Feb. 18 2019 — The oil-rich countries of the Gulf Cooperation Council (GCC) are starting to go green, creating the space for a viable market for green finance. The GCC, like the rest of the world, has committed to diversifying its economy away from fossil fuels. The GCC mainly wants to reduce its dependence on oil, which makes its economy vulnerable to falling oil prices. But it also wants to respond to growing demands for action on climate change from policymakers and multilaterals that seek to encourage financing to achieve the nationally determined contributions set out under the Paris Agreement.
For these reasons, led by the United Arab Emirates, the GCC over the past few years has been investing in renewables, particularly solar power, and already hosts an active and growing renewables market. The International Renewable Energy Agency (IRENA) in its 2019 report expects that nearly 7 GW of new renewable power generation capacity is expected to come online by the early 2020s. These are all transactions that could be funded via green finance.
The green bond market in the GCC is, however, still in its infancy, despite strong growth globally over the past five years (see box). Until now, the region's primary focus has been on its economically vital hydrocarbon industries that have been driving GDP growth since the 1930s. The first and only green bond in the region was issued only recently by the National Bank of Abu Dhabi (now First Abu Dhabi Bank, after its merger with First Gulf Bank) in March 2017, for a total of $587 million. In green loans, we have only seen Masdar in Abu Dhabi tap the market with a green $75 million revolving credit facility (RCF) in September 2018 to fund its sustainability projects. There have been no green sukuk yet from issuers in the GCC. Today, climate finance in the region consists of a small number of large projects financed by loans or concessional loans from banks, governments, multilaterals, and climate funds such as the Green Climate Fund.
The Global Green Bond Market
Given rising global awareness of climate change and the urgency of response needed, it is not surprising that the green bond market has achieved strong growth over the past five years. And despite rising interest rates and a slowdown in new issuance in 2018, green bond issuance still surpassed 2017's record of $155 billion with 3% growth to $167.3 billion (see "Green Finance: Modest 2018 Growth Masks Strong Market Fundamentals For 2019," published on Jan. 29, 2019).
Green Finance Can Play A Role In Funding The Huge Pipeline Of Renewable Projects
We believe green finance in the GCC has the potential to play a bigger role in funding the region's ambitious pipeline of green projects. The region continues to make good progress toward green growth and transition to a low-carbon economy, setting new sustainability and resilient infrastructure targets that are creating demand for capital and new green financial vehicles. The United Arab Emirates (UAE) and Saudi Arabia are ahead of the other GCC members in this area as the region's biggest energy markets. Deployment in the rest of the region is limited to demonstration and pilot projects.
After signing the Paris Agreement in 2016, the UAE pledged as part of its nationally determined contribution (NDC) to increase the share of clean energy in its total primary energy mix to 27% by 2021, reduce gas flaring, integrate carbon capture and storage, reform tariffs, deregulate fossil fuel prices, and adopt efficiency standards for buildings and household appliances. Furthermore, the UAE's Energy Strategy 2050 aims to cut carbon dioxide emissions of power generation by 70%, increase the contribution of clean energy in total energy mix from 25% to 50%, and improve the consumption efficiency of households and corporates by 40% by 2050. Such a transition will require an investment of $163.3 billion over the next 31 years, equivalent to an annual spend of more than $4.6 billion.
Specifically, Abu Dhabi, in its economic strategy through 2030, considers ways to reduce the emirate's oil dependency and achieve a 65% contribution to GDP from nonoil sectors. Plus, the country also set a target of generating 7% of its energy capacity with renewables by 2020. As for Dubai, its 2050 integrated clean energy strategy plans to increase solar energy to 7% of its total generation mix by 2020, 25% by 2030, and 75% by 2050.
Saudi Arabia, in its NDC, also wants to diversify its economy and invest in a mitigation program that includes energy efficiency and clean energy projects, promotion of carbon capture, greater use of natural gas, further reductions in gas flaring, and improved water and waste water management. Furthermore, according to Saudi Vision 2030, the kingdom aims to produce 3.45 GW of renewables by 2020, 9.5 GW by 2023, increasing to 30% of the total mix by 2030. Saudi Arabia's government indicated it seeks to attract between $30 billion-$50 billion of new investment in renewables by 2030. By 2021, there are also targets to reduce electricity consumption and peak demand by 8% and 14%, respectively.
