Antidote To Flint: Tapping The Bond Market To Solve Water Issues

by: AllianceBernstein (AB)

By Erin Bigley and Eric Glass

A contaminated water crisis in Flint, Michigan, is a painful reminder of why America's aging water infrastructure needs an update. Green bonds may provide a cost-effective way for governments to act and an opportunity for environmentally conscious investors.

Green bonds are gaining attention for their ability to channel capital to sustainable infrastructure projects. And they appeal to investors who want to make a positive social or environmental impact while also generating a financial return.

Though still a small part of the global bond market, green bonds are growing quickly. A record $42 billion were issued last year, and 2016 issuance has already surpassed that, according to the Climate Bonds Initiative, a nonprofit group that promotes environmentally sound investments and sets green bond certification standards.

States, Cities, Local Governments Get Involved

About 8% of green issuance over the past 10 years comes from US state, city and local governments and public utilities, according to Moody's Investors Service. But given today's public resource constraints and infrastructure needs, we expect green issuance to increase.

In 2013, the American Society of Civil Engineers gave the US a cumulative grade of D+ on infrastructure and estimated it would take investment of $3.6 trillion by 2020 to bring it up to snuff. The country's water infrastructure is particularly overburdened, as illustrated by the incidents of lead seepage into the drinking water in Flint and at Chicago and Newark schools.

Recently, water utility authorities in Massachusetts, San Francisco, Washington, DC and elsewhere have tapped the bond market to upgrade storm water and wastewater management and to bring facilities into compliance with the US Clean Water and Safe Drinking Water acts.

Some of the most innovative municipalities are combining water supply and hydroelectric power. In Portland, Oregon, the city power utility is benefiting from new technology that places small turbines inside gravity-fed drinking water pipes. The resulting hydroelectricity produces enough energy to power 150 homes without any environmental impact. The turbines also monitor the quality of the drinking water.

Lucid Energy, the company that developed the technology, plans to share the profits with the city, and is in talks with other cities about similar projects. Some may be partly financed with green bonds.

More Bang for Your Buck

In our view, all this adds up to an opportunity for investors who want their investments to make an impact. The opportunity is particularly appealing in the muni market.

That's because in most cases, green municipal and conventional bonds from the same issuer are pricing at similar levels today. This means investors who buy a green municipal bond get the usual tax advantages along with the built-in protections that come with sustainable investment without having to pay a premium for it. It's like getting risk mitigation for free.

This situation may not persist. As the market grows, issuers who invest in green projects and go through the trouble and expense to be certified by a third party as green may expect to see their cost of capital reduced through lower borrowing costs. If that doesn't happen, the incentive to pay for green certification may disappear.

Making Sure It's Really Green

That third-party certification is important. Because the green bond market is a new one, it's up to the bond issuer to provide assurance that the project funded is truly green. Most issuers do this by asking a third party to verify that funds are going toward sustainable development - but not all. Investors should do their own research before they buy to be sure of what they're getting.

Some governments and water authorities may be investing in green projects but not providing enough specific information to confirm their environmental bona fides. An analysis by the Climate Bonds Initiative identified $30 billion in outstanding "climate-aligned" green US municipal bonds this year. But only 32% had submitted to third-party review and been officially labeled green.

That may be starting to change. Earlier this year, the San Francisco Public Utilities Commission's $240 million wastewater revenue bond was the first green bond certified under the Water Climate Bonds Standard, a set of criteria developed by the Climate Bonds Initiative. Others may soon follow.

We hope more municipal issuers seek green certification in the future. But that doesn't mean investors can't get involved now. Plenty of state and local governments are already committing to innovative green projects. These are the type of issuers likely to offer strong investments. Investors who can identify the most forward-looking issuers now are likely to benefit in the long run.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AB portfolio-management teams.