yujia, Gautam Jindal ESI In-house Seminar 15 April 2015
- 2. Why you should be interested in green bonds? 2 2014: US$36.6 billion Estimated Issuance: 2015: US$100 billion Green Climate Fund: $10billion Copenhagen Accord: US$30 billion for 2010 to 2012 US$100 billion a year by 2020 2018:US$300 billion 2020:US$1 trillion
- 3. Green Bonds • Green bonds are fixed income (debt) financial instruments that are applied exclusively towards projects with significant environmental benefits 3 T0: Bond issuer receives principal T1 to TMaturity: Bond issuer pays coupon on the bond at pre-determined intervals TMaturity: Bond issuer repays principal Standard bonds vs. green bonds •Bonus feature of “green” – positive environmental outcomes •Flat pricing of green bonds to conventional bonds •Pari passu applies
- 4. Labelled and Unlabeled green bonds 4 Labelling process acts a discovery tool for investors. Additional costs compensated by potential new investors and green reputation enhancement Total green bond universe: US$502.6 billion
- 6. Ensuring Financial Integrity Type of Green Bond Definition Green Use of Proceeds Bond A standard recourse to the issuer debt obligation for which the proceeds shall be ring-fenced to green projects. Green Use of Proceeds Revenue Bond A non-recourse to the issuer debt obligation in which the credit exposure in the bond is pledged cash flows of the revenue streams, fees, taxes, etc. and the Use of proceeds of the bond goes to related or unrelated green projects. Green Project Bond A project bond for a single or multiple Green projects for which the investor has direct exposure to the risk of the projects with or without potential recourse to the issuer. Green Securitized Bond A bond collateralized by one or more specific projects, including but not limited to covered bonds, Asset backed securities and other structures. The first source of repayment is generally the cash flows of the assets. 6
- 8. Development of Green Bonds 8
- 9. Stage 1: Financial Innovation driven by investor demand • Investor Demand driven by socio-economic factors ▫ Increasing socially responsible investors ▫ Climate change awareness ▫ Shifts in the financial markets • Financial innovation facilitated creation of new instrument • Supply met by credible issuers creating market for investment grade products 9
- 10. Stage 2: Building market depth and width • Favorable market conditions fuelled demand and broadened investor base ▫ Conventional investors disproportionately affected • Media and publicity prompted both demand and supply reactions • Diversification of bond issuing parties 10
- 11. Stage 3: MRV and Quality Assurance • Introduction of voluntary standards and protocols to instil regulation and discipline ▫ Green Bond Principles ▫ Green Bond Standards and Certification • Provision of MRV services to support market development emerges ▫ Increase in independent auditor organizations • Investor demand unhampered by lack of strong definition 11
- 12. Stage 4: Market Standardization and Scalability • Continued revision of MRV guidelines in response to various stakeholders ▫ Involvement of ICMA as advisory of GBP ▫ Building technical expertise at Green Bond Standards and Certification • Expansion of available financial services ▫ Creation of Green Indices ▫ Introduction of dedicated green bond funds 12
- 13. Drivers of Green Bonds 13
- 14. Asian experience • Initial stage: Financial Innovation stage • Potential demand signaled by strong demand for recent issuances • SSAs benchmark issuances are priming the market, with various corporate issuances testing the waters • Interest (limited?) from financial intermediaries • Policy directives to build green bonds market ▫ Indonesia ▫ China ▫ India 14
- 15. Current Challenges International Asia • Delicate balance between leniency and stringency • Environmental attribute (definitive or relative) characteristic • Lacklustre secondary market performance an area of concern • Sourcing for demand (international and domestic) • Ensure pipeline of high- quality supply/projects • Developing MRV expertise • Role of policymakers 15
- 16. Future Outlook • International outlook ▫ Continued growth ▫ Building market depth and width (homogenous issuances) ▫ Increasing bond issuances from emerging economies ▫ US$100 billion? • Regional outlook ▫ Policy-heavy move towards mobilizing green bonds ▫ Continued market leadership from SSAs ▫ Potential financial sector issuances 16
- 17. 17 Thank you! Energy Studies Institute 29 Heng Mui Keng Terrace Block A, #10-01 Singapore 119620 Jacqueline Tao Tel: (65) 6516 6692 Email: esity@nus.edu.sg
- 18. Roadmap of Green Bond Markets in Asia 18 ASEAN financial market development -ASEAN+3 Bond Market Initiative -Intra-ASEAN capital mobility
Editor's Notes
- Good afternoon. So as most of you must have known, Gautam and I are currently working on a project with ERIA on analyzing the challenges to utilizing green bonds as a financing instrument for renewable energy projects in Asia. So this afternoon, I would like to use this opportunity to provide an introductory overview on what are green bonds.
