I've often said that if I could raise money at 4 percent to 7 percent interest, I could change the world, because mid-single-digit returns are what long-term investments in renewable energy, efficiency, rail, and other energy transition solutions typically deliver.
Unfortunately, that's been difficult to do. Until recently, that is. As I explained in my last column, new waves of financial innovation are finally bridging the gap between the natural lenders for such projects and those who build them.
But if those innovations are waves, then there is a veritable tsunami of capital swelling beneath them: billions of dollars worth of green bonds (also known as climate bonds) and structured finance that can deliver energy solutions for entire cities.
The London-based Climate Bonds Initiative, a non-governmental organization (NGO) facilitating the growth of the green bond market, defines a green bond as "one for which the issuer declares that the proceeds will be applied (either by ring-fencing, direct project exposure or securitization) towards climate and/or environmental sustainability purposes."
As CEO and co-founder Sean Kidney wrote in a Nov. 1 post, "green bonds are about the 'green' qualities of the underlying asset, not whether a company is relatively green or not."
I asked Kidney why green bonds are necessary. "We have to rapidly speed up and scale up the capital that's flowing toward climate change solutions -- both mitigation and adaptation," he explains. "Climate scientists tell us we need a low-climate world by 2050, and we have to move quickly to get there. We have to be moving capital now."
"A big chunk of our work is explaining to government how they can finance a rapid transition. There's definitely not enough government money to do it all, as well as deal with the disasters we're going to have, especially if you look at the scale of what's just happened in the Philippines. We need to make everything we possibly can a private sector investment to free up public money for the more urgent tasks."
The opportunity is huge: The global bond market is $78 trillion in size, dwarfing the $53 trillion global equities (stock) market. By educating its participants -- such as pension funds, insurance companies, infrastructure funds, sovereign wealth funds, and big banks -- Kidney believes that a large part of bond investments can be mobilized to address the climate challenge.
"Eighty-nine percent of green bond investments are investment-grade," he said. "Investors need to know they could be swapping non-green for green investments and not losing anything, while addressing macro risk to their portfolios."
That macro risk includes climate policy, and public opinion turning sour on fossil fuels as the damage from climate change becomes increasingly undeniable. A sister NGO called the Carbon Tracker Initiative, also based in London, has been educating investors about the risk of "stranded assets" in their portfolios, such as fossil fuel reserves on the balance sheets of oil, gas, and coal companies which ultimately may be deemed "unburnable" as world governments work to limit the increase in global temperatures.
"Our task is to work with asset owners to educate them about the stranded asset risk to their portfolios, and to make them aware of an upside as governments invest in energy transition," Kidney says.
Bank of America Merrill Lynch and Citigroup have put forth a paper outlining a framework to define what constitutes a green bond, how candidate projects should be evaluated, how proceeds should be managed, and how reporting should be conducted. Under the framework, eligible green bond projects would include:
- Renewable energy
- Waste management
- Land use
- Clean transportation
- Energy efficiency
- Clean water
- Other mitigation
The paper also calls for the formation of a "Green Bonds Working Group" to co-develop formal eligibility standards and help build credibility for the green bond market. Underwriters include SEB of Sweden, JP Morgan, HSBC, Bank of America Merrill Lynch and Citigroup.
Additionally, working groups are being organized around the world to specify eligibility criteria for specific sectors. For example, Kidney says the bio-energy working group includes the World Wildlife Fund, Boeing, the Nature Wildlife Fund, and academics.
Development of the Climate Bonds Initiative is already well under way, with a standards and certifications team that publishes formal guidelines, third-party certification by KMPG (one of the "Big Four" international auditing firms) and other agencies, insurance, controlled rights to use the Certified Climate Bond trading logo, and other hallmarks of an established scheme. The group has certified one bond so far: a $500 million, seven-year bank bond linked to wind energy loans, which will soon come to market. More are in the pipeline.
Climate Bonds hopes to list green bonds on Bloomberg terminals by the end of this year and to publish a green bond index next year. Those developments would make it simple and easy for investors to locate and buy green bonds, especially fund managers and asset owners with limited due diligence capability in the sector, Kidney says.
Ultimately, an accepted green bond framework will reduce the cost of capital for green projects, but green bonds are already cheap. Kidney notes that a recent bond issuance in the Netherlands cleared at 12 basis points (12 hundredths of a percent) above mid-swaps (a benchmark for the interest rate cost of a variable rate bond) instead of the expected 15 basis points, purely on its green credentials.
Two of the largest issuances this year were made by International Finance Corporation (IFC), an independent offshoot of the World Bank that holds a $48.8 billion portfolio. In February, IFC issued a $1 billion, 3-year, AAA-rated green bond with an interest rate set 15 basis points over 3-year U.S. Treasury bonds. And earlier this month, IFC issued another $1 billion, 3-year, AAA-rated green bond with a coupon of just 0.625 percent (4 basis points over U.S. Treasury bonds). Kidney expects IFC to issue at least another $1 billion in green bonds next year.
This week, the French utility EDF launched a €1.4 billion ($1.97 billion) green bond with a 2.25 percent annual coupon exclusively for financing renewable energy projects. The issue was oversubscribed by a factor of two, EDF said.
