Over the past year, $500 million-plus worth of environmental bonds have been issued, mostly by multilateral development banks. The World Bank issued its 37th green bond since 2008, with its smallest denomination of $2.1 million in the last month. Recently, a private British wind power firm issued a ?10-million retail bond. At least two more are in the offing.
Although only a few people are familiar with environmental bonds, they could be the vehicle needed to raise the large amounts of capital for tackling climate change. The World Bank?s other agencies estimate this to be a staggering $200 billion to $1 trillion every year until 2050.
According to the International Financial Services, London, pension funds alone had assets worth $29.5 trillion under management at the end of 2009. Although many have been increasing allocations to alternative asset classes, fixed income still makes up about a quarter of their assets. Numbers may have changed since the financial crisis but, a couple of years ago, sovereign wealth funds managed almost $4 trillion, with more than a third of their assets allocated to fixed income. Regardless of whether these funds pursue environmental objectives, the numbers reveal a large untapped potential in the fixed income space to access capital for climate-related investments. The trend of investing in low-carbon growth is likely to remain, considering policy movements at the macro level. Clearly, capital is available.
How would this capital flow? Projects need financing individually, and institutional investors are highly unlikely to directly invest in individual projects. Institutions also say that available instruments are not sizeable enough to channel the kinds of capital flows needed to match mitigation needs (see chart). Bonds could change this by directly liaising with institutional investors to leverage necessary capital. Because bonds are rated, liquid and asset-backed, they make the typical risk elements known. Investors would not only get access to projects but also bypass any intermediaries.
Climate bonds are not new. However, the lack of long-term performance of low-carbon technologies and carbon markets has prevented the growth of climate bonds. But things are changing. Carbon markets have existed since 2005 and traded almost $150 billion in 2010. Renewable energy capacities in India have increased by 14% CAGR (over 1997-2010, total installed grid connected renewable energy capacity increased from 3,517 MW to 18,655 MW, making for a total increase of 430%) over the last decade and are set to grow by 13% CAGR in the next decade. A whole new slew of incentives are being introduced by the Indian government, most notably the rapidly emerging Renewable Energy Certificate (REC) trading programme.
For renewable energies, climate bonds are ideally suited because of their high capital costs, predictable running costs and ability to generate stable returns.
Additionally, they are eligible for carbon credits and RECs, which increases their returns. Properly designed projects in India can yield stable returns of 18-22%, sometimes more, depending on the price of RECs and/or carbon credits. A simple bond structure could, therefore, comprise a fixed interest rate and a variable portion linked to the sale of carbon credits and/or RECs. For this, the Central Electricity Regulatory Commission has an important role to play to reduce policy risk?by enforcing renewable purchase obligations.
Investors, typically of the pension fund kind, normally look for long-term investments with low levels of risk. In return, they get lower returns than on infrastructure or real estate investments. Renewable energies are perfectly suited for this. If issued by a credible institution, which is another necessity, the combination is perfect. Investors would find a way to channel ?emerging markets? allocations, work with the credible and sophisticated counterparts they require, and meet climate change commitments. Projects would benefit from much-needed capital and funding schemes.
To kick-start a green infrastructure bond market, an institution that is familiar?and comfortable?with renewable energies and their associated risks should take the lead. The Infrastructure Finance Development Corporation, for example, which has financed a significant portion of the total renewable energy capacity in less than a decade, could play an important role. It could speed up the creation of a liquid market by improving the risk profile of these bonds, draw in foreign funds, and ensure that bonds are issued and properly managed. So, designed properly, climate bonds could well be the next environmental asset class after carbon credits!
The author is chief strategy officer, EVI