Green bonds: The $2 trillion opportunity 

Amazon founder Jeff Bezos calls India one of the fastest-growing markets in the world. While cut-throat competition is par for the course in ecommerce, here’s another humongous market that the environment-conscious entrepreneur could consider: Green bonds. And the competition’s not so intense. In fact, even if Bezos—currently the richest person in the world—invested his entire personal worth of more than $100 billion, there would be space for at least another 18 more similar investments in Indian green bonds.

Does this sound unbelievable? No, the numbers are not plucked out of thin air—according to figures we’ve culled from websites of government ministries—including the ministry of housing and urban development and the ministry of new and renewable energy—India needs at least $1,913.7 billion (Rs 120 lakh crore) to finance green infrastructure projects. And it’s open for business.

Before we break it down to what India needs the money for, it is worth considering how much the country spends on infrastructure. According to a Bank of America Merrill Lynch (BofAML) report, the country spends approximately $140 billion annually on infrastructure, growing at 15%-16% every year, of which 30%, or $40 billion, gets categorised as green infrastructure. A minuscule amount of that comes from green financing, including green bonds.

Confused? Let’s tackle what a green bond is. It is a fixed-income debt instrument with a fixed tenor and interest rate and is no different from a regular bond except in one respect: The issuer publicly states that it is raising capital to fund “green projects”, assets or business activities with environmental benefits. Funds can be raised from all hues of investors—financial institutions, sovereign wealth funds, multilateral agencies, private equity firms or even corporate entities.

“Green bonds are an important financial instrument that can mobilise private sector investment into climate-smart infrastructure projects,” says Monish Mahurkar, vice-president, corporate strategy and resources, International Finance Corporation (IFC). Green bonds can be raised both in the international and domestic markets, but funds are usually raised in dollars.

Besides green bonds, green financing has many other forms—both in debt and equity. It can also include grants, equity, guarantees, and subordinate debts—a loan or security that ranks below other instruments with regard to claims on a company’s assets or earnings.

Since that’s taken care of, let’s put the issue in perspective: India has raised $6.15 billion through green bonds since 2014, lagging way behind China which raised $37 billion in 2017 alone. Again, in terms of corporate bonds and debentures, the past four years (till May 2018) saw the issuance of $377.61 billion and public issues of $16.81 billion in India. A BofAML report forecasts that by 2020, China will issue $55 billion of green bonds every year, while India and Japan will issue a far lower amount of $15 billion each.

While the target seems ambitious, this is something India needs to fulfil its pledge of bringing down its carbon emissions intensity—emission per unit of its GDP—by 33%-35% from 2005 levels by 2030, under the 2015 Paris Agreement on Climate Change. And, the reduction has to happen even while its economic activities increase in line with its aspiration to become a developed economy.

Let’s look at why India needs this kind of money. Meeting the target of 175 gigawatt of renewable energy capacity by 2022 will require $100 billion (this has been revised to 227 GW); new metro networks in 10 cities with a population of more than two million, another $7.7 billion; development of electric vehicles by 2030, $667 billion; 2.5 million green homes by 2020 would need $1 trillion; municipal waste management projects by 2030, some $11 billion; and urban wastewater management, another $128 billion. According to a report by the International Energy Agency, India’s absolute energy demand by 2040 is likely to be 25% of global energy demand—the growth fuelled by new infrastructure, an expanding middle class, and 600 million new electricity consumers. Hence, the urgent need for green financing.

Take renewable energy. Of the targeted 175 GW, India’s current renewable capacity is 69 GW. “Given that renewable power plants operate at a far lower efficiency than a thermal power plant—the utilisation level is around 7%—much more generation capacity will be required to meet the targeted figure,” says Amish Shah, BofAML director and co-head of India Equity Research.

Since most renewable power projects work on an 80% debt and 20% equity model, the total debt financing requirement will be around $80 billion. That’s the kind of opportunity for India’s financial institutions, private equity players, corporates and others to tap into, Shah says. For the Indian corporate sector, financial institutions, and government agencies, this could well be the moment they had been waiting for because the world today is more worried about climate change and its adverse impact than ever before. Many experts, including global fund managers, believe that “extreme weather is the number one global risk today with environmental challenges acting as the ultimate risk multiplier”.

