Next Season’s Green Bond Harvest Innovations in Green Credit Markets JUNE 2014 ACKNOWLEDGEMENTS This paper was prepared by the IFC Treasury Market Operations Department and the Kellogg School of Management. The authors are Elizabeth Coston (Kellogg School of Management), Esohe Denise Odaro (IFC), Evelyn Hartwick (IFC) and Jamie Jones (Kellogg School of Management),. It has greatly benefited from inputs and comments from Marilyn Ceci (JPMorgan), Stephen Liberatore (TIAA-CREF), Mary Spelman (IFC), Rusmir Musić (IFC), and Matthew Morrison (IFC). DISCLAIMER This document has been prepared for informational purposes only, and the information herein may be condensed or incomplete. IFC specifically does not make any warranties or representations as to the accuracy or completeness of these materials. IFC is under no obligation to update these materials. This document is not a prospectus and is not intended to provide the basis for the evaluation of any securities issued by IFC. 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All figures contained in the document refer to US dollars unless otherwise stated TABLE OF CONTENTS Acknowledgements ............................................................................................................................. 1 Disclaimer............................................................................................................................................ 1 Introduction.......................................................................................................................................... 3 Background ......................................................................................................................................... 3 What Makes a Bond Green? ............................................................................................................ 5 Rationale .......................................................................................................................................... 6 A Bundle of Firsts ............................................................................................................................. 8 Ready for Harvest ................................................................................................................................ 8 Green Project Bonds ........................................................................................................................ 8 Green Asset Backed Bonds ........................................................................................................... 10 Bank Guaranteed Issuances .......................................................................................................... 11 Social Impact Bonds ...................................................................................................................... 13 Green Trade Finance ..................................................................................................................... 15 The Path Ahead................................................................................................................................. 16 TABLE OF FIGURES Figure 1: Issue size vs. Maturity for Green Bonds, 2012-April 2014 .................................. 7 Figure 2: Structure of IFC Credit Enhancement Offering......................................................... 12 Figure 3: Structure of Greater Gabbard OFTO Novermber 2013 Bond Offering .................... 13 Figure 4: Social Impact Bond Structure ........ 14 NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 2 INTRODUCTION Climate change is not just an environmental challenge. It is a fundamental threat to economic development. Unless the world Capital markets have been a source of funding takes bold action now, a warming planet for green1 investments for a number of years, threatens to put prosperity out of reach for but until recently, financing was predominantly millions of people and roll back decades of from equity. Private equity, venture capital, and development gains. Climate change will affect government funding were the most accessible every region of the world, and those least able sources of capital when green technologies to adapt will be hit hardest. In the poorest such as solar and wind were in early stages of countries, climate change will increase the cost development. More recently, as these of development by 25% to 30%. Inaction today technologies have been tested, proven, and will mean much higher costs in the medium refined, funders have naturally progressed and long term, plus greater risks. along the capital structure towards public equity and debt financing to support growth IFC and the Kellogg School of Management and scale. At the same time, leading financial have collaborated to author this paper which institutions have provided impetus for attempts to cover the bounty of credit tools expanded green investing. available for harvesting by issuers and sponsors, with the aim of attracting new In 2008, the World Bank Group2 issued its investments to green industry. This paper is “Strategic Framework for Development and the first in a series to proffer avenues to Climate Change3,” which outlined the enhance the financial environment towards development challenges posed by global addressing this gap. In November 2013, IFC climate change and sought to develop an produced a stocktaking analysis on existing operational response to them. The report’s mechanisms to mobilize private capital for authoring committee recognized the inclusive green growth in developing “enormous financial gap for addressing climate countries.5 While a number of investors and change” and encouraged the development and corporates are beginning to embed support of market-based financing environmental sustainability governance mechanisms.4The World Bank Group has considerations into their investment strategies, made climate action a top priority as part of its some investors have identified a lack of twin goals to eradicate extreme poverty and investment opportunities, short tenors, boost shared prosperity. insufficient track record and liquidity concerns as barriers to their entry into the budding green credit markets. This paper proposes a brief overview of efforts that could circumvent these 1 We use the term ‘green’ to describe investments in barriers by introducing a mix of innovative climate change mitigation and adaptation. For IFC’s products to attract different kinds of fixed definitions of these terms, please see income investors and draw more private capital ifc.org/climatemetrics into funding green technologies. 