4 October 2012 – Climate bonds that aggregate energy efficiencies and are targeted to institutional investors could fund climate solutions in coming years.
Climate bonds are about to get a lot more street cred with pension funds and other big investors, thanks to the creation of an international standard for climate initiatives that is expected to take effect in a matter of months.
Leading the charge on this standard, and crusading for climate bonds that have scale and tick the right boxes for institutional investors, is Sean Kidney.
The Australian is the executive chair and co-founder of London-based NGO Climate Bonds Initiatives. Its parent is Network for Sustainable Financial Markets.
The Fifth Estate spoke to Kidney last week when he was in Sydney to meet financial institutions, fund managers and banks.
Getting a standard defined for these bonds means investors would be able to monitor and verify the climate effectiveness of their investments, Kidney says.
A globally circulated discussion paper about the standard is expected to produce a definition by Christmas.
Kidney’s organisation comprises institutional investors and NGOs who are developing the standard with verifiers that will be certified.
“It is a bit complicated because while a lot of work has been done around NABERS ratings and so forth [such as BREEAM or LEEDS] – and these are relevant because the carbon footprint of buildings is an important metric – these are not specifically aligned,” he says.
“Some things can be laid bare, such as wind or solar power, but others like energy efficiency or bio-energy are not necessarily always thought of as climate [positive] for a range of reasons.
“Australia could issue sovereign bonds in the National Broadband Network and certify them, for instance. Corporate bonds and project bonds could also be eligible.
“We need to come up with some common international definitions of what should be in and what should be out so that when we label an energy efficiency investment as a climate-related investment it fits some kind of international standard.
“We are going to be referencing existing standards, rather than starting from scratch, so part of this is to make sense of a patchwork quilt of standards.”
One of the people Kidney talked to while in Australia was former member of Lend Lease Sustainability Solutions and Green Building Council of Australia founder, Ché Wall, who is part of an international working party looking at the definition of efficiency investments that can be labelled climate bonds under this new international standard.
“When pension funds want to invest in carbon abatement there is no accountability mechanism,” Wall says. “This is the missing piece of capital allocation for people who need capital.”
Kidney says the new standards will be the ISO equivalent of green bonds.
The World Bank has a lot of research in the market for its climate bonds, he says, but they do not have a verification mechanism.
“Not having verification might have been acceptable five years ago, but that is not the case today for international investors,” he says.
Whether the standard remains in the hands of an NGO or becomes part of an international apparatus will be decided later, Kidney says, suggesting an organisation such as ISO could oversee it.
“The standard is deliberately designed for institutional investors to ensure the products they buy are relevant to climate, not just energy efficiency, solar or renewable,” he says. “We are looking at a model taking in the transition to a low-carbon economy.”
His job is to get scale for climate bonds through the aggregation of renewable energy and energy efficiency projects so that they appeal to big investors.
“Climate bonds are about scale but also about engaging capital markets,” he says.
Considering the bond market is nearly twice as large as the equity market, Kidney believes much of the funding for climate solutions should come from bonds.
He says New York has a tax increment bond that securitises forward property tax increases that are created as a result of green building development, for example. Money raised is used to finance that green property development.
“Securitisation [aggregating assets in a structured finance vehicle to distribute risk] is a way of creating product for these bonds,” he says.
“At the moment there are few opportunities to invest in renewables, and tackle climate change head on.
“We need to change the perception of renewable energy investments as a novelty, and to do that we need a grand pact between governments and institutional investors.
“Governments engineer streams of large-scale investment opportunities and do everything they can do to make sure they are investment grade; in return institutional investors turn on the taps.”
Kidney says while governments provide incentives for residential housing in the form of tax and regulatory relief, he does not see them creating incentives for high-performance buildings any time soon.
“Ours is a broader argument that when governments look at stimulus activities, they should be looking at green activities because of the twin benefits of stimulating the economy and addressing the long-term threat of climate change,” he says.
Kidney expects aggregation vehicles will most likely be hosted by multnational developing national banks (MDBs) in developing countries in the short term, rather than rich, developed nations because, part of the role of MDBs is to securitise loan portfolios or assets.
“Investors tell us that if they were offered two fixed-income products with the same risk/reward ratio and one was green and the other brown, they would choose green,” he says.
“Why wouldn’t you have your cake and eat it too in energy efficiency?
“But there are the issues of what product is available to them, and the scale and demand to meet their needs.”
Notwithstanding these issues, Kidney says climate bonds are gaining traction, but not quickly enough. He expects they will become commonplace in five to 10 years, but should be widely used in two years if they are to effectively mitigate the risks of climate change.
There has been a major re-rating towards bonds globally in the past decade with $100 trillion worth of bonds on issue, compared with $55 trillion in global equities.
“We have $20 trillion worth of investors, including pension funds, who have signed aggressive statements to governments about the need to address climate change,” he says.
“They are saying they are interested in green products, but they are not going to sacrifice yield because they can’t justify that.
“Roughly 40 per cent of the trillion dollars a year the International Energy Agency (IEA) says needs to be spent globally is in the energy efficiency business. This is the amount they are saying we actually need to avoid catastrophic climate change.”
Consistency and cohesiveness around metrics is a key issue.
Kidney says there needs to be an energy star rating in every country, but countries like Germany, for example, don’t have this star system.
With property project-based, counting methodology is easy, he says, but it just isn’t scalable down to an individual building.
Kidney says Climate Bonds Initiatives is talking to two major MDBs in Latin America about creating country portfolio loans through buying energy efficiency loans from banks in their region, then putting them into a special purpose vehicle (SPV) and securitising them with some credit enhancement or discount.
“They need the credit enhancement because there is not much track record with energy efficiency-backed assets, even if they do have strong cash flows, plus they are coming out of emerging countries,” he says.
“To establish the market there is going to be some incredible energy required, but that’s what an MDB can do.”
Kidney thinks that in Australia, though, superannuation fund managers, not public sector banks, will be the ones that will drive climate bond investment.
He cites National Australia Bank and Eureka Fund’s Management and others partnering with Melbourne City Council to fund sustainable projects that could be securitised. New South Wales is on a similar course.
Wall says aggregation is key: “You can’t aggregate a five-star NABERS building with a four-star building, but we have got 500 green-star buildings in Australia. A few are five-star buildings investment grade that could be securitised quite easily because they are up to a common standard for securitisation.”
Defining a climate bond
Kidney says the climate bond is likely to aggregate similar kinds of investments such as residential housing stock, asset leasing or a bunch of office blocks that have cash flow. They will have a life cycle of three to 25 years – longer than the average political cycle.
“There are all sorts of things that would be compliant investments from the people who provide the widgets if you could define the widgets to insulation products such as solar,” he says.
From a corporate bond aspect he says there companies like Honeywell and Schneider that focus on energy efficiency and then build out the project finance side of things.
“One of the proposals we are looking at is to certify the refinancing of highly rated stock, which is on one side of the ledger, and on the other side we certify project finance to convert buildings from, say, two to four stars.
“We are also looking for a metric for a minimum level of improvement on energy efficiency, but that metric is up for grabs at the moment.”