The ABC's of 'Green Bonds'

“We need bold action on climate change. It comes down to a simple choice: we continue with business as usual and hope for the best. Or we act now and build a resilient future. Our generation may not be able to solve all the problems related to climate change, but we can do our part to leave a better planet for the next generation.“

-Kristalina Georgieva Chief Executive Officer The World Bank

In this article, I would like to talk about the birth of an idea that has blown up into a $129 Billion market today. It has also led to the birth of several other thematic bonds like itself creating an overall of $2 Trillion markets around it (as per the numbers Bloomberg released dated March 23).

What are ‘Green Bonds’?

Green Bonds are a type of debt instrument with which capital is being raised to finance environmental projects (mostly renewable energy, energy efficiency, emission reductions projects). It is a key financial mechanism driving the global economy’s transition to a greener future. At times, they are also called climate change bonds.

There are four types of green bonds:

• Green “Use of Proceeds” bond: secured by assets (comparable to standard bonds)

• Green “Use of Proceeds” revenue bond: secured by income-producing projects

• Green project bond: secured by a projects assets and balance sheet

• Green securitized bond: secured by a larger asset pool

Additionally, there is the ‘Environmental Impact Bond’ which is similar to green bonds.

When did it all start?

European Investment Bank (EIB) issued the first bond in 2007 under the name of ‘Climate Awareness Bond’. It was a structural note linked to carbon and equity where the principal was backed by renewable energy and energy efficiency assets. One year later in 2008, World Bank issued its first ‘Green Bond’ with SEB (Sandinaviska Enskilda Banken AB) that enabled institutional investors to engage through their mainstream portfolios and where the principal was earmarked for renewable energy and energy efficiency.

Who are the issuers?

They are fixed income securities issued by:

• World Bank

• Regional Development Banks

• Financial Institutions

• Government and other corporations

So how does it work?

It is easy to understand the financial mechanism for the investors as it is structurally the same as a normal bond, which didn’t have any project or country-specific risk.

Green Bond Principles

The four core components for alignment with the GBP are:

1. Use of Proceeds

2. Process for Project Evaluation and Selection

3. Management of Proceeds

4. Reporting

Example structures:

• Green gilts

• Green retail bonds

• Green investment bank bonds

• Green corporate bonds

• Green infrastructure bonds

• Rainforest bonds

• Index-linked carbon bonds

• Water bonds

Pros and Cons

Benefits of Green Bonds

• Fixed-income financial instruments

• Low-cost long term debt

• Tax-exempt bonds

• Increased capital access

• Financing across developmental stages

• Encouraging the emergence of new green innovations and technology

• Raise capital for environmentally focused projects

• Burnishes the reputation of investors and their portfolios

• They typically carry a lower interest rate than the loans offered by commercial banks

• Lower risk

• Green bonds could support India aims to install 175 GW of renewable energy by 2022, which will require an estimated $264 billion of investments.

• More awareness and investors in the ‘green finance’ space

‘Green’ is not always perfect

• It is not easy to define the impact of these investments.

• Lack of accepted taxonomies, defining ‘what is green’ across different asset classes and industries.

• Possibility of ‘Greenwashing’.

• Lack of clarity and standardization in reporting guidelines, metrics and transparency.

• Proper evaluation requires experimentation and control groups which in turn will is time-consuming and expensive.

• Inadequate contractual protection for investors.

• Lack of obvious pricing benefit in going green.

The Eligible Green Projects Categories

• Renewable energy (including production, transmission, appliances and products)

• Energy efficiency

• Pollution prevention and control

• Environmentally sustainable management of living natural resources and land use

• Terrestrial and aquatic biodiversity conservation (including the protection of coastal, marine and watershed environments)

• Clean transportation (such as electric, hybrid, public, rail, non-motorized, multi-modal transportation, infrastructure for clean energy vehicles and reduction of harmful emissions)

• Sustainable water and wastewater management

• Climate change adaptation

• Circular economy adapted products, production technologies and processes

• Green buildings

Source: The World Bank Green Impact Report 2018

Are ‘Green Bonds’ important in India?

While reading this article many of you might think that ‘Green Bonds’ is just a fancy foreign concept that will take years to come to India. But that’s not the case. In 2020, India became the second-largest emerging green bond market after China. Since 2015, India has gone from zero to $ 10.3 Billion.

‘Green Bonds’ Milestones for India

Timeline of Green Bonds in India (Source: TERI)

• In 2018, the State Bank of India (SBI) entered the Green Bond market with a $650 million certified climate bond.

• In the first half of 2019, India became the second-largest Green Bond market globally after China with $10.3 billion worth of transactions, as per the Economic Survey 2019-20.

• In October 2019, India joined the International Platform on Sustainable Finance (IPSF) to scale up the environment-friendly investments.

Way Forward and future trends

Increase in number and scale of green projects – environmental and green projects dramatically increasing in size calls for multi-tranche financing sources.

• Proven Technology – track record established for many clean energy technologies reducing the risk profile of the sector.

• Green Investment Banks – will assist in the creation of a liquid market in green bonds by insuring bonds and temporarily purchasing sub-tranches of subordinated debt (EIB Project Bond Programme).

• Smart cities projects - may be suitable to attract private investment and may soon culminate into India's first green municipal bond. 

• Effective tool- Green bonds act as an effective tool to tap climate funds from developed countries under Paris accord.

• Increased complexity – development of green bonds into a complex product that appeals to investors with different risk appetites (e.g. high yield green bonds).

• The expanded universe of issuers – Governments and financial institutions will look to the Green Bond market for funding their clean energy commitments.

• Demographics- Shifting demographics of investors to millennials and Gen Z who are more climate-conscious increases the demand for the ‘Green’ sector.

• Standardization – recent draft proposal published by Climate Bonds Initiative, London for an industry-wide compliance standard to allow for more transparency and consistency in green bond issuances.

• Competitive pricing – demand for well-structured green bonds could make them a lower-cost option for issuers.