2 The World Bank Group consists of five organizations: International Bank for Reconstruction and Development (IBRD), International Finance Corporation (IFC), International Development Association (IDA), Multilateral Investment Guarantee Agency (MIGA), and International BACKGROUND Centre for Settlement of Investment Disputes (ICSID). More information at www.worldbank.org. 3 At the United Nations Framework Convention World Bank. Development and Climate Change: A on Climate Change in 2009, world Strategic Framework for the World Bank Group. 2012. http://siteresources.worldbank.org/EXTCC/Resources/Ful governments agreed to cooperate on limiting lFrameworkDocument1212008Book.pdf the increase in global temperatures to 2° C 4 above pre-industrial levels in order to prevent World Bank Development and Climate Change: A Strategic Framework for the World Bank Group. 2012. http://siteresources.worldbank.org/EXTCC/Resources/Ful lFrameworkDocument1212008Book.pdf 5 IFC. Mobilizing Public and Private Funds for Inclusive Green Growth Investment in Developing Countries. 2013. NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 3 the negative effects of climate change. Without projects examined.10 However, development additional efforts to reduce GHG emissions bank financing alone cannot meet the overall beyond those in place today, emissions growth funding needs necessary to implement is expected to persist driven by growth in resources for climate change mitigation and global population and economic activities. adaption. Conversely, institutional investors Baseline scenarios, those without additional have trillions of dollars in assets of which only mitigation, result in global temperature a small percentage reaches green investment increases from 3.7 °C to 4.8 °C compared to with an even smaller amount going to pre-industrial levels. Getting the world on a 2 developing countries. This is of critical °C emissions path would mean a different importance given that much higher greenhouse investment landscape. Estimates vary on the gas emissions are expected to come from level of investment required to achieve this developing countries. Innovation in pathway6. The International Energy Agency environmental financing through the use of estimates the financing requirement to achieve new instruments and the enhancement of the 2 °C target is $53 trillion in cumulative familiar ones could tap a greater portion of investment to 2035.7 Increasing private sector private investors’ assets to flow towards clean capital is essential to meet this target. To adapt energy projects. to a world 2° degrees Celsius warmer, developing countries will require $75–100 Since the advent of the first Green Bond, billion per year over the next 40 years to build aggregate issuance rose to $19 billion by the resilience to these changes, and mitigation end of 2013. At the start of the year the costs are expected to be in the range of $140– President of the World Bank Group, Jim Kim, 175 billion per year by 2030.8 This is a salient estimated that Green Bond issuance would problem given that over the next two decades, reach $20 billion by September and $50 billion greenhouse gas emissions are expected to by the end of 2015. By late May 2014, year to nearly double in the developing world, although date issuance had grown to $19 billion a decline in the industrialized world is matching the total raised in the first five years expected. of the Green Bond.11 This growth is heavily owed to the entrance of corporate Green Bond The first ever “Green Bond” was issued by the issues. Standard & Poor’s estimates that the International Bank for Reconstruction and corporate Green Bond market in 2014 will Development (IBRD) in 2008 – a SEK2.3 reach $20 billion, double the size of last year’s billion bond9 with a maturity of six years, total Green Bond issuance. Corporate Green instigated by demand from a group of Bonds bring competitive risk-adjusted returns Scandinavian investors. Previously, in 2007, to suit varying risk preferences as they offers EIB had issued a similarly structured bond with investors green exposure without increasing ring-fenced proceeds under the label of their risk appetite as the bonds carry exactly “Climate Awareness Bond.” Multilateral the same credit profile, and pay the same Development Banks (MDBs) were the sole yield, as the issuer’s conventional bonds. issuers of Green Bonds up until 2013 and can JPMorgan Managing Director Marilyn Ceci continue to play a significant role in financing commented that “A big part of the allure of green investment as well as to leverage Green Bonds is that they give investors the significant resources from the private sector to opportunity to invest in a climate-friendly do so. An IFC analysis publicized that one agenda without taking the exposure of dollar of IFC financing was leveraged around individual projects.” four times from private investors across 563 There are now quite a number of participants in the green credit markets including issuers, 6 IPCC. Climate Change 2014: Mitigation of Climate Change Report. 2014. 10 7 Patel, S. and Musić, R., (2013), Leverage in IFC’s IEA. World Energy Investment Outlook. 2014 8 World Development Report 2010. Climate-Related Investments: a Review of 9 years 9 The bond was later increased to a total amount of of Investment Activity (Fiscal Years 2005–2013). 11 Swedish kronor (SEK) 2.7 billion. Climate Bond initiative reporting. NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 4 assurers, underwriters, investors, and  Sustainable land use (including advocates. Underwriters and bookrunners are sustainable forestry and agriculture) playing an increasingly important part of  Biodiversity conservation mainstreaming Green Bonds. A number of  Clean transportation banks have publicly declared that they are  Clean water and/or drinking water.14 committed to the growth of the sector through underwriting. Participating in the Green Bond The GBP also identifies four types of Green market is also becoming an increasingly Bonds: important competitive benchmark for underwriters with the introduction of league GREEN USE OF PROCEEDS BOND: a tables specifically tracking the Green Bond standard recourse-to-the-issuer debt obligation market, such as The Climate Bonds Initiative’s for which the proceeds shall be moved to a Green Climate Bonds Underwriters League sub-portfolio or otherwise tracked by the issuer Table.12 Additionally, assurers play a key role and attested to by a formal internal process in providing credibility within the Green Bond that will be linked to the issuer’s lending and sector as the market