- Before I begin, I would like to address one fundamental question. Why should we care about green bonds? And I’ll answer that question with a graph. This graph shows the annual green bonds issuance from 2007 to 2014. The market for green bonds started off in 2007/2008 with a total issuance of less than USD2 million. In 2014, total annual issuance netted USD36.6 million. This growth is expected to continue, with 2015 issuance expected to hit USD100 billion, and in 2018, it is expected to reach USD 300 in 2018, and by 2010, it will reach USD 1 trillion. To give more perspective to the numbers: The initial pledge to the Green Climate Fund in 2014, which was largely seen as a success on the climate finance front, barely reached USD 10 billion. With the 2014 green bonds issuance alone, we would have fulfilled all of the fast-start finance requirements, and we would have reached out 2020 long term financing requirements by this year. What this shows is that the mobilizing of private sector finance would be faster, more efficient and at a larger scale if we are able to position climate change issues as green investment opportunities, particularly for mitigation issues. This will leave more public sector finances for adaptation activities, which are poorly suited for private sector involvement. Green bonds provides such investment opportunities, and the growth of this market has shown that there is a stream of investor capital for green assets.
- So what are green bonds? Whilst there is yet to be a concrete definition of green bonds, they can be broadly defined as fixed income debt instruments that are applied exclusively towards projects with significant environmental benefits. I’ll go into a bit about the financial structure of bond products. So basically, when you issue a bond, the bond issuer would have a financial liability to the holders of this security, The issuing entity would receive the proceeds of the bond issuance upfront, after which it is obliged to pay interest (commonly referred to as coupon) at a pre-determined rate at pre-determined intervals up to the bond’s maturity. At bond maturity, the bond issuer is required to repay the whole principal. This term structure is especially suitable for infrastructure investments, which require a large initial outlay of capital and low operation and maintenance costs, and a longer payback period. So what differentiates green bonds from conventional bonds is the environmental feature. However, the environmental attributed are not priced into the green bonds as the initial idea surrounding green bonds was to price it according to principles of flat pricing, whereby the bond price is the same as conventional bonds issued by the same issuer since the credit profile of the issuer is the same.
- Before we go on further, I would like to highlight a major difference between two distinct groups of green bonds. Firstly, labelled green bonds refers to bonds being marketed as green bonds, while the non-labelled green bonds universe refers to bonds that are used for environmentally friendly projects, but are not marketed as green bonds. The question now, is why bother labelling. To protect the integrity of green bonds and prevent greenwashing, the issuer, more often than not, would have to conduct extra due diligence, particularly in the form of environmental assessment, to support its green claims. Given the flat pricing policy of green bonds, the additional costs related to a green bonds issuance, notably in the form of environmental assurance, verification and communication, would have to be absorbed by the bond issuer. So the argument is that the labelling process acts as a discovery tool for investors, particularly the ESG mandated investors, who would have to align their portfolio to a particular socially responsible strategy. So a green bonds issuance not only comes along with green reputation enhancements, but also attracts new investors.
- A key point of green bonds is that the green credentials of a bond are based on the projects or assets linked to its issuance, not the green credentials of the organization issuing the bond. So we often see organizations, particularly corporations, who are not particularly environment related issuing green bonds. For example, the landmark issue in 2014 was a corporate green bond issued by EDF, a French utility corporation, to support its renewable energy ventures, although EDF is also involved in dirtier power generation such as coal and other fossil fuel based power generation. This characteristic, then induces two main areas of concerns with regards to finances raised by green bonds: firstly the transparency on the use of funds and the environmental integrity of the project.