The green bond market is already substantial, at $72 billion globally. Issuers of big (at least half-billion-dollar) "labeled" green bonds include the European Investment Bank, IFC, the World Bank, the Export-Import Bank of Korea, and the Communal Bank of Norway. Some $4.4 billion in green bonds have been issued in the United States, as well as $83 million worth in the United Kingdom, according to Bloomberg. "Unlabeled" green bonds, a much larger market that includes those used to underwrite China's rail expansion, round out the green bond universe.
But that universe needs to be much bigger. "We think we need a $300 billion-a-year market," Kidney told me. Total issuance is growing at 25 percent per year, he estimates, and he expects the labeled market to double each year.
To make that happen, though, the Climate Bonds Initiative needs more funding so it can develop criteria for various sectors more quickly. As part of that effort, the organization is rolling out a corporate partners program where the tax-deductible nature of its funding should be attractive; working with the Chinese government to help them develop a domestic green bond market ("I'm predicting that they'll be the world's leading green bonds market within two years," Kidney says); and establishing a "green sukuk" (a green Islamic bond) program in the Persian Gulf.
A different twist on green bonds has emerged in New York: the focus is on financing climate-related municipal projects.
Suppose you were the mayor of a major U.S. city, and a financier came to you and said, "Tell you what: We'll replace 200,000 streetlights in your city, which will save you $1.2 billion in energy, operations and maintenance costs over 20 years, guaranteed. Just sign here, and we'll give you a $300 million check at closing, with the rest of the savings payable in monthly installments over the next 20 years." What would you say, except "Give me a pen!"?
That's exactly the proposition that New York-based Lance Capital, LLC has made to a major U.S. city, the name of which is currently undisclosed pending completion of the deal.
Lance Capital, a longtime non-bank private lender in commercial real estate finance, stumbled on this creative approach to financing municipal energy efficiency through its experience in financing custom interiors for tenants of major office buildings.
I spoke with CEO Richard Podos about how his company developed its unique approach: "Johnson Controls [one of the world's largest managers of commercial property, with deep expertise in building energy efficiency] called us and said, 'We've got a lot of clients who want energy efficiency stuff and you guys seemed to have an innovative way to bring capital into real estate deals. Can you do the same with efficiency?' "
So far, Lance Capital has issued about $1 billion worth of bonds, and has a pipeline of over $2 billion to finance such projects for Johnson Controls. Unlike green bonds, these bonds are backed by the creditworthiness of the borrower, not by the project. That makes the instruments a good match for major municipalities, which typically have good credit ratings, with major infrastructure needs. For example, if New York City decided to proceed with building a seawall to protect it against the next Hurricane Sandy, Lance Capital could organize a bond to pay for it, backed by the creditworthiness of the Big Apple.
"What's missing in the marketplace is long-term money," Podos explains. "Most of the solutions are in the 5- to 10-year range. In real estate, you're usually doing 20 years plus, which is a better match for energy efficiency projects. In a typical ESCO deal [with an energy service company, or ESCO], virtually all of the savings go to pay off the investment until it's paid off, and only then does the user get the benefit. We don't think that's compelling story. Nobody cares about not making a return until eight years down the road. So we've crafted a solution that delivers savings immediately."
Recently, the California Public Utility Commission invited Lance Capital to help major commercial consumers find ways to finance energy efficiency projects to reduce their demand after the SONGS nuclear plant was turned off. (See my story on the SONGS closure here.)
"The insight is: Everybody knows that cities are budget-constrained, with short-term concerns about union salaries, pension funds, health care, etc.," Podos says. "They don't want to issue bonds to raise capital when they're in the middle of laying off police and fire staff, so it's really hard for a mayor or city council to announce that they're spending $20 million on efficiency, even though it makes sense."
"So we issue service contracts, where the service provider handles the financing. We bring the capital to the table in the service contract. It's better from a public perception perspective, and it's better for the credit rating because it reduces operational expenses immediately and it's not on the balance sheet."
Using conventional net present value analysis, Lance Capital has developed a methodology to identify the savings from an energy efficiency project over 15 or 20 years, get a guarantee from a company like Johnson Controls, and then monetize it.
"I've been in commercial real estate for 25 years and I've never had such a compelling value proposition to offer people," Podos enthuses.
By issuing private placement bonds based on a series of cash flows from efficiency projects, Lance Capital can package and sell the projects to pension funds, insurance funds, and other players in the fixed income market, with typical yields that are slightly (75 to 100 basis points) over the city's general obligation bonds. Lance Capital itself also invests directly in the bonds.
"It's more expensive than conventional municipal bond issuance, but not much, and more efficient than any other financing vehicle we've seen in the marketplace," Podos says.
Currently, the company is in initial discussions with various cities across the country about efficiency upgrades for street lighting, schools, police departments, and other public buildings, according to Podos.
I really didn't think I'd be able to say this so soon, but that world-changing day, when billions of dollars of capital can be unleashed for mid-single-digit returns, seems to have arrived. What else can one conclude when it's possible to raise a billion dollars at a lousy four basis points over a T-bill, and pour it into renewable energy and efficiency projects? That's risk-free pricing, and shows that the bond market is finally getting comfortable with the energy transition and climate mitigation programs.
So watch out, fossil fuel incumbents. All we need now is a few more players to step up to fund expansion of the Climate Bonds Initiative, then it will be time to release the Kraken of energy transition.