expands from the MDB investment operations for projects. Pending sphere to corporate issuers. such investment, it is recommended that the issuer make known to investors the intended types of eligible investments for the balance of WHAT MAKES A BOND GREEN? unallocated proceeds. As with any nascent field, it is important to GREEN USE OF PROCEEDS REVENUE have consensus on definitions and application BOND: a non-recourse-to-the-issuer debt for Green Bonds. Recognizing this need, a obligation in which the credit exposure in the consortium of investment banks came together bond is to the pledged cash flows of the to form a drafting committee for a set of Green revenue streams, fees, taxes etc., and the use Bond Principles (GBP).13 The Principles, of proceeds of the bond goes to related or released in January 2014, outline guidelines unrelated Green Project(s). The proceeds shall for the issuance of a Green Bond. Not only is be moved to a sub-portfolio or otherwise the aim to provide clarity to potential issuers, tracked by the issuer and attested to by a but also to standardize practices and formal internal process that will be linked to the procedures that will improve transparency for issuer’s lending and investment operations for underwriters and investors. While the projects. Pending such investment, it is guidelines are voluntary, they are currently recommended that the issuer make known to supported by 25 investment banks. According investors the intended types of eligible to the GBP, the defining characteristic of a investments for the balance of unallocated Green Bond is how the proceeds are utilized. proceeds. Still evolving are the sectors in which the proceeds must be invested, but for now the list GREEN PROJECT BOND: a project bond for includes: a single or multiple Green Project(s) for which the investor has direct exposure to the risk of  Renewable energy the project(s) with or without potential recourse  Energy efficiency (including efficient to the issuer. buildings)  Sustainable waste management GREEN SECURITIZED BOND: a bond collateralized by one or more specific projects, 12 including but not limited to covered bonds, http://www.climatebonds.net/2014/05/green-bond- underwriters-league-table-released-2013-10-billion- ABS, and other structures. The first source of biggest-issuance-year-yet#sthash.g0bLGPCK.dpuf repayment is generally the cash flows of the 13 Green Bond Principles, 2014: Voluntary Process assets. This type of bond covers, for example, Guidelines for Issuing Green Bonds. January 2014. http://www.ceres.org/resources/reports/green-bond- principles-2014-voluntary-process-guidelines-for-issuing- 14 green-bonds/view For IFC’s climate definitions, see ifc.org/climatemetrics . NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 5 asset-backed securitizations of rooftop solar have proven that there is tremendous investor PV and/or energy efficiency assets.15 interest and much more potential for this product in various structures.” In addition, the matter of certification is touched upon in the GBP. Getting third party Green Bonds are gaining in popularity as a certification on the use of proceeds for new liquid, easy-to-understand instrument, showing Green Bond issuers provides comfort to that climate investment can penetrate the $80 investors that the issuer is putting funds trillion global bond market. For investors, towards eligible and suitable projects. The Green Bonds combine an attractive investment GBP lays out three types of assurers, including proposition with an opportunity to support second party consultants, auditors, and third climate-related projects. party or independent verifiers. Typically, corporate bonds are used to raise capital for Bond issues can be tailored to the needs of general funding needs, without specified use of diverse financial market players and support a capital. However, with Green Bonds, range of corporate as well as government companies are making a commitment to direct climate change mitigation efforts. Subsequent money to very specific types of investment. to the IFC February 2013 Green Bond which Rob Fernandez, VP of Credit Research, and set precedent of a successful jumbo size Tim Coffin, SVP of Consultant Relations of Green Bond, the average size of Green Bonds Breckenridge, believe this could eventually grew from c. $160 million in 2012 to c. $350 have credit implications: “In the municipal million in 2013 to c.$420 million in 2014 YTD market, the use of proceeds is paramount to as illuminated in Figure 2 below. The Green the credit. In the corporate market, if a Bond space is gaining prominence, and if company is issuing a Green Bond, current trends are extrapolated for the full year management is demonstrating their 2014, the global Green Bond market will be commitment to improving their environmental roughly 3.2% of value the US corporate bond risks. When they do that, we believe the market, up from 1% in 2013 and 0.4% in company’s credit profile may be strengthened 2012.16 as well.” As the market continues to expand, we envisage more use of such independent certification, ratings and even auditing. RATIONALE To date, the majority of Green Bonds that have been issued fall under the “use of proceeds” category and are generally vanilla in structure. IFC believes that given the enormous size of the investment required to combat climate change, sensible innovative structures in the credit markets should be encouraged in order to mobilize more private capital to finance climate friendly projects. Evelyn Hartwick, Head of Socially Responsible Bonds Program at IFC states that “Since IFC’s first Green Bond in 2010, IFC has raised $3.4 billion through the program. In 2013, IFC issued a landmark $1 billion offering, which was the largest Green Bond to date at that time. The size of the bond was in itself an innovation towards building market depth and liquidity. Subsequent issues 16 Bloomberg New Energy Finance. Green Bonds Market 15 Green Bond Principles. Outlook. 