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Investing in projects with environmental benefits
Climate change is a major problem in today’s world and it affects almost every sector in the economy, directly or indirectly. One way through which we can combat this problem financially is through Green Bonds. Green Bonds, like any other bond, is a fixed-income instrument that focuses on mobilizing resources from domestic and international capital markets and channelizes it for environment-friendly projects, such as sustainable waste management, renewable energy, pollution prevention, etc. The risk and returns involved are similar to the traditional bonds.
The World Bank is the largest issuer of Green Bonds. According to the World Bank’s 2020 Impact Report, 111 projects are eligible for green bond financing. Since 2008, it has issued $14.4 Bn in bonds with 164 green bonds across 22 currencies. About $1 Bn equivalent in bonds were issued in FY 2020.
Source:World Bank Impact Report 2020
Emerging trends and evolution of green bonds
Since its inception in 2007, the green bond market has reached cumulative issuance worth $1 Tn. The volume of labelled green bonds has been increasing steadily since 2013. It had issuance worth $280 Bn in the year 2020. With greater emphasis on environmental, social, and governance (ESG) objectives, the green bond market is still evolving and has started to gain its popularity.
Source: Climate Bonds Data Intelligence Reports
Green Bonds can be broadly classified into the following categories:
● Use of Proceeds Bonds– These are standard recourse-to-the-issuer debt that has the same credit rating on the stock market as the issuer’s other bonds. An example of this is the European Investment Bank’s Climate Awareness Bond. It has raised €7.6 billion during the period 2007–2014.
● Revenue Bonds- These are debt instruments with non-recourse-to-the-issuer. Its proceeds generated by fees, taxes,etc. are reserved for green or environmentally friendly projects. For example, AAA rated revenue bonds worth $321.5 Bn issued by Iowa Finance Authority which were backed by water related fees and taxes collected by the State.
● Green Project Bond- These project bonds are involved in the development of one or more environment-related projects for which the investor has direct exposure to the risk. For instance, a US development finance institution, OPIC, had issued $47 Mn worth of green guarantees for US investors. The amount will be used to invest in a photovoltaic project in Chile, called the Luz del Norte project.
● Green Securitized Bonds- These bonds are collateralized by one or more specific projects, where the first source of repayment is generated through the assets.It is similar to how the US based solar installer SolarCity Corp entered the green bonds market by backing it with solar lease agreements.
Cost efficiency and growth in revenue achieved with the issuance of green bonds
Various costs are involved in the issuance of bonds, which may depend on the value of the bond, complexity of the deal, taxes, issuer’s risk profile and other things. In case of green bonds, the fee is generally calculated as a fraction of the market face value of the emission. Thus, the cost of issuance of green bonds may vary from a few thousands to millions of USD.
Moreover, compared to conventional bank loans, green bonds have a positive impact on the profitability of environment-friendly projects. This is indicated by higher IRR for shareholders. Higher IRR is attributable to lower financing costs of green bonds relative to bank loans.
Green bonds have proven to be more efficient towards sustainability goals, compared to other means of financing. According to Asian Development Outlook, on an average, Asian firms that issue green bonds improve their environmental performance by 30% after 2 years. Additionally, companies that issue green bond issuers have proved to show greater resilience during the pandemic.
Regulatory and tax incentives
Taxes may hurt when it swallows a part of your investment returns. An added advantage of green bonds is that they come with tax incentives. Since green bonds are built exclusively to develop projects that are beneficial to the society, green bond holders enjoy tax exemptions and tax credits, making it more attractive compared with traditional bonds.
In order to classify a bond as a green bond, it must go through a process of third party verification to ensure that the proceeds are directed towards environment projects. Institutions like the International Capital Market Association’s Green Bond Principles and the Climate Bonds Initiative’s (CBI) Climate Bond Standards help in this classification. Green bonds are usually governed by the following principles:
● Use of Proceeds — issuer should specify the category and clearly mention the definition of environment benefit of green project towards which the proceeds will go.
● Project Evaluation and Selection Process — issuer must give an overview of its investment decision making process
● Management of Proceeds — proceeds should be managed through a sub-portfolio or attested to by a formal internal process that should be disclosed
● Reporting — details of investments made from proceeds and environmental benefits achieved should be regularly reported.
Feasibility and challenges in issuance of green bonds
The above principles ensure transparency in the use of proceeds which would help investors in making the right decisions for their investments. However, often the reporting standard is weak in the bond market. Since the value of the bond depends on a number of factors including complexity of the deal and issuer’s risk profile, it leads to variation in the cost of issuance. Low value issues in developing countries sometimes make other financial options more affordable.
Growing focus and impact assessment of green bonds
It is evident that green bonds have started to gain popularity as there has been greater awareness towards environment issues and climate change. The market is still new and it has a lot of potential to evolve along with the economic environment. Its direct impact lies in the performance of the underlying project and has the potential to drive nations towards net zero. Several multilateral development banks have adopted a harmonized framework for impact reporting of green projects which is expected to allow a more stringent measurement of impact. Transparency, agreed standards and principles, Measurement, Reporting and Verification (MRV) are important drivers of incentives.
As awareness about the environment is increasing, the green bond market will surely see a bright future. Even though it does not guarantee high returns, socially responsible investors are still investing in these tax efficient bonds to get the positive environmental returns. Green bonds will prove to be a promising instrument to achieve net zero along with some fixed income.
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This article has been co-authored by Tamanna Kapur, who is in the Research and Insights team of Torre Capital.