- So how do we address the financial integrity of green bonds? Although the concept of raising funds to support green projects within an organization seems like a great idea. The operational difficulties in ascertaining the flow of funds within an organization often leads to question as to the reliability of the due diligence covered. Thus, the financial integrity of the bond is usually ensured by earmarking the proceeds to finance environmental-friendly projects or are tied to a green underlying asset. This attribute has been used to classify the different green bonds. Particularly, the Green Bond Principles, which is a set of voluntary industry based set of guidelines published by a consortium of leading banks, who are underwriters for green bond issuances, to set basic standards and guidelines to ensure the integrity of the rapidly developing green bond market. The Green Bond Principle introduced four distinct types of green bonds. Green Use of Proceeds Bond A standard recourse to the issuer debt obligation for which the proceeds shall be ring-fenced to green projects. Green Use of Proceeds Revenue Bond A non-recourse to the issuer debt obligation in which the credit exposure in the bond is pledged cash flows of the revenue streams, fees, taxes, etc. and the Use of proceeds of the bond goes to related or unrelated green projects. Green Project Bond A project bond for a single or multiple Green projects for which the investor has direct exposure to the risk of the projects with or without potential recourse to the issuer. Green Securitized Bond A bond collateralized by one or more specific projects, including but not limited to covered bonds, Asset backed securities and other structures. The first source of repayment is generally the cash flows of the assets.
- However, given the complex and integrated nature of environmental issues, ambiguity surrounding environmental assessments has resulted in various controversies. Ensuring environmental integrity is highly critical, especially given that more than half of the current investor pool is made up of ESG mandated institutional investors. The Climate Bonds Initiative, an international investor-focused non-for-profit organization, promoting large-scale investment in the low-carbon economy, have thus moved to come up with more concrete technical specifications on what would constitute green. They have also developed their own Climate Bond Standard and Certification Scheme, a voluntary certification and assurance scheme for green bonds.
- After understanding the basics of the green bonds market, we shall now go into detail on the development process of this green financial instrument. The international development process of green bonds is largely a market-driven process, with a minimal role for policymakers. The whole process of development of the green bonds market could be divided into four different stages.
- The Skandinaviska Enskilda Banken AB (SEB) and the World Bank pioneered the idea of a green fixed income product, and in 2007/2008, they jointly launched the world’s first green bond. The first green bond was a product specially tailored to satisfy demand from Scandinavian pension funds looking to invest in environmentally friendly fixed-income products. A number of different socio-economic factors could explain the demand for institutional investors for such environmentally friendly fixed income products. Socially responsible investing was beginning to pick up in the fixed income sector, after its equity counterpart explored the notion decades beforehand. The increasing proliferation of climate change concerns, accelerated by promotion by the media, academics and non-governmental organizations, has moved climate and environment issues further up in the public agenda. The better understanding of the climate related risks has also motivated increased attention towards green energy, thereby prompting a change in investor behaviour. Particularly in the case of institutional investors, which has a long-term risk outlook and thus are disproportionately affected by climate change. Changes in the investment climate, particularly after the 2008 Global financial Crisis, to a more risk-averse and stable growth strategy has resulted in the increased demand and expansion of relatively stable markets such as the fixed income and sustainable investing markets. Furthermore, increased regulation of financial institutions, particularly in terms of holdings in risky assets, further increased the demand of fixed income products. These changes drove the market for green bonds. This demand cannot be realised without the aid of financial intermediation, who helped to come up with the low-risk, stable returns investment instruments that aligns with their investment mandate. Financial innovation, specifically the process of ring-fencing of proceeds came out due to financial innovation. The presence of credit worthy supply was also critical at the initial stage of market creation. The supply side of the equation was matched by international developmental banks. International developmental banks, who has the mandate to provide funding to address climate change concerns, were well-positioned to supply the required projects to meet demand. The existing project assessment criteria and transparency of reporting ensured the environmental integrity of the bond and thus fulfilled the environmental mandates of the institutional investors. In addition, with strong credit ratings and minimal risks, the green bond issuances from SSAs aligned with the risk and return paradigm of the investors, thereby attracting more institutional investors, which helped to build liquidity in the market.