2014. NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 6 Figure 1: Issue size vs. Maturity for Green Bonds, 2012-April 2014 Source: Bloomberg, Kellogg analysis As the labelled “green” credit market grows, an clearly a focus for us, to target new investors. array of funding products could be utilized to We were very happy to have achieved attract new investors beyond impact investing additional investor diversification. And we do funds and the few early adopters of a “socially think that is one of the advantages for issuers responsible investment (SRI)” mandate. This in Green Bonds.” potential shift in investor type was reflected in the books for IFC’s benchmark Green Bonds in Breckinridge Capital Advisors is one of the 2013. The February bond’s orderbook more recent investors to move into the Green contained 85% of socially responsible Bond space. A US fixed income manager that investors, while the ensuing November bond offers sustainable investment strategies, the had 26% allocated to traditional investors. firm was not initially active in the market for Denise Odaro, Head of Socially Responsible several reasons. Traditionally, portfolio Investor Relations for IFC asserts that “the managers’ preference was for US agencies allocation strategy is a deliberate effort to over MDBs. With the introduction of Green encourage traditional investors to adopt a Bonds, Breckinridge started to take a closer green mandate in their investment themes. In look at these issuers. However, given the small order to fill the financing gap for climate transaction sizes in the early days of the mitigation and adaptation, the market should market, the firm’s investment team had embrace traditional investors to participate”. In concerns about liquidity. IFC’s landmark $1 addition to progressing environmental goals, billion issuance in 2013 brought comfort that Green Bonds also help issuers diversify their the market was liquid and growing, and it was investor base. Suzanne Buchta, Managing with that issuance that Breckinridge began to Director, Bank of America Merrill Lynch participate. The credit team at the firm realized (BAML) Debt Capital Markets said of the that MDB issues provide a solid means of bank’s inaugural Green Bond: “That was diversification into issues that are AAA rated. NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 7 Another Green Bond investor, New York based respectively amounting to a total of EUR2.5 TIAA-CREF Asset Management (TCAM) has billion ($3.5 billion). The bond’s orderbook was long been involved in SRI fixed-income but only open for 2.5 hours and was three times notes that the industry in general is just now oversubscribed with $10 billion of orders started to expand offerings in this space. received reflecting continued strong investor Stephen M. Liberatore, CFA, Managing demand for the product.17 The city of Director and lead SRI fixed-income portfolio Johannesburg South Africa issued a $136 manager for TCAM, mentioned that in the million Green Bond in June 2014 which was publicly traded fixed-income market, investors 1.5 times oversubscribed. It was the first Green can gain exposure to securities that have Bond to come from a municipal authority in an attractive risk-adjusted return potential along emerging market and the first Green Bond to with direct and measurable social and/or list on the Johannesburg, Stock Exchange.18 environmental benefits. TCAM moved into Green Bonds in early 2010 and has since invested over $500 million in various Green READY FOR HARVEST Bonds, expanding its holdings from supra- sovereign agencies to include those from As noted earlier in the paper, the majority of corporate and municipal issuers as well as Green Bonds issued so far have fallen under structured securities. the use of proceeds category; the bond payment cash-flows are not dependent on A BUNDLE OF FIRSTS revenues from the funded projects but rather from the issuer’s balance sheet. Therefore the Thus far, 2014 has seen a number of debuts in use of proceeds bonds rely on the credit rating the public green credit markets. Noteworthy of the issuer which, prior to the entrance of transactions include Toyota as the first auto corporates, has been mainly triple-A rated services company to enter this arena and the MDBs. Towards broadening and sustaining the first to bring an asset backed transaction with growth of the environmental finance market, its $1.75 billion multi-tranche Green Bond in there are some interesting innovations, some March. Unilever was the first company in the already employed, that could deepen the types consumer packaged goods industry as well as of credit available in the green market. Here, the first issuance in pound sterling with its five are presented. GBP250 million ($411 million) bond also in March. In the same month, Solactive AG GREEN PROJECT BONDS launched Solactive Green Bond Index, first index in the market to provide exposure to Project bonds have been outlined in the Green Green Bonds. The MDBs have also continued Bond Principles as a potential source of to innovate in the market: EIB issued the first financing for green projects. There are several Green Bond in Samurai format while IBRD aspects which distinguish them from use of issued the first benchmark “Kangaroo” Green proceeds bonds in terms of their risk profile. As Bond in April. In May, Regency Centers their name suggests, project bonds are used to became the first US Real Estate Investment fund pre-identified projects, with investors Trust (REIT) to enter the Green Bonds space directly exposed to the risk of those projects. with a 10 year, $250 million corporate bond This is in contrast to the use of proceeds linked to their portfolio of shopping centers. bonds where proceeds go into a carved out Until recently, the biggest single issue Green sub-portfolio within general funds and where Bond was EDF’s November 2013 EUR1.4 investors are exposed only to the risk of the billion bond ($1.9 billion), the first Green Bond issuing institution. While use of proceeds in euros by a large corporate. It was twice oversubscribed and was a great success 17 http://www.environmental- among institutional investors. In May 2014, finance.com/content/news/gdf-suez-issues-record- French multinational electric utility company, breaking-%E2%82%AC2.5bn-green-bond.html 18 GDF Suez, issued its first Green Bond in two http://www.bloomberg.com/news/2014-04- tranches of six and twelve year tenors 17/johannesburg-plans-meetings-in-may-to-market- debut-green-bond.html NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 8 bonds are recourse to the issuer, that is not five year, secured offering21. They noted that necessarily the case with project bonds. interest in the bond was strong, and that the Instead, the bonds may be secured by the “environmental quality stamp has been assets for which construction is being funded. important for many investors.”22 They also provided a second opinion from the assurer There are a number of reasons why project DNV that the bond meets the criteria of the bonds have not been widely used in the Green Green Bond Principles. Given that the bond Bond market thus far, although they show was not rated, this second opinion may have potential. Primarily, project