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View from Davos January 2 2014

Can green bonds help prevent climate catastrophe?

A groundswell of support for green finance means headway is being made in the transition to a low-carbon economy, with new sustainable models of finance, the issuance of green bonds and initiatives to level the playing field among banks. 
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Can green bonds help prevent climate catastrophe?

Momentum is building in green finance as bankers become more aware of the uncertainties surrounding the risks and rewards of investing in fossil fuels, as well as the advantages of investing in new carbon markets.

The economic models of carbon mitigation (carbon reduction) and carbon adaptation (adapting to climate change) cut across many different sectors and types of financing. Their long-term trend is clear, according to bankers, but the short-term growth path is likely to be bumpy, as new sources of energy (for example, wind, solar, hydroelectric and waste), ‘green’ real estate and new transport technology (for cars, trucks, aircraft, railways and ships) battle traditional industries, and policy ebbs and flows in support of the transition. For example, carbon trading volumes have fallen.

Leonie Schreve, head of sustainable lending at Dutch financial services and insurance group ING, says: “We see new sectors emerging, and existing sectors and clients changing their business models to ensure they will be leaders in tomorrow’s world.”

Stumbling blocks

One of Sweden’s biggest banks by Tier 1 capital, SEB, has had environmental standards embedded in its credit risk policies since 1997. Environmental manager Jonas Solehav is well aware of the major stumbling blocks in the transition to a low-carbon economy. If the cost of carbon emissions were added to fossil-fuel energy costs, either by direct pricing or taxes, then, as Mr Solehav says, “financing renewable [energy] would go a lot faster than today”.

As it is, total global climate finance flows amounted to only about $359bn in 2012, according to a report by the Climate Policy Initiative (CPI), an independent team of analysts and advisers backed by hedge fund manager George Soros. CPI estimates that $700bn a year needs to be invested worldwide in climate-related projects every year up to 2030, if global average temperatures are not to rise above 2 degrees Celsius from pre-industrial levels, a target every major government has endorsed.

Breaking down the $359bn total for 2012, there was an even split between developed and developing countries. The lion’s share of 65% was allocated to renewable energy and energy efficiency. The public sector (multilateral and development banks, climate funds, the Global Environment Facility and so on) provided 38% of the total.

Public sector finance continues to be indispensable in developing countries where private sector lending for wind or solar power, for instance, simply would not get off the ground unless there was also some underwriting, equity investment, credit investment, insurance, electricity price tariff, policy incentive or concession from the public sector. Not only are there country risks that need to be assessed but also, as in developed countries, a gap that needs to be overcome between the perceived and the actual risks of a climate-smart project. Due to a lack of familiarity with many climate-related technologies, investors consider them riskier than they are in reality, say bankers.

The CPI’s latest report gives a clear indicator of just how little mainstream investors are attracted to climate-smart projects: less than 1% of the total global $359bn in green financing in 2012 came from institutional investors – comprising pension funds, equity funds, hedge funds, foundations and insurance funds, which just in Organisation for Economic Co-operation and Development (OECD) countries had total estimated assets of more than $71,000bn in 2011, according to OECD data. As Vikram Widge, head of climate finance and policy at the International Finance Corporation (IFC), the private sector arm of the World Bank, aptly puts it: “Institutional investment: it was a capellini [thin pasta], so to speak, in a spaghetti diagram [of financial flows into climate-related investment].”

Ones to watch

Against this background, three initiatives involving banking groups are worth watching in 2014 for the innovations they are bringing to green finance: carbon emission, and environmental risk assessment and management; new models for trade and energy finance; and the development of new financial products. Each of them, though not without challenges, could potentially bring the shift to a low-carbon economy that much closer.

Of the new financial products, the one that is raising most expectations generally is the green bond, say IFC officials. It was first issued by the World Bank in 2008 after the product was developed with Christopher Flensborg, SEB’s head of sustainable products and product development.

A turning point in the fledgling market came in February 2013 when the IFC issued a $1bn May 2016 green bond, the first benchmark-sized green bond, which drew orders not only from US socially responsible investment funds, which was expected, but also from many major US institutional investors, including Calpers (the Californian Public Employees Retirement System, the biggest pension fund in the world) and BlackRock, the US-based investment management company with trillions of dollars of assets under management.

Mr Widge attributes the success of the bond, which was heavily oversubscribed, and its acceptance among institutional investors to the fact that it was issued at exactly the same price and on the same terms as any other IFC AAA rated bond based on the IFC’s own account. The only difference, but a significant one, is that all the proceeds of the green bond are ringfenced and can only be used for projects that meet the IFC’s environmental and climate-change standards, which are considered a best practice reference.

“This is not raising any more money than the IFC would usually raise... But it is trying to create a new market that is not very liquid or understood among institutional investors – what investing in green would be like,” says Mr Widge.