Kuwait, Bahrain, Oman, and Qatar have set out positive but less ambitious steps toward sustainability in their NDCs, including plans to reduce carbon footprints and introduce policies that would support mitigation and adaptation programs. For example, Kuwait's sustainable energy target is to increase renewables to 15% of the mix by 2030; Bahrain's is 5% by 2025 and 10% by 2035; Oman's is 10% by 2025. Qatar is aiming to install 200-500 MW of solar by 2020, and is committed to diversifying its economy so it can gradually reduce its dependence on hydrocarbon industries.
The Foundations For Green Finance Are Being Built
GCC governments have also laid groundwork for a green finance sector to support their sustainability targets. In October 2018, new legislation came into force in the UAE that provides a framework for sovereign bond and sukuk issuance to facilitate development of its primary and secondary green financial markets. Among the most promising effort is the desire and commitment of the Dubai government to take a lead and become a hub for the green finance in the region. The Dubai Green Fund, established by the Dubai Electricity and Water Authority (DEWA), is keen to play a key role in financing green projects and provide concessionary loans for investors. It is aiming for $27.2 billion in green assets under management.
The Emirate of Abu Dhabi is also aiming to become a green bond pioneer in the region. On Sept. 18, 2018, Masdar (also known as Abu Dhabi Future Energy Co.), a renewable energy company, signed the first green revolving credit facility (RCF) in the Middle East, totaling $75 million, with four local and international banks. The RCF is consistent with the Loan Market Associations' Green Loan Principles and aims to provide funding for new and ongoing investments for Masdar's global technology and sustainable real estate projects. In another development, the Abu Dhabi Security Exchange announced it joined the UN's Sustainable Stock Exchanges initiative to encourage sustainable investment.
Despite all of these advances, the green finance market in the GCC is still in an early stage of evolution and lacks cross-border financing and the presence of institutional investors such as pension funds that we see in other developed capital markets. We believe that a combination of green and vanilla sukuk as well as conventional green bonds could provide the substantial funding support that is required for the realization of the region's sustainability targets. In particular, new and conventional green finance vehicles could lower the cost of capital for overseas cross-border financing and open up a wider pool of capital of Islamic and conventional investors. Notably, we think that a number of the utilities we rate in the GCC could consider green issuance; yet they would most likely also expect to obtain pricing at least equivalent to conventional issuance before proceeding.
Renewable Energy Capacity Is Set To Accelerate
By the end of 2018, the GCC region had renewable energy (RE) capacity of 867 MW, or 0.6% of its total electricity capacity. The biggest share of renewable energy capacity is in the UAE (68%), followed by Saudi Arabia (16%), Kuwait (9.11%), and Qatar (5%), which clearly reflects countries' sustainability initiatives (see chart 1). Looking forward, according to IRENA, renewable energy deployment in the GCC is set to grow by an annual compound growth rate of 179% from last year, with total additions of 6.7GW by 2020. This will be led primarily by the UAE, Oman, and Kuwait (see chart 2), with solar photovoltaics being the dominant technology.
As Green Finance Grows, Real Estate Is Bound To Share In The Proceeds
The expected rise in renewable energy capacity in the GCC is not the only potential force for the development of green finance in the region. Looking at green bonds issued globally in 2018, we see that almost equal amounts of proceeds were channeled to the real estate sector, making energy (31%) and buildings (28%) sector leaders in the market. Overall, according to the Climate Bonds Initiative's January 2019 report, "Financing Low Carbon Buildings with Green Bonds," $126 billion had been allocated to low-carbon building assets and projects as of end-November 2018.