finance does not been something the company felt was represent a large portion of the traditional fixed important to provide investors additional income space, and thus one would not expect comfort. it to represent an outsized portion of the Green Bond space either. In 2013, there was $204 MidAmerican Energy, a US-based utility, has billion of project finance issuance, or about 3% also come to market with two project finance of the $6.1 trillion issued in debt capital bonds, albeit ones with very different terms markets globally.19 Investors have waded into than the Arise issue. In February 2012 the the Green Bond market at the low end of the company issued its first Green Bond, a 28 risk spectrum, flocking to issues with triple-A year, $850 million issue to finance the Topaz ratings having yields very similar to those solar project. This was upsized from an initial offered by non-Green Bonds. Project bonds $700 million after being oversubscribed. At the are more likely to be either lower rated or time, this represented the largest bond offering unrated altogether. This is because projects for a renewable-energy project without a U.S. entail a certain level of construction and government guarantee, demonstrating that delivery risk which prevent a premium rating. green capital markets can be supported According to a KPMG report addressing the through the private sector. The company project finance market, the majority of UK followed up on that offering with a $1 billion, 22 public/private partnership projects have had an year bond in June 2013. The maturities of underlying rating of BBB-/BBB. Meanwhile, the these bonds were significantly longer than the most significant liquidity in the bond markets average Green Bond outstanding at 6.5-7 occurs at credit ratings of BBB+ and above.20 years.23 Both issues were rated initially Baa3 by Moody’s and later upgraded to Baa2 in April However, as investors become more 2013. These bonds demonstrate proof of comfortable with the Green Bond space and concept for the project financing market, given start to seek diversity in the credit ratings and their maturity and credit rating do not match duration of their investments, project finance is the typical Green Bond profile but were by all one structure in which they are expressing measures well received by the market. interest. The most recent project financing bond to come to market was from Arise, a The most obvious candidates for future project Swedish wind power company. In April 2014, finance issues are companies pursuing large the company raised SEK 1.1 billion ($160 scale renewables projects as well as public million) to refinance 10 wind projects through a sector entities with climate resilience projects. Real estate developers like Vasakronan that 19 $204 billion figure from Thomson Reuters. “Asian Banks Top Project Finance Deals in 2013.” January 17, 21 2014. Arise AB press release. “Arise successfully issues a http://www.reuters.com/article/2014/01/17/projectfinance- five year green bond of SEK 1.1 billion.” April 15, 2014. rankings-idUSL5N0KR1L820140117 http://globenewswire.com/news- $6.1 tn figure from Dealogic. Global DCM Review, Full release/2014/04/15/627276/0/en/Arise-successfully- Year 2013. issues-a-five-year-green-bond-of-SEK-1-1-billion.html 22 http://www.dealogic.com/media/89098/dealogic_global_d Climate Policy Initiative. The Global Landscape of cm_review_-_full_year_2013_-_final.pdf Climate Finance 2013. October 2013. 20 KPMG. Project Finance and the Capital Markets: http://climatepolicyinitiative.org/wp- Bridging the Divide. content/uploads/2013/10/The-Global-Landscape-of- https://www.kpmg.com/AE/en/IssuesAndInsights/Articles Climate-Finance-2013.pdf 23 Publications/Documents/markets/Project_finance_and_C Kellogg calculation based on size-weighted average apital_Markets.pdf maturity of currently outstanding bonds from Bloomberg NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 9 are emphasizing green construction could also historically been the mainstay. A step towards conceivably raise capital through project achieving scale adequate for green financing. Municipalities pursuing infrastructure securitization would be the use of credit projects such as water or waste treatment enhancement by public or private entities to facilities might also employ green project lower the credit risk for investors in early clean financing. Investors could vary depending on energy ABB issues. the nature of the issue. In the corporate realm, Google has been an active project financier, Hannon Armstrong Sustainable Infrastructure committing over $1 billion to wind and solar pioneered the green ABB market in 2013 with projects. It would also make sense for its issuance of a $100 million ABB backed by individuals, mutual funds and insurance the cash flows of over 100 wind, solar and companies to begin to take a look at this energy efficiency projects at 20 properties space, given their interest in long-dated assets. across the US. Total green asset-backed bonds issued since that date – across five Having said that, project bonds are only really deals from four different issuers – is $2.08 accessible to well-capitalized project sponsors billion. In November 2013, SolarCity’s initial developing onshore wind or solar PV projects solar-backed ABB marked the first step in relatively established renewable energy sounding out investor demand for the product, markets. Otherwise sponsors would have to although small at $54.4 million. The company raise the coupon significantly to attract issued a second ABB ($70.2 million) in March investors. Clean Energy Pipeline reported that 2014. Toyota Financial Services issued the of the eleven project bonds completed auto industry’s first green ABB in the amount of between 2012 and 2013, only one (Soitec $1.75 billion. The offering was upsized from Solar’s Touwsrivier solar CPV project) was for $1.25 billion to accommodate demand as a project that did not have a major energy institutional investors demonstrated strong company or an institutional investor sponsor. interest in investment opportunity. Toyota’s Also, as of October 2013, no project bond had bond takes the form of a standard auto-loan ever been executed for a biomass or offshore backed asset backed security whose cash wind project, undertakings which are much flows are tied to repayments of outstanding riskier from a technology perspective.24 loans for the company’s cars. Proceeds of the bond will be used to fund new retail finance contracts and lease contracts for Toyota and GREEN ASSET BACKED BONDS Lexus vehicles that meet specific green criteria, including