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Can Climate Bonds Advance Renewable Energy Finance?

Victor Hugo once wrote that “there is nothing more powerful than an idea whose time has come.” This little piece of wisdom, penned in the aftermath of the French Revolution, applies well to the emerging topic of climate bonds.

Climate bonds are increasingly being discussed at the highest levels among leading banks, fund managers and investors around the world. If they can be successfully scaled, they have the potential to revolutionize the way renewable energy projects are financed worldwide.

According to the Climate Bonds Initiative, climate bonds ‘‘are themed, asset-backed or ring-fenced bonds specifically issued to finance climate mitigation and adaptation measures.’’

There are three primary drivers behind this growing interest:

First, a number of analyses by both banks and by leading international bodies have pointed to an approximately US $1 trillion annual shortfall in low-carbon investment over the next three to four decades.

Second, it has dawned on many that if we are going to successfully address the climate issue, the investment community is going to have to play a central and pro-active role.

And third, many investors and fund managers are being squeezed by historically low government bond yields, and are actively seeking better returns in new sectors and asset classes that were previously off the radar.

Currently, renewable energy projects around the world, from the U.S. to India, and the European Union to Sub-Saharan Africa, are largely financed on a one-off basis. This leaves each individual project lender or investor to manage the unique risks that each project faces.

In response, governments, investors, and utilities have developed various policy and regulatory instruments to help reduce these risks. These include long-term contracts, government guarantees, currency agreements, and a set of technical measures such as the priority dispatch rules.

Despite these various measures, investors often remain exposed to a host of other less manageable risks, including political and economic risks, which are harder to hedge.

Given that the majority of renewable energy projects are smaller than US $50 million, many of the investors and fund managers that may want to finance these kinds of low-carbon assets simply can’t: deals are too small, due diligence demands are too great, and the individual project risks are both too disparate and too high.

The result is that in almost every jurisdiction in the world, financing renewable energy projects is far costlier than it could be. Moreover, this means that these projects are more expensive for consumers, making the transition to a low-carbon energy system slower, costlier and more challenging to implement politically.

Climate bonds have the potential to change this.

They enable individual projects, with all their unique risks and exposures, to be pooled, reducing the cost of debt and making renewable energy even more competitive. This matters, because the cost of capital is one of the primary determinants of project costs.

Also, by pooling and effectively securitizing renewable energy projects, they create a recognizable product that investors can buy, and one that can be bundled into larger offerings, making it possible for the largest funds to participate. This helps match investment flows to the scale of the challenge of creating a low-carbon future.

In a major deal announced in February, the International Finance Corporation (IFC) issued a US $1 billion bond to support renewable energy and energy efficiency projects in the developing world, making it the largest climate-themed bond issuance to date. It attracted investors from around the world, including some of the better-known players in the market such as California’s teachers retirement fund (CalSTERS) and the Washington State Investment Board.

What is perhaps more important than the diversity of investors is the fact that the major issuances in recent months, like the IFC’s, have had solid bid-to-cover ratios (ranging from 1.5 – 2.5), an indication that demand currently far outstrips supply.

And yet, despite their growing appeal, some challenges remain.

While there is a wide range of low carbon investments out there, not all of them are well suited to being bundled up and sold as bonds. A number of issues need to be resolved if they are to be scaled successfully, including the standardization of the origination process (i.e. which projects qualify, and on the basis of what underlying conditions), and the establishment of credible certification and verification processes.

However, if this scale-up is successful, what could emerge over the course of this decade is an entirely new universe of standardized, asset-backed, triple-bottom-line investments that significantly increase the flow of capital to low-carbon infrastructure worldwide.

Now that would be powerful.

Toby D. Couture is Director of Renewable Energy at IFOK GmbH in Berlin, a leading international consultancy working on renewable energy and sustainability issues worldwide. Sean Flannery is Director of Investable Sustainability Strategies at Meister Consultants Group (MCG), IFOK’s Boston-based subsidiary. He sits on the advisory board of the Climate Bonds Initiative. 

Lead image: Chart and coins via Shutterstock

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