A recent IFC report pegs India’s green financing market even higher than the government’s figures. India will need to mobilise $3.1 trillion, and about half the total investment has to come from the private sector, it says.

Thus, green financing is a big opportunity. No wonder the global market is teeming with new players—specific green bond funds, ESG (environmental, social and governance) fixed income funds, pension and insurance funds such as Aviva and Aegon (which have earmarked a portion for green investments), along with traditional financial institutions such as the Asian Development Bank and IFC.

When one raises money via green bonds, it is usually for renewable energy projects (including transmission), low-carbon transport and buildings, waste and pollution control initiatives or projects that are supposed to improve community health or any other social services. But the scope can be enlarged to include nuclear energy generation, transmission of electricity—including those from renewable sources—besides electrification of railways, and projects for sustainable land use. Fisheries and aquaculture, climate-smart farm inputs, forestry, preservation and restoration of natural landscapes, too, fall in this category as also green buildings, smart grids, protection of coastal, marine and watershed environments, information support systems (including climate observations and early warning systems), and soil remediation, among others.

The portfolio for green bonds, thus, is substantial. However, it comes with its own set of challenges, and it’s not just about finding the right kind of sustainable projects. There is a need to develop an escrow account for parking funds for their timely use (since capital raised has an interest component to it), proper evaluation and selection of projects, and tracking, monitoring and reporting to ensure that funds are used only for the intended projects. To take care of all these, there’s need for proper verification and certification of the projects by independent consultants, and bond rating by specialised agencies, among others.

Thankfully, the policies and guidelines are in place in India, though such independent consultants—who can certify projects as green bonds or rate green bonds—are limited. Market regulator Securities and Exchange Board of India (SEBI) in May 2017 came out with norms for issuers of green debt securities, with details about the decision-making process the issuer has to follow to determine the eligibility of the project. It also talks about the system to be used for tracking the deployment of funds and the need to disclose independent reviewers. SEBI also said institutions using the funds raised via green bonds would have to make a disclosure in their half-yearly and annual reports.

Yet, as Bank of America country head and president Kaku Nakhate points out, local markets have still not understood the concept of green bonds as the West has. Thus, India has raised only $6.15 billion from 16 issuances. Also, all companies that have latched on to green bonds—ReNew Power Ventures ($475 million), CLP Wind Farms ($95 million), Hindustan Powerprojects ($59 million), and Hero Future Energies ($44 million)—are in the renewable energy space.

Green bonds in the developed world have become an asset class of their own, providing de-risking, scale, and liquidity for climate finance. National governments, mortgage providers, energy conglomerates, banks, airports, and real estate companies, are all tapping into this market. Also, several independent opinion providers, ranging from non-profit organisations to certification companies, help issuers meet environmental objectives. These include the Center for International Climate and Environmental Research at the University of Oslo that provides a framework for selecting eligible green projects; Norwegian testing, inspection and certification laboratory DNV GL; and Vigeo, which has expertise in assessing ESG issues.

The lack of such certifiers was a challenge BofAML faced when it decided to launch India’s first five-year $500 million dollar-denominated green bond in the U.S. for Export Import Bank of India (EXIM Bank) with a coupon rate (interest rate) of 2.75% in March 2015. The bond was a great success and was subscribed over 3.2 times by a host of international investors, including green investors, which subscribed to nearly 16% of the allocated bonds. With this issuance, EXIM Bank was able to not just attract a new class of socially responsible investors, but also got access to the Australian dollar, the Singapore dollar, and Samurai bond markets. Also, BofAML was able to bring down the coupon rate by nearly 20 basis points—one basis point is 1/100th of 1%—over a five-year period, which helped it to bring down the cost of funds.

“One of the major benefits of a green bond is that it can be tightened at the tightest edge of the range,’’ explains Raj Balakrishnan, head of India investment banking, DSP Merrill Lynch. Simply put, it means that while the price of a green bond is benchmarked to a particular kind of credit—like any other bond—its success is measured by how much of the coupon or interest rate can be brought down during the negotiation with the investors by convincing them about the project.

“Even if you are able to save 0.25% on a $500 million five-year green bond, then you have saved $1.25 million every year, which is not something to sneeze about,” contends Balakrishnan. Again, the frequency of tightening the coupon rate is far higher in the case of green bonds, nearly 90% of the times, compared to only 50% in the case of regular bonds, experts say.