powertrain, fuel efficiency Asset backed bonds (ABB) typically allow and emissions. financing to be based primarily on the risks of asset pools rather than solely on the credit risk Green mortgage-backed securities are also an of a project sponsor. ABB can play a role in option. As the US Energy Efficiency Mortgage expanding sources of funding and possibly Program explains, lower energy costs mean reduce borrowing costs for climate projects. that building owners are more able to repay For sponsors unable to access funding at the mortgages—and they are a better credit risk25. desired tenor and cost because of perceived As mentioned above, commercial banks could credit risk, ABB can be employed. In the participate in this market and possibly offer a climate space, solar and energy efficient price advantage for green mortgages. Such buildings securitizations have been done in the loans could then be preferentially treated for US in recent months. However, this remains an capital ratio purposes, or securitized and sold infantile market. A key hurdle limiting the as Green Bonds with an enhanced credit rating growth of this asset class is that the size of compared to “ordinary” mortgages. green investments are relatively smaller than those in other sectors where securitization has 24 25 http://www.cleanenergypipeline.com/download/cleanener U.S. Department of Housing and Urban Development, gypipelineweeklyreview8123413.pdf 2013. NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 10 BANK GUARANTEED ISSUANCES IFC provided a 20% guarantee to Ciputra Residence's IDR26 504billion ($44 million) There is an opportunity to expand the market three-tranche bond. The bond proceeds will go further by adding on credit guarantees or towards constructing buildings that meet enhancements. There are a couple of ways to environmental standards. The bond sale was achieve this: a bank could provide a loan to the divided into three tranches – an IDR200 billion issuer at the outset of the project, or it could three-year with a coupon of 11.4%, an IDR224 provide a contingent credit line to be drawn billion five-year with a coupon of 12.4% and an upon if the revenues of the project are not IDR80 billion seven-year with a coupon of sufficient to ensure senior debt service. The 13.0%. IFC’s partial guarantee bumped up the effect of either option would be the same, ratings of the bonds by one notch to single-A. namely elevating the credit quality of the senior The partial guarantee reduces the loss severity debt sold to investors. The bank guarantee in the case of a default. The rating increase would enable issuers who are developing was based on an overall recovery estimate, projects with a certain degree of risk to access taking into consideration the execution of the investors who otherwise might not be guarantee and the proceeds from company interested in the credit. liquidation. Orders for the bonds reached more than IDR1trillion. The structure of the For corporate bonds, IFC provides partial transaction can be seen in Figure 2 below. credit guarantees to enable issuers to gain access to the market (through rating enhancement for example, if they need to reach a specific rating to attract key institutional investors). The recent Ciputra Residence transaction in Indonesia is a good example of this. This is the first IFC green building project in the East Asia-Pacific region with a commitment from the client to reduce energy consumption by at least 20% compared with benchmarks for equivalent buildings. It sets a precedent for the housing and property sector. 26 Indonesian Rupiah (IDR). NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 11 Figure 2: Structure of IFC Credit Enhancement Offering The EIB and the European Commission have mentioned that the Gabbard deal was “the first also begun to explore this option through the round 1 OFTO of sufficient size to have Project Bond Initiative, which was created to attracted the interest of the capital markets.”28 foster institutional investment in eligible The credit guarantee was exactly what was infrastructure projects throughout the needed to entice institutional investors, one of European Union. The funding provided through the goals of the program. Indeed, the this pilot program is specifically geared announcement of the deal highlighted that towards projects in the energy, transport, and “unlocking support of institutional investors to information and communication technology provide long-term investment in European sectors, although it is not exclusive to green energy infrastructure is crucial for stimulating projects. However, one green project has economic growth and creating new jobs.”29 already been supported through the initiative. While this example utilizes an MDB, it is In November 2013, the Greater Gabbard conceivable that a commercial bank could offshore transmission link (OFTO), a UK-based create a Special Purpose Vehicle (SPV) to offshore wind project, issued a GBP27 305 fund its next large scale green projects and million project finance bond with a 4.137% provide a credit guarantee in order to attract coupon due in 2032. The proceeds of the bond investors and achieve a lower cost of capital. were used to finance a new transmission link to connect the wind farm with the mainland electric grid. The EIB provided a GBP45.8 million guarantee in the form of a contingent credit line, which represented 15% of the bond 28 issued. This enabled a credit rating of A3 from European Commission Interim Report on the Pilot Moody’s, which the rating agency noted was Phase of the Europe 2020 Project Bond Initiative. December 2013. http://eur-lex.europa.eu/legal- one notch higher than a standalone credit content/EN/TXT/PDF/?uri=COM:2013:929:FIN&qid=1395 would have received. The structure of the 926421930&from=EN transaction can be seen in Figure 3. 