We note a similar trend in the allocation of green bond proceeds raised by First Abu Dhabi Bank, dominated by green building projects (65%), followed by solar plants (14%) and district cooling (14%) projects (see chart 3). Across the GCC region, nearly 50% of all electricity consumed goes to the residential sector and 70% of homes are not insulated. Therefore, a significant share of climate change mitigation initiatives in the region are focused on lowering energy consumption in buildings by introducing energy efficiency standards and using mature energy-saving technologies and green building codes.
Green Bond Market May Grow Alongside Debt Capital Markets
Given the sheer amount of renewable projects in the pipeline and the region's concentration in the real estate market, development of a GCC project bond market is also key. Historically, local and international banks active in the region have been very accommodative of large transactions, offering very attractive pricing levels and terms. The vanilla bond markets have played a relatively minor role, though this has been gradually changing over the past few years.
However, looking at the size of more recently announced projects, we believe the capital markets may play a more important role in funding some of these projects in the near future, which could also support the growth of the green bond markets. For example, once some of the green projects become operational, the refinancing stage of some of these assets may present an opportunity for the capital markets in general and green bonds more specifically.
Two examples of project finance transactions in the region that were refinanced by the bond markets are the $2.3 billion Ruwais Power Co. PJSC (Shuweihat 2) refinancing in 2013, where $825 million of existing debt was refinanced via a project bond--the first project bond offering by an independent power and water project in the Middle East. In another transaction, Emirates Sembcorp Water & Power Co. refinanced some of its existing debt via a $400 million project bond. Both transactions were rated 'A-' by S&P Global Ratings at time of issuance.
Taking A Cue From Southeast Asia, Islamic Green Finance May Grow
The global effort to mitigate climate change has drawn growing attention from Islamic and conventional investors to new forms of green finance and has triggered development of the green sukuk market. Green sukuk are Islamic financial instruments that are Sharia compliant, where issuers use proceeds to finance investments in renewable energy or other environmental assets such as solar parks, biogas plants, wind energy projects, as well as renewable transmission and infrastructure projects.
The Islamic finance industry counts assets of $2.1 trillion globally, and S&P Global Ratings believes it will grow at a 5% rate for the next two years. Historically, GCC issuers have been an important driver of growth for the global sukuk market, and we believe the first green sukuk in the region are just a matter of time.
Since Tadau Energy issued the first green sukuk in Malaysia in July 2017 for $58 million to finance a solar power project in the country, the market has expanded and now totals $2.1 billion in assets (as of September 2018). Today, the green sukuk market is concentrated in Malaysia and Indonesia, although issuances are likely to come from the GCC region over the next few years. A rapid takeoff in Southeast Asia suggests there is great potential for the green finance market to grow in the GCC, especially given the strong market presence of the Islamic financial industry there, in particular in the UAE, Saudi Arabia, and Qatar.
Green sukuk, as new financial products, have the potential to further broaden the Islamic financial market and close the gap between the conventional and Islamic financial worlds. This could allow GCC issuers to access a wider pool of capital, which is necessary for the green sukuk market to develop. Green sukuk could attract conventional investors by providing a high degree of certainty about the allocation of the proceeds and by filling the fixed-income supply gap for green investors. Sharia-compliant financing of environmental projects could also diversify the investor base in the green financial market.
Green Issuance Is Likely To Come From Sovereigns, Utilities--And Perhaps Real Estate Companies
Overall, we expect the global green bond market to grow at 8% in 2019 and diversify further by country. GCC governments have been taking substantial steps to move away from oil and support the low-carbon transition. There have already been incentives from Dubai and Abu Dhabi's governments to become a green finance hub in the GCC. Renewable energy capacity installation has grown and is set to expand further, in particular in the UAE, Saudi Arabia, Kuwait, and Oman. Rising climate awareness, strong environmental policies and regulations, and demand for green and infrastructure projects in the region will likely continue to support development of the green finance market. This is likely to comprise a diverse combination of conventional green bonds and green and vanilla sukuk, which could lower the cost of capital and help provide the massive amounts of funding for projects in the pipeline. We believe new issuance will grow and come from sovereigns, utilities--and potentially real estate companies--to support the GCC governments' sustainability initiatives.