Scaling up

It is the objective of the IFC and banks, though, to eventually move institutional investors to another level with an asset-backed green bond, which could be issued with a lower, investment-grade credit rating as investors assume the risk of the underlying asset and “hopefully a higher yield,” says Mr Widge. Then, combining the money raised from the green bond with the pool of money raised at the project level, bankers believe it really would be possible to scale up green investments.

“I think it can be huge in terms of unlocking the money of institutional investors and plugging the gap in financing climate-smart infrastructure needed in emerging economies,” says Mr Widge.

But before the move to the next level in the market takes place, the IFC, SEB and reportedly some other European, US and Asian banks believe it is necessary to first establish a standardised framework for issuing green bonds to ensure the security, integrity and quality of the market and avoid ‘green washing’ – the insincere or unregulated issuance of green bonds.

“All are now working with us to see if we can create a standardised approach to issuing green bonds,” says Mr Widge.

 

Green bond bubbles?

Citi, JPMorgan Chase and Bank of America Merrill Lynch were planning to roll out their own Green Bond Principles on January 1, say Citi officials. According to a draft published by EuroWeek, the principles provide issuers of green bonds with disclosure and transparency guidelines.

However, the principles leave it up to each issuer, whether a corporate, bank or municipality, to decide which criteria to employ to define the green use of the bonds. (Several climate-friendly and environmental definitions that have already been used in the market by the World Bank, the International Finance Corporation, the European Investment Bank, the Organisation for Economic Co-operation and Development, and others are listed in an appendix that green bond issuers may refer to if they want).

Meanwhile, Christopher Flensborg, head of sustainable products and product development at SEB, says another framework designed for a global green bond market and including input from banks in the US, European and Asia will be ready in “six to nine months”. It will be different in other important respects from the Citi, JPMorgan and Bank of America endeavour, which, Mr Flensborg says was “too rushed”. The Citi officials’ response is: “The market is not waiting. For example, Citi already has two mandates to lead manage green bond issues [in 2014].” 

To avoid the confusion of different definitions of green, it is important to establish a single set of definitions, says Mr Flensborg. Some bankers also think scientists who have knowledge of climate change, but no economic interest in the development of the green bond market, should be involved in the definition and verification of a bond’s green use.

It is also necessary to decide what governance or rules need to be in place as the risks of not having them are big, says Mr Flensborg. Without adequate governance, some bankers say, the green bond market may not provide the green performance, in terms of investments in climate mitigation and climate adaptation, that many are hoping for.

Mr Flensborg says he is not interested in picking a fight with other banks but rather in opening up a constructive discussion on what is needed for a framework that can guarantee the security and integrity of the green bond market. At the time of writing it was possible, but not at all certain, that the differences between the two groups might be reconciled, and that SEB and other banks might end up signing up to the Citi group’s proposal.

Meanwhile, Marshal Salant, Citi’s global head of alternative energy financing in capital markets, thinks standardisation in the green bond market could be helpful further along, for some smaller consumer markets, such as individual residences. He says if a customer “wants to borrow money to put a solar panel on their roof or pay for window insulation or replace a water heater, to upgrade their energy efficiency... if you had more standardised contracts we could pool those loans together and bring them to the asset-backed securities [market]”.

For some, this sounds as if green bonds, potentially with AAA credit ratings, high demand from yield-hungry investors and rapid expansion, will become the new asset class that will protect the world from climate catastrophe. For others, just the idea of thousands of ordinary US householders’ loans being combined and sliced and diced as securities underlying green bonds seems a throwback to the US housing bubble. For such pessimists, the green bond’s arrival, far from saving the world, could become the next financial nightmare.

But Mr Flensborg warns: “Unless there is a degree of governance, it is likely that good intentions will be abused by someone with less good intentions, and you may end up in a situation like in the US mortgage crisis, where there was basically an expansion in the sale of mortgages pushed by bankers who were only looking at the returns they could get for their dollars.” (See box, Green bond bubbles?)

Equator Principles

A second initiative, the Equator Principles (EPs), a long-established globally referenced credit risk management framework, is to be extended in its latest updating to take effect this month. The role of the EPs will be broadened from the assessment and management of environmental and social risks of project finance – a specific type of lending relating to large-scale infrastructure projects such as power plants, pipelines, dams and mines – to all project-related corporate and bridge loans. In addition, the assessment and management of climate change and carbon emission risks will be addressed more prominently.

Banks that have signed up to the EPs now have to publish the greenhouse gas emissions for all projects they support when carbon emissions exceed 100,000 tonnes annually. And the sponsors of such projects (for example, energy companies and independent power producers) must do an analysis of a more energy-efficient alternative to the high carbon-emitting project.

John Graham, a principal environmental specialist at IFC, says: “We expect bringing the client to do this analysis will open their eyes to opportunities, for instance in terms of energy consumption and costs, that they may not have considered before.”