29 European Investment Bank. “Second Project Bond Issue for Great Gabbard OFTO Demonstrates Strong The European Commission’s interim report on Investor Interest.” December 2, 2013. http://www.eib.org/projects/press/2013/2013-204- the pilot phase of the Project Bond Initiative institutional-investor-support-for-greater-gabbard- offshore-transmission-link-encouraged-by-first-use-of- 27 British Pound Sterling. project-bond-credit-enhancement-scheme-in-uk.htm NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 12 Figure 3: Structure of Greater Gabbard OFTO November 2013 Bond Offering Source: Greater Gabbard OFTO Plc Prospectus Filing The mechanism might also be particularly payment, and only have to commit their appealing to issuers whose credit ratings are resources to a solution once results are on the cusp of investment grade. Many achieved. The external organizations that are pension and insurance funds have explicit providing an intervention are guaranteed a restrictions against high yield investments long term funding source, and investors are written into their by-laws. An increase of one to able to earn both financial and social returns. two points into investment grade territory provided by a credit enhancement could make Up until this point, SIBs have exclusively all the difference in attracting those types of addressed human capital challenges, but there investors. is reason to think the structure could work for environmental ones as well. When considering SOCIAL IMPACT BONDS a commitment to combat climate change, the same factors are at play. Governments are Social Impact Bonds (SIBs) made their debut often theoretically supportive of the in 2010 as an innovative way to finance investments required, but do not have the projects or interventions that have a positive upfront capital required to make them. Through social impact and result in public sector such investments, governments have the savings. Their label is a misnomer, as SIBs are potential to see cost benefits both directly in not actually credit instruments. In fact, they areas such as energy savings, and indirectly in allow for private capital to fund long term areas such as the healthcare or infrastructure projects, with governments providing a variable costs (which may be associated with return at the end of project through repayment environmental factors such as air or water of a portion of the cost savings. A generic quality). There are plenty of organizations that structure for an SIB can be seen in Figure 5.30 can execute energy efficiency improvements, The innovation in SIBs is that governments can climate mitigation and other green strategies, support services without providing upfront but lack a steady long term capital source to do so. Finally, as demonstrated by the successful 30 reception of Green Bonds thus far, there are Costa, Kristina and Jitinder Kohli: “Social Impact Bonds: New investors who are interested in funding projects York City and Massachusetts to Launch the First Social Impact that deliver both social and financial returns. Bond Programs in the United States.” Center for American Progress. November 5, 2012. http://www.americanprogress.org/issues/economy/news/201 In a working paper from the CASE i3 Initiative, 2/11/05/43834/new-york-city-and-massachusetts-to-launch- David Nicola provides a case study of how an the-first-social-impact-bond-programs-in-the-united-states/ SIB could be applied to a $400 million market opportunity in the storm water system of NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 13 Philadelphia, Pennsylvania. Storm water has to the asset class for its secure income stream the potential to be a massive environmental and low risk profile. Cathy Clark, Director of the issue, as poor management of a system is tied CASE i3 Initiative on Impact Investing at Duke to water pollution, which generates adverse University’s Fuqua School of Business, argues health effects as well as remediation costs. that Environmental Impact Bonds (EIBs) may Cities can stave off these challenges by even have advantages over SIBs. One of the developing “green” infrastructure. An SIB could challenges with SIBs is that it is difficult to provide upfront capital for green infrastructure. create and track social metrics. Clark notes: “In In this case, the project’s success would be the EIB ecosystem, however, many measured by the reduction of storm water standardized metrics already exist, and thanks runoff which translates into cost savings that to scientific knowledge and rigorous Nicola estimates could be paid out within five environmental monitoring already underway, years. He outlines several different payment we can readily develop new ones.”32 mechanisms, each with varying degrees of Additionally, she points out that while an risk. Private investors could expect to achieve improvement in social outcomes such as anywhere from a 4.6% to 13.4% IRRs if the reduced recidivism may have positive cash project met or exceeded expectations.31 Given flow consequences for a municipality, natural the high degree of variance in the potential resources have actual revenue streams return scenarios, SIBs are unlikely to appeal to associated with them. This simplifies traditional fixed income investors who gravitate structuring and would allow, Clark argues, for payment streams during the life of the EIB that could “entice more conservative investors.”33 Figure 4: Social Impact Bond Structure Source: Based on Center for American Progress diagram of Goldman Sachs recidivism SIB 32 Clark, Cathy: “Bringing Social Impact Bonds to the Environment.” Stanford Social Innovation Review. November 26, 2013. 31 Nicola, David J. “Environmental Impact Bonds.” CASE http://www.ssireview.org/blog/entry/bringing_social_impa i3 Working Paper. November 2013. ct_bonds_to_the_environment 33 http://sites.duke.edu/casei3/files/2013/03/CASEi3_EIB_R Ibid. eport_FINAL-links.pdf NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 14 tenors for the financing of equipment and GREEN TRADE FINANCE projects that have climate change benefits. In fiscal year 2013, 8% of IFC’s trade transaction Trade finance provides a market-based volume was climate-related. A number of solution to the differing needs of importers and players active in the traditional trade finance exporters, and is an essential part of the global space have already carved out portfolios economy. About $125 billion of trade financing dedicated to financing green trade. For transactions occurred worldwide in 2013.34 example, the US Export-Import Bank has a The provision of letters of credit, loans for program called “Renewable Express,” which import/export, and performance guarantees provides funding to small-scale solar projects are all included under the trade finance developed for the export market. umbrella. Trade finance is characterized by its low risk profile. The International Chamber of In time, given the right regulatory and policy Commerce trade register reports a 0.021% environment, commercial banks could be default rate on short term trade finance encouraged to follow suit issue and offer a instruments from 2008-2011, despite high price incentive or longer tenors for equipment volatility in the global capital markets during and projects that have clearly defined climate this timeframe.35 Until Basel III, banks had change benefits as IFC has with its Climate developed few products