Green Finance: the Next Driver of Real Growth?

S&P Global Ratings
Written By: Michael Wilkins, Dmitri Sedov and Dr. Richard Mattison
S&P Global Ratings
Written By: Michael Wilkins, Dmitri Sedov and Dr. Richard Mattison

Green finance is coming of age. It's being propelled by a variety of forces unclenched by the 2015 Paris Climate Agreement, and the need it created to finance $1 trillion a year in investments for renewable energy and other initiatives to limit global warming.

At the same time, long-term investors are also recognizing the threat from greenhouse gases and have begun, albeit cautiously, to diversify portfolios away from climate risk and carbon-based investment. The final push is coming from corporations as they start to contend with the consequences of increasingly extreme and violent weather and flooding. Gradually, many are starting to see that aggressively managing environmental exposure may be more than risk management; it may be good for business.

In the middle of some of these environmental epiphanies, green bonds are finding their place in the market. Recognized as a source of overall economic growth, this new, not fully formed instrument is finding a following—most significantly in China among government officials who see the potential to use these bonds to shift growth to the real economy. For the rest of the globe, they represent a path to escape the slow-growth, low interest rate trap of the past decade.

Last year was a turning point for green bonds. After the Paris Agreement, China and other economies began to fund major investments in climate-friendly energy and infrastructure. The green bond market doubled to almost $83 billion. China went from virtually nowhere to becoming the No. 1 issuer, with nearly $37 billion of green bonds. Growth also accelerated among corporates, with issuance tripling to $28 billion as energy companies, auto makers, and even tech companies tapped the green bond market.

For green finance to fulfill its potential for China and the rest of the world, green bonds need to be fully accepted by mainstream investors. With a concerted push by the world's largest institutions, including major pension funds, the finance industry is responding with assessments, evaluation tools, and processes to provide green finance the reliable metrics and transparency needed for comparison with other investments and widespread acceptance. Standardized evaluations assessing sustainability can also help investors benchmark issues that are not labeled green but have positive climate impact. Next steps can include extending mandates for disclosure of environmental, social, and governance (ESG) performance by issuers and investment managers.

The opportunity and the promise

"...green finance is a major opportunity. By ensuring that capital flows finance long-term projects in countries where growth is most carbon intensive, financial stability can be promoted. … by allocating capital to green technologies, the prospects for an environmentally sustainable recovery in global growth will increase." --Mark Carney, Governor of the Bank of England and Chair of the Group of Twenty's Financial Stability Board

Is green finance ready to save the world? It may seem an unlikely hero, since money raised to fund environmentally friendly development currently represents only a sliver of the global debt market. That, however, is about to change.

Policymakers, executives, and investors around the world are increasingly ready to recognize green bonds and other financial instruments that support sustainable development as necessary drivers of growth in a global economy. They're also beginning to feel the consequences of the historical addiction to fossil fuels. Indeed, last September, Mr. Carney hailed green finance as an indispensable tool to mobilize capital for long-term growth and to help economies break out of the slow-growth, low interest rate "trap" of the past decade.

Nowhere is the commitment to green finance more visible than in China, where the government hopes to use green bonds to pursue two urgent goals: to reduce the pollution that's stifling productivity and threatening its citizens, and to generate steady, sustainable growth in the real economy. In the government's 13th Five-Year Plan, covering 2016 to 2020, China has laid out an ambitious initiative to meet the nation's environmental commitments to help cut global greenhouse emissions and address the devastating pollution problem at home, primarily connected to its use of coal and other fossil fuels.

The plan involves, among other things, transformative investments in renewable energy, the production of low-emission vehicles, and new transportation and water infrastructure. It's a massive undertaking that will require expenditures that could exceed $600 billion a year, with most of it coming from private funds raised through green finance instruments. The People's Bank of China has said it expects 85% of the initiative to be built with private funds, which would translate into $300 billion or more in Chinese green bonds a year—by itself three times the total amount of green bonds sold globally in 2016.

Industrializing green finance

China's boost to the green bond market comes at a time when momentum is already building. Today, green bonds are less than 1% of the total bond market—but the demand for and supply of green investments is rising rapidly as new issuers enter the market and institutional investors look more aggressively for ways to hedge their climate exposure.

Around the world, green finance is poised to move into mainstream investing as a safe and effective way to earn a return, protect portfolios from climate risk, and fund sustainable growth. But before green bonds can fulfill their role as enablers of broad economic growth, work still needs to be done to "industrialize" green finance—essentially to create the infrastructure and standardization necessary for participation by a wide spectrum of the investment community.

Green bonds today do not fully qualify as mainstream investment vehicles because they lack the benchmarks and evaluation instruments, as well as the standardized processes that make high-volume investing possible. But with pressure finally building from investors, government agencies, nongovernmental organizations (NGOs), and issuers, the finance industry is beginning to respond with the kind of sophisticated and reliable tools needed for efficient markets.