- Though the initial uptake for green bonds was slow, consistent with uncertainty associated with an infant market, the demand began to pick up after more large-scale benchmark issuances helped to build the market. After the first issuance in 2007/2008, progress was slow. Issuance in the early years of development (2007 to 2009) were limited to issuances from the World Bank and the European Investment Bank (EIB), who were the pioneers of the green bond market. Issuances began to pick up in 2010, with various supranational, subnational and agencies (SSAs) entering the market from 2010. Demand outstripped supply of most of these bond issuances, with most of the issuances picked up by institutional investors. Including international development banks etc. Whilst the success of initial issuances by SSAs sparked market interest in this product, thereby promoting growth of the market, the existence of favourable market conditions, such as the quantitative easing in the States, which increased investor interest in and appetite for low-risk bonds, in search for higher yield. Media publicity of green bond deals and proliferation of information further promoted the market. Corporate issuances entered the market 2013, which expanded the depth of the market, and increased choices for investors with different agendas. The development and emergence of such new issuer types with varying credit profiles, along with diverse capital and funding needs extends the credit and maturity curves as the market evolved to meet a variety of risk/return requirements, thereby promoting growth of the market.
- With compounding investor interest, the market grew, along with increasing calls of transparency and disclosure within the market to ensure the integrity of the product. Market players responded to the investor’s calls for more MRV, thereby producing standards and protocols. As corporate issuances began flooding the market, the lack of regulation in the market, coupled with the heterogeneity of potential issuances and underlying projects, concerns were raised on safeguarding the label. From the investor’s perspective, controversies with regards to the “greenness” of the bond will likely manifest as market risk and reputational risk when they are seen to be engaging in such instruments, thus increasing their demands for uniform quality assurance across the asset class. Various observers of the market have also commented that the lack of quality assurance may ultimately lead to the destruction of the market, should investor confidence be dissipated. the Center for International Climate and Environmental Research (CICERO), dominated all third party verifications until 2014. Following the rapid growth of the green bond asset class in 2014, the year also saw the emergence of various other third party verifiers such as VIGEO, DNV, KPMG, OEKOM and CH2MHILL
- As the market matures, there are increasing calls for standardization and benchmarks to facilitate informed decisions making. The availability of market standard indices is important in establishing clear, broadly accepted guidelines for the new issuers rapidly entering the market. These benchmark indices facilitates investor participation in the market. Financial intermediaries have already responded to calls for more market benchmarks. The earliest green bonds index, the Solactive Green Bonds Index, was introduced in 2013 by the German index provider. Market onlookers valued the creation of this index to be highly beneficial for fund managers while also praising its contributions in terms of awareness building. However, the influence of Solactive was limited to the European region. The introduction of the Barclays, Merill Lynch and S&P green bonds, were crucial in offering a global benchmark for investors. Development of ancillary financial services for the green bonds sector seems to be modelled after its conventional financial instrument counterparts. The diversification of the existing indices allows comparisons of assets across different risk and return paradigms. Of particular significant is the S&P green bond index and green project bonds index. The differentiation was made to account for the difference in investment grades for the larger share of green bonds issued by SSAs or large international companies and the high-yield bonds issued by SMEs. The creation of these indices allow investors and other financial intermediaries to accurately assess the potential and performance of the market. For example, an assessment of these indices revealed that green bonds have a lower credit risk and has been shown to have lower returns volatility compared to conventional fixed income products. Besides information related financial services, financial derivatives have also began to emerge to attract the interest of retail investors. Dedicated green bond funds such as the Calvert Green Bond Fund (CGAFX) and the Nikko AM Shenton World Bank Green Bond Fund not only ensures a steady demand for new green bonds issuers, but also opens up the green bonds market to retail investors, further expanding the pool of potential investors.
- Given the various challenges in determining the environmental aspects of a green bond, verification for environmental integrity is largely viewed as an absolute attribute, instead of a scaled and relative characteristic. Giving a definitive rating to a green bond, as with the current approach put forth by the GBP and CBI, disregards the degree of “greenness” of a bond and negatively discriminate against projects that are truly green. While recognizing the difficulties in providing an integrated approach in assessing the sustainability aspects of a project, there has been increasing calls for a rating system to differentiate between different shades of grey. As the market expands and a diversity of bonds are introduced, a more structured assessment criteria could emerge to address these concerns. The current investor pool for green bonds are made up of mostly buy-and-hold investors, which may limit the performance of green bonds in the secondary market. The nature of green bonds, especially the alignment of financial structure and low credit risk of SSAs issuers, attracts buy and hold investors. Indeed, there has yet to be high level of activity in the secondary market. The lack of a secondary market reduces liquidity in the market which increases liquidity risks for investors. A limited secondary market may also reduce the uptake of green bonds, given that a natural switching process is much easier for investors. In addition, it limits the participation of retail investors who lack access to initial offerings, which are increasingly seen to be in demand for such green financial products as well.