to package and sell Smart Trade. A simple structure could be trade finance instruments to investors, as they implemented such as bundling loans or letters were content to hold them on their own of credit into a vanilla product that institutional balance sheets. However, a change in the investors could buy. In fact, Korea’s Export- regulatory environment has meant stricter Import Bank (KEXIM) has done something capital requirements, which has in turn along those lines already. In February 2013, prompted banks to look for ways to pass the bank came to market with a Green Bond. It project finance investments on to investors. was structured as a use of proceeds bond, and KEXIM only described the proceeds as going The key group of institutions that currently act to extend loans to climate-friendly projects. So as intermediaries in general trade finance are it was not exactly advertised as a trade MDBs and Export Credit Agencies (ECAs). For financing product, but the bulk of KEXIM’s example, IFC has a $5 billion Global Trade business is conducted in that market. Investor Finance Program (GTFP), which provides uptake of the issue was extremely strong. The guarantees to banks involved in financing trade $500 million offering received $1.8 billion of in emerging markets. These guarantees are orders and ended up being priced at a slight transaction-specific and can take the form of premium to a comparable non-green KEXIM letters of credit, trade-related promissory issue.37 notes, accepted drafts, bills of exchange, guarantees, bid and performance bonds and The composition of the investor pool in the advance payment guarantees. An expansion case of the KEXIM issue was about 70% into corresponding green versions could be impact funds and 30% mainstream funds. So it considered. IFC also has an initiative called is likely that impact investors would be strong “Climate Smart Trade”36, which provides supporters of green trade finance products. support in the form of price incentives or longer But institutional investors would also benefit from the low volatility and portfolio diversification that trade finance provides. In a 34 Dealogic. Trade Finance League Tables, Full Year 2011 interview, the vice chancellor for 2013. January 7, 2014 investments at Vanderbilt University explained 35 International Chamber of Commerce. 2013 Global the school’s investment in a trade finance fund: Risks Trade Finance Report. April 2013. http://www.iccwbo.org/products-and-services/trade- 37 facilitation/icc-trade-register/ Kidney, Sean: “Korean Exp-Imp Bank $500m Green 36 Bond: way-oversubscribed, 95bps over UST. Bingo & http://www.ifc.org/wps/wcm/connect/industry_ext_content bravo!” Climate Bonds Initiative. /ifc_external_corporate_site/industries/financial+markets/t http://www.climatebonds.net/2013/02/kexim-green-bond/ rade+and+supply+chain/gtfp/gfm-tsc-gtfp-ee-info NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 15 “In a broadly diversified portfolio you need strategies like this—ones that are not immediately sensitive to spreads widening or interest rates rising.”38 So as long as the product looks roughly comparable to non- green trade finance, institutional investors are likely to line up as well. THE PATH AHEAD Many of the efforts to develop new financing instruments that address climate change have been successful thus far. Although the seeds of the green market have only just begun to sprout, there is vast potential ahead. Attracting private investors to the climate finance arena is an imperative element towards addressing the financing gap for climate change mitigation. Institutional investors are a subject to varied regulatory constraints with a complex array of service providers and multiple investment approval steps which makes introducing new asset classes or investment themes a lengthy process. In spite of this, a number of investors and corporates are beginning to embed environmental sustainability and governance considerations in their investment strategies. Still to be considered is the regulatory environment in which these green credit markets are developing. The next paper will explore what policies and regulatory changes could support their continued growth. 38 Tuinick, Britt Erica: “How hedge funds are financing the Latin American trade Boom.” Institutional Investor. April 1, 2011. http://www.institutionalinvestor.com/popups/printarticle.as px?ArticleID=2796745 NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 16 ABOUT IFC ABOUT THE KELLOGG SCHOOL OF MANAGEMENT IFC, a member of the World Bank Group, is the largest global development institution focused The Kellogg School of Management is one of exclusively on the private sector in developing the world’s top business schools. Located in countries. Evanston, IL, near Chicago, Kellogg was founded in 1908 and has earned a global Established in 1956, IFC is owned by 184 reputation as a leading management member countries, a group that collectively institution, particularly in the marketing determines our policies. Our work in more than discipline. Kellogg is known for its a 100 developing countries allows companies collaborative, team-oriented student and financial institutions in emerging markets culture. For more information about the to create jobs, generate tax revenues, improve Kellogg School, corporate governance and environmental visit http://www.kellogg.northwestern.edu. performance, and contribute to their local communities. ABOUT IMPACT INVESTING AT KELLOGG IFC’s vision is that people should have the Impact investing at Kellogg is linked with the opportunity to escape poverty and improve school’s work in social innovation, which is their lives. designed to address the converging challenges that students and industry professionals face IFC provides financing for a variety of today as they strive to create inclusive global sustainable energy and climate change prosperity. As part of the growth and scaling mitigation ventures. Through its sustainable track of the Kellogg Innovation and energy investments, IFC has played a Entrepreneurship Initiative, impact investing is pioneering role in helping to remove barriers developing the next generation of investment for clean energy technologies and services in professionals who serve a dual mandate of emerging markets. benefit and returns, and is advancing thought leadership in this emerging field. NEXT SEASON’S GREEN BOND HARVEST: INNOVATIONS IN GREEN CREDIT MARKETS 17 Contact Information: IFC Investor Relations International Finance Corporation 2121 Pennsylvania Avenue NW Washington, DC 20433 Web www.ifc.org/investors Twitter @IFC_Investors 2014