The market keeps expanding

In the meantime, green finance continues to grow despite the constraints. Total green bond issuance almost doubled in 2016, rising to close to $83 billion from $42.4 billion in 2015 and bringing the sum of green bonds outstanding to about $200 billion. In 2017, issuance is expected to more than double again to $200 billion. Given China's needs and growing interest in green finance, issuance could swell to $1 trillion a year as early as 2020, according to the Climate Bonds Initiative, an investor-focused nonprofit created to promote climate change solutions through capital markets. The London-based group's members include major financial services corporations, such as HSBC and Standard Chartered; financial data companies, such as S&P Dow Jones Indices and the London Stock Exchange Group; large institutional investors and asset managers, such as the Ceres-sponsored Investor Network on Climate Risk and BlackRock; and global NGOs and foundations, such as the International Institute for Sustainable Development.

Driving this growth are the environmental commitments made by nations, including China, at the UN Climate Change Conference in Paris in 2015. To date, 133 nations out of 197 that attended the conference have ratified the Paris Agreement to reduce their greenhouse gas emissions to a level at which global warming can be kept below 2 degrees Celsius and preferably at 1.5 degrees Celsius. Currently, the earth's temperature is already almost a degree Celsius higher.

It is estimated that meeting that goal will require nations to spend somewhere in the neighborhood of $1 trillion a year from now through the end of 2035. This kind of large-scale infrastructure spending would generate a massive increase in green finance, with green bond issuance potentially reaching between $620 billion to $720 billion a year, according to estimates by the Organisation for Economic Cooperation and Development (OECD).

Demand still exceeds supply

For most of the decade since the first green bonds were offered in 2007, the largest issuers were international development banks, such as the World Bank's International Finance Corporation. Today, the fastest growth is among corporations, which now issue almost one-third of the total market.

Corporate issuance nearly tripled last year, to $28 billion from $9.6 billion, according to S&P Global Ratings. Among the companies coming to market in 2016 were Apple, which with a debt offering of $1.5 billion became the first U.S. tech company to issue a green bond; French energy giant EDF, which issued a €1.75 billion green bond to fund hydroelectric and other sustainable-energy projects; and China's Geely Holding Group, which issued a $400 million green bond for producing emission-free London taxis.

Green bond issuance by sovereigns and sub-sovereigns is also growing. In January 2017, for example, France issued what was hailed as the first green sovereign—though Poland had issued a small sovereign green bond at the end of 2016. Funds from the 22-year, $7.5 billion French bond will be used for renewable energy and other environmental projects. In addition to nations, U.S. municipalities and agencies are coming to market, including the Indiana Finance Authority, the New York City Housing Development Corp., and Sound Transit Authority in Seattle. The Climate Bonds Initiative estimates that there are about $30 billion in outstanding environmentally connected municipal bonds in the U.S.

China takes the lead

China, however, is the really big story on the supply side. From a standing start in mid-2015, Chinese enterprises, including banks, corporates, and subsovereigns, led issuers from other nations offering nearly $37 billion in green bonds last year.

Among the biggest issues: In June 2016, China sold the first international green bond in three currencies, a $3 billion issue by the Bank of China that was sold in U.S. dollars, euros, and Chinese yuan. Earlier in the year, Shanghai Pudong Development Bank and China's Industrial Bank raised $3.5 billion in two separate issues. Agencies and corporates have been active, too, including Wuxi Public Transport and Beijing Enterprises Water Group. BAIC Motor Corp. was the first state-owned enterprise to issue a corporate green bond, raising $388 million. The first Chinese green bond was issued in 2015 by wind energy firm Xinjiang Goldwind Science & Technology. It was for $300 million, and like most green bond issues, it was oversubscribed, in this case by more than fourfold.

Meanwhile, demand for green investments continues to spread from a core group of "conviction" investors to a broad range of institutions, including public and private pension funds, insurers, and other long-term investors. In recent months, the New York State Comptroller's Office, major insurers AXA and Allianz, financial services giant HSBC, and investment manager BlackRock have all committed to invest billions in green bonds. And The Portfolio Decarbonization Coalition, a UN-sponsored group of 27 institutional investors and asset managers controlling $3.2 trillion in assets, has committed $600 billion to fund green projects and investments. The group includes France's largest pension funds, the Dutch public employee pension fund, and the Church of Sweden, as well as a dozen asset managers.

These investors are finding that green bonds are similar to core infrastructure investments, providing similar durations and risk as well as the stable and predictable cash flows that pension funds, insurers, and other institutions seek to fund their liabilities. Green bonds offer the additional benefits of reducing climate risk exposure and providing portfolios with another category of fixed-income investment for diversification.

The market still lacks tools

Today, green bonds cannot fulfill their mission as an engine of sustainable growth in China and around the world because the green finance sector still lacks critical standards and tools. While there is clearly growing demand for green bonds and the number of issuers is rising, these financial instruments remain beyond the reach of some investors. They cannot become a more mainstream investing vehicle until they are "institutionalized" with reliable benchmarks and transparent evaluation methods so that they meet governance requirements of all portfolio managers and can be easily traded and incorporated in portfolios.

