Could climate bonds pave the way to a low-carbon economy?

They’re still a niche product with a reputation for attracting ‘tree huggers’ but climate bonds are gaining mainstream momentum.

We may have ideas for what we must do to move the world economy from its current high-carbon path to a low-carbon future. The problem now is how to pay for them.

Inevitably, much of the heavy lifting will have to be done by the bond markets, which are more suited than equity markets to the long-term investments that need to be made in power infrastructure, transport networks, agriculture, water, waste buildings and industry. Investors, particularly those that have signed up to the UN-supported Principles for Responsible Investment, are increasingly looking to put their money towards areas that will provide returns that are more sustainable and climate bonds are the ideal vehicle for this.

“Bonds are particularly suited for providing the capital for the long-term environmental infrastructure required to build a low-carbon, climate-resilient economy,” says the Climate Bonds Initiative, which campaigns for more investment in low-carbon solutions.

According to HSBC, around $10tn  (£6.5tn) of low-carbon investment was needed between 2010 and 2020 in the energy sector alone, $6tn of it in the form of debt. Climate bonds, where the money raised is allocated purely to low-carbon activities, could be crucial.

The market is growing rapidly – in 2012, $74bn of climate bonds were issued, 25% more than the previous year, says Bridget Boulle, programme manager at the Climate Bonds Initiative. That makes the total climate-themed bond market now worth $346bn. Issuance remains dominated by the transport sector, particularly rail, followed by energy.

Nonetheless, compared to the size of the overall market, issuance remains tiny. “When climate bonds are issued, demand seems to be reasonably strong,” Boule says. “The lack of products is the biggest barrier to the growth of the market.”

Most climate bonds issued to date have come from the multilateral development banks such as the World Bank, the European Investment Bank and the International Finance Corporation. Stuart Kinnersley, portfolio manager of the Nikko Asset Management World Bank Green Bonds fund, says the rationale is clear. “The World Bank’s primary mission is sustainable development and the reduction of poverty. There is clearly a strong environmental aspect to that. It wanted to mobilise capital in this direction.”

Crucially, the bonds offer the same yields as other World Bank bonds, but investors get the transparency of knowing how the money they allocate will be used. “It is important to provide mainstream returns,” Kinnersley adds. “It’s also about giving investors more choice about where their money goes. That has been a big weakness in the global bond market for many years. If you lend to a sovereign [government] you have no influence on how the money is used. These bonds go to specific projects that reduce emissions or alleviate the adverse consequences of climate change.”

Some companies have also issued project bonds to finance particular renewable energy projects, such as the $1bn raised by Warren Buffett’s MidAmerican Energy to pay for the world’s biggest solar farm in California.

Currently, the main buyers are ethical investors, but mainstream institutions are starting to look at the market. “There is a lot of underlying interest. But translating that into final demand is more problematic,” Kinnersley says. Partly this is because few investors are aware of the market, while many that are aware think it is too small and illiquid. “At the moment, the big pension funds still look at this as a relatively small space. But equally, a lot of investors just don’t know that these bonds exist.”

The market currently lacks much of the infrastructure it needs to attract investors, says Dr Steve Priddy, head of research at the London School of Business and Finance. “There is huge potential for the market to grow but it needs established indices so investors can understand the performance of climate bonds relative to each other and the institutional framework that will allow investors to trade them.”

There are systemic barriers that limit the market’s expansion, he adds. “All pension funds have mandates that dictate what they should invest in. If you are up against a mandate that says the fund should track the index, it is very difficult to invest in climate bonds.”

The green or climate bond label is too niche, says Tim Currell, global head of sustainable investment and corporate governance at Aon Hewitt. “It makes it look as if only tree huggers need apply. It creates a sort of ghetto. And at the moment, there are not many investment grade bonds out there. Institutional investors like pension funds need investment grade because it is lower risk.”

There are signs, however, that investors are starting to appreciate the qualities of green bonds. The state of Massachusetts recently tried to raise $1bn, $100m of it for green projects. According to Boule, the green tranche – the first green issue by a US municipality – was oversubscribed while the rest was undersubscribed, raising only $575m. That kind of thing makes the banks sit up and take notice and many more are likely to seek to get involved in the market.

Climate bonds are gathering momentum, says Raymond Seagar, head of sovereign, supranational and agency debt at Bank of America Merrill Lynch. “It’s still a niche product, but there is greater interest from investors and issuers alike. It will grow from here.”