Piotr Mazurkiewicz, another IFC environmental specialist, commenting on the fact that some financial institutions have continued to support controversial projects such as the 1760-kilometre-long Baku-Tbilisi-Ceyhan oil pipeline, even after signing the EPs, says: “You can always challenge the consistency, the implementation, the disclosure and the transparency of different [EPs] banks. But the fact that the EPs are a common framework that they all agreed to, with 78 banks today from 35 countries now signed on and all using the same framework, is a big achievement.”

ING’s Ms Schreve, who is currently chair of the EPs, praises the initiative for creating a level playing field among banks. “[The EPs] enable us not to compete on environmental and social risk assessment and management. We all can give the same answers to our clients and use the same standards.” These standards are the IFC’s social and environmental performance standards and the World Bank’s environmental, health and safety guidelines, which provide direction on pollution prevention, and safety and best practice for 63 different industries.

Sustainability in motion

Shawn Miller, global director for environmental and social risk management at Citi, a founding member of the EPs, believes the initiative helped set the sustainability movement in banking in motion. “In terms of changing banking and triggering sustainability across different banks in different regions, I think the EPs have been absolutely essential and a very useful tool,” he says.

 

World’s biggest solar power plant

For bankers eager to scale up renewable energy investments, there have been two good pieces of news lately. First, on December 5, 2013, US president Barack Obama ordered the ‘greening’ of all federal government buildings in the US. According to the presidential directive, all these buildings must more than double their use of electricity from renewable resources to 20% by 2020.

Secondly, technology costs for large-scale renewable projects have fallen in the past two years as economies of scale start to take hold. A striking example of this was 2013’s issue of the largest renewable project finance bond to date and the first large-scale solar financing completed in the US without a government guarantee. This was a $850m bond issue that, together with a $345m senior secured credit, funded California’s Topaz Solar Farm, a 579-megawatt solar project and the largest solar energy project in the world. It will generate enough electricity for an estimated 400,000 Californian homes and displace the equivalent of 775,000 tonnes of carbon. Citi executed the bond offering and Barclays was lead manager.

While sustainability may be a vague term that can mean different things to different banks, in general it refers to a bank’s environmental and social risk assessment, and management designed to protect a client and the bank from potentially damaging exposure related to environmental mismanagement, for example an oil spill or deforestation, which can lead to business losses and reputation damage.

Meanwhile, UK bank Barclays has played a leading role, together with Cambridge University’s sustainability leadership programme, in setting up the Banking Environment Initiative (BEI), with 10 other global banks from Asia, Europe, the US and Latin America (BNY Mellon, China Construction Bank, Deutsche Bank, Lloyds Banking Group, Nomura, Northern Trust, Santander, Sumitomo, Mitsui and Westpac).

Barclays vice-chairman of corporate banking Jeremy Wilson says that the initiative was to “see whether we, as an industry, can, with our corporate clients, do more than we are able to do at the moment. The question was: everyone knows the Equator Principles are there. But could more be done?” He continues: “The first thing we did was to establish a principle that the banks in the group would not do anything without working in conjunction with their (corporate) clients.”

Out of this collaboration, the BEI has developed various work streams; some nearer fruition than others. For instance, one collaboration with the Consumer Goods Forum, which has 400 companies and a combined procurement power of more than $3000bn, according to the BEI, has led to a proposal for a “sustainable shipment” business model in global trade finance. The idea is that banks could provide financial incentives to companies trading sustainably produced soft commodities, such as palm oil, soy, timber products and beef, which are widely believed to now cause the most tropical forest destruction, the BEI says. This business model, which has the dual aim of driving sustainability more broadly in the supply chains of major trading companies and manufacturers, and achieving net deforestation in the production of soft commodities by 2020, could be formally unveiled this month.

US action

Meanwhile in another collaboration, banks and US, European and Chinese electricity companies are working on a business model to help level the playing field and balance the risks and rewards of investing in fossil-fuel companies and renewable energy technologies.

The BEI says discussions here have focused on the inadequacies of current ways of valuing energy investments, where a purely price-based financial analysis fails to take account of the uncertainties of current policies and regulations, and the fact they are not static. For example, India, Japan and several European countries have carbon or carbon-related taxes, China is considering introducing them and changes are under way in the US.

As part of president Barack Obama’s Climate Action Plan, announced in June 2013 by the US Environmental Protection Agency, the US has introduced tough rules for limiting carbon emissions by new power plants. It has also pledged to set more controversial carbon pollution limits for existing US power plants before the end of President Obama’s second term in January 2017 (see box, World’s biggest solar power plant).

In these circumstances, the BEI proposes that a more accurate way to value energy companies in capital markets could be provided by an options valuation system. This could make investment in a marginal or non-viable clean energy project attractive when taking risk asymmetries into account. For example, a US onshore wind generation project, which is now non-viable when compared with the current low grid prices of US onshore natural gas (due to the discovery of major shale gas deposits) would, in a greener policy and regulatory world, have advantages in terms of risks that are greater than the disadvantages.

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