Green finance has been evolving for more than a decade without the infrastructure and guardrails that have been developed for other investments. In the current system, green bonds are issued under voluntary guidelines and are credit rated like any other bond. But it has fallen to a cottage industry of independent firms that offer second opinions to verify the "greenness" of each issue, specifically, whether the bond will actually be used in ways that address the climate challenge. There are not even universal standards for defining what types of investments qualify. In some countries, "clean coal" could be included in a certified green bond. In others, no fossil fuel-based investments would be eligible. Some firms that provide a seal of approval for the greenness of projects will not bless hydroelectric projects, but others will.

But like the market itself, tools and market institutions are coming of age as well. In the past two years, with a concerted push from the world's largest investors, central banks, multilateral organizations, and regulators in China and other countries, new frameworks and tools for green finance are being developed. In 2015, a group of investors convened by the socially responsible asset manager Ceres issued a Statement of Investor Expectations, which outlined what investors want to see from green bond issuers in terms of criteria, disclosure, and proof of climate impact. The signatories included a who's who of institutions, including the CalPERS pension fund that represents more than half a million current and former California state employees.

Governments should consider incentives

That same year, 27 members of the Climate Bonds Initiative, ranging from AXA and BNP Paribas to Zurich Insurance, signed the Paris Green Bonds Statement, in which these investors, with more than $11 trillion in assets among them, asked governments to support issuance of green bonds through policy, tax incentives, and other mechanisms. They also asked for independent certification of green bonds, as well as greater transparency about the environmental credentials of issuers, particularly corporates.

At its 2016 meeting in Hangzhou, the G-20, for the first time, issued a statement calling for the development of green finance and launched a Green Finance Study Group to create international standards and metrics to assess the impact of green finance. (S&P Global is a member of the study group.)

Following the Hangzhou summit, the People's Bank of China issued guidelines for the nation's green finance industry, and other countries, including India and Mexico, have recently approved green bond frameworks. In December 2016, the Financial Stability Board's task force on climate-related financial disclosures issued recommendations for financial and nonfinancial companies covering 85% of the world's greenhouse gas emissions.

The next step is developing industrial-strength evaluation and benchmarking systems that will give investors and issuers a consistent, rigorous, and transparent method for assessing—and ultimately pricing—green issues. With these tools, ratings agencies will be able to evaluate green bonds both from a financial and an environmental perspective, and eliminate lingering questions of so-called "greenwashing."

In addition, the same green finance evaluations can be applied to bonds that are not specifically labeled green, but which include some green elements. For example, a corporate or municipal bond used partly to finance an energy-efficient building could be rated on its environmental impact. This would be a useful service to portfolio managers who seek some green diversification and could help issuers drum up enthusiasm for debt that supports environmentally-friendly activities. Having a reliable benchmarking system that evaluates the sustainability aspects of investments as rigorously as the financial aspects could be a game changer for economies like China looking to achieve sustainable growth.

What can policy makers do next?

Mandate investor disclosure of portfolio climate risk.

At the heart of any good financial market is transparency, and the next logical step in ensuring the integrity of green finance and its widespread use is to require disclosure of the anticipated climate impact of assets held by investors as well as new issues.

In 2016, France enacted the Energy Transition for Green Growth Act, a sweeping piece of climate legislation that included the first investor climate reporting mandate. Article 173 compels asset owners and managers to disclose climate risks in their portfolios. The reporting must cover ESG issues, as well as requiring information on the carbon footprint of investments.

This enhanced disclosure and transparency is already resulting in re-allocation of capital: In January 2017, France's massive pension fund Fonds de Réserve pour les Retraites (FRR) announced plans to "decarbonize" both its fixed-income and equity portfolios. Such a reporting requirement, if instituted across the EU and beyond, could compel asset managers and funds to start competing for business on the basis of how well they manage investments for sustainability as well as returns.

Require corporate disclosure of climate and broader ESG risk.

A similar mandate could be enacted for issuers. In 2016, the European Commission mandated nonfinancial reporting requirements for companies with more than 500 employees. Companies in their annual financial reports now must disclose information on ESG matters using UN, OECD, and International Organization for Standardization guidelines. Issuers are required to include ESG reporting in any effort to raise capital. Issuers will have to demonstrate how sustainability factors drive longer-term value, providing additional assurances to investors that their green investments will have the intended results.

Green finance is at a classic inflection point

Momentum is building as a rapidly growing number of governments, institutional investors, and corporations acknowledge the financial as well as physical threats posed by climate change and a fossil fuel-based economy. The green finance market is built on this very recognition, and the key to its almost inevitable expansion will be the tools it will provide to help world economies learn how to grow sustainably and mitigate environmental risks.

 

(Editor's note: This commentary was first published by the China Development Forum on March 18, 2017.)