Also, there are accompanying benefits. “If a company is perceived to be doing the right thing—going green obviously means being more responsible towards the environment—and having the right processes, investors are going to attribute a lower cost of capital because they believe that the company is going to be more sustainable than others,” Balakrishnan says. A lower cost of capital means higher profits and better performance on the stock markets. For companies in the business to-business space, those with environment friendly business practices have a higher chance of finding willing vendors and more qualified people ready to work for them over time. Not to mention the perfect public relations opportunity.

“One major way to give a fillip to green bond issuance,” argues Nakhate, “is to make these bonds tax-free. It is only then companies and others will wake up and take notice.’’ She believes India can afford to allow foreign-currency denominated bonds into the country because its external debt to GDP ratio is quite low—20.2% at the end of March 2017. A low ratio means the economy produces and sells goods and services sufficient to pay back debts without incurring further debt.“Evangelism for green bonds has also become a part of our duty,” Balakrishnan says.

It is interesting to note that the genesis of India’s first dollar-denominated green bond was over cups of coffee. At the spring meeting of the International Monetary Fund in 2014, then EXIM Bank chairman and managing director Yaduvendra Mathur met Nakhate to discuss green financing for Indian projects. “It took little time to convince Mathur about the efficacy of green bonds, and work on the process started immediately,’’ says Nakhate. But it took nearly six to nine months for things to fructify—to provide “the overall structuring” such as fixing an escrow account, identifying eligible green projects, conducting a roadshow for global investors, crafting the use of proceeds, and finding the right institutions for certifications. The proceeds were finally used to strengthen metro rail projects in Sri Lanka and Bangladesh.

After the success of the first issuance, in May 2016, BofAML acted as an advisor and a joint book-runner for a five-year $500 million green bond for Axis Bank with a coupon rate of 2.87%, the lowest offered by an Indian private sector issuer. Here, too, the bank managed to tighten the price by 15 basis points during execution. Among the investors were sovereign wealth funds and pension funds, which contributed 10% to the overall kitty, while 55% was lapped up by fund managers and insurance companies. Axis Bank promised to allocate this fund to projects of renewable energy, urban mass transport, and low-carbon emission buildings, among others. BofAML has raised $1.47 billion through three rounds of green bond issuance in India.

Nakhate credits her enthusiasm for green financing to Bank of America global CEO Brian T. Moynihan’s deep commitment and interest in green bonds. He has promised to issue $125 billion in multi-year environmental businesses to “accelerate the transition to a low-carbon economy through lending, investing, capital raising and developing financing solutions for clients around the world”. Today, BofAML is the biggest issuer of green bonds in the world (nearly $31.3 billion till June 26, 2018).

Agreeing with Nakhate on the local market, Balakrishnan says green financing in sectors other than renewable energy is yet to grow roots.

China, for instance, used BofAML’s services in May 2016 as an underwriter for $400 million of green bonds for auto manufacturing company Zhejiang Geely, for five years at a coupon rate of 2.75%. The proceeds were to finance or refinance projects for the design, development, and production of zero-emission electric vehicles for a London taxi service.

Similarly, there are municipal green bonds (or muni bonds) that are helping governments build smart cities. Today, nearly 180-plus green city bonds in 13 countries have been issued. While India, too, has issued a couple of muni bonds for smart cities, they’re not classified as green bonds.

But it’s not as if green bonds are devoid of risks. Like regular bonds, green bonds are vulnerable to a host of risks. For example, there will always be market risks such as concerns about interest rate fluctuations and its impact on the market value of debt, as well as worries about being paid back in a falling interest rate environment, among others.

Then there are political risks, such as changes in regulations and legislation that can adversely impact the project, and the repatriation and expropriation of profits. Finally, there is the risk of obsolescence—a new technology overtaking the older one.

Yet, for a capital-scarce country such as India that wants to take on the mantle of a responsible nation in the global struggle to save the world, green bonds—with new and long-term investors willing to provide low-interest loans for a just cause—could be a ready solution for its infrastructure deficit. An opportunity India can ill afford to lose—and a market too big for investors to ignore.

(The article was originally published in July 2018 issue of the magazine.)