The Role Of Green Bonds In The Climate Challenge

Includes: GRNB
by: VanEck

The "climate challenge" is one of the most complex issues facing the world today. A year after launching the VanEck Vectors® Green Bond ETF (NYSEARCA:GRNB) and in recognition of Earth Day, we revisit the role that green bonds can play in the transition to a low-carbon economy.

Where We Are Today

2017 was another record year for green bond issuance, once again nearly doubling the issuance of the prior year, an encouraging trend that reflects the growing demand for sustainable investments. But discouragingly, 2017 also saw a rise in CO2 emissions for the first time in four years. It was one of the hottest years on record (2016 was the hottest) and one characterized by extreme weather events and the most expensive hurricane season ever. It's clear that more needs to be done, and quickly, if the goals of the Paris Agreement are to be achieved.

Nearly 200 countries ratified the Paris Agreementi in 2015, pledging to reduce greenhouse gas emissions to limit global warming to less than 1.5-2 degrees Celsius above pre-industrial levels. Each signatory must develop and maintain target reductions in emissions, and in 2017 several countries, most notably France, issued green bonds to help finance these efforts.

The Paris Agreement was dealt a blow when the U.S. announced its decision last June to exit the Agreement. While disappointing, the impact of the withdrawal is unclear and progress will likely continue (see Paris Exit Won't Squash Green Bonds). The rest of the world has reaffirmed their support, and many U.S. cities, states, and companies have pledged to help deliver on the U.S. emissions reductions targets. Encouragingly, the U.S. was actually the largest issuer of green bonds in 2017.ii

Still Moving Forward

Although progress may have felt uneven in 2017, there is palpable momentum not only in the growing issuance of green bonds, but also the increasing recognition of the risks of climate change and the magnitude of the challenge. The World Economic Forum's 2018 Global Risks Report identified environmental risks among the most significant systematic risks facing the world in terms of likelihood and impact.iii In addition to the immediate physical impact of climate change and the financial risks associated with stranded assets, secondary risks can include food and water shortages, social unrest, and large-scale involuntary migration.

An estimated $1 trillion in new investment is needed annually to transition to a low-carbon economy.iv This is in addition to the massive infrastructure spending needed to modernize existing and build new infrastructure to address population growth - all of which will need to be low/no carbon emissions. Overall, up to $90 trillion in new infrastructure investment will be the estimated need through 2030.v This significant investment need creates potential financing opportunities for investors, and green bonds are well suited to meet this challenge.

The Role of Green Bonds

Green bonds are like conventional bonds, except that the proceeds are used only to finance environmentally friendly projects. Investors do not need to adopt new or untested structures. Many green infrastructure projects are long-dated in nature, require significant upfront investment, and generate ongoing cash flows. As a result, green bonds will likely be a significant part of the overall financing of green projects, in addition to equity, loans, and other financing types. Most green bonds are backed by the full balance sheet of the issuer, allowing investors to direct capital towards specific projects without taking on the direct risk of the project.

At the same time, the full spectrum of bond types, credit enhancement structures, and risk transfer mechanisms are available in the green bond space. For example, 2017 saw innovations such as green sukuk,vi green commercial mortgage backed securities (CMBS), and the largest green sovereign bond to date. The massive size of the global fixed income market, the array of structures available, and the inherent flexibility of the Green Bond Principles have put green bonds at the forefront of addressing the climate challenge.

Focus on Transparency

Increased and more standardized disclosure related to climate risk assessment and management has long been at the top of ESG (environmental, social, and governance) investor demands. Regulators are accelerating the push to help quantify and evaluate these risks. For example, in 2015 France began mandating carbon disclosure for listed companies and carbon reporting for institutional investors. Similarly, in 2017 the Financial Stability Board's Task Force on Climate-related Financial Disclosures (TCFD) released its final recommendations for financial disclosures, taking into account various climate scenarios with the underlying assumption that climate risks are, or could become, material to investors and impact the risk-return profile of an organization. To date, over 250 organizations have expressed support for the TCFD's recommendations.vii

By disclosing the use of proceeds of green bond issues, as well as developing green bond frameworks to identify, assess, and manage climate risks and investments, green bond issuers are in many ways ahead of the curve. And to the extent that the market does begin to adequately factor in climate-related risks into market pricing, entities that are proactively addressing and disclosing these risks will likely benefit.

Facing the Climate Challenge

The cost of the climate challenge is so significant that it can be difficult to grasp, as are the potential consequences of failing to mitigate or adapt to climate change. The accessibility of green bonds, therefore, makes them an extremely valuable tool to address this challenge.

Because green bonds are like conventional bonds, and have similar risk and return profiles, investors of all types - large and small, traditional and those with an ESG mandate - can seamlessly incorporate them into their portfolios. Policymakers have begun to provide guidance to the market, which will help promote standardization and reduce risk to green bond issuers and investors. We feel the green bond market is well positioned to play a leading role in meeting the global climate challenge head on.

Important Disclosure

i Paris Agreement is an agreement within the United Nations Framework Convention on Climate Change that entered into force in November 2016, and aims to strengthen the global response to the threat of climate change by keeping a global temperature rise this century well below 2 degrees Celsius above pre-industrial levels and to pursue efforts to limit the temperature increase even further to 1.5 degrees Celsius.

ii Source: Climate Bonds Initiative

iii Source: World Economic Forum

iv Source: International Energy Agency

v Source: The Global Commission on the Economy and Climate

vi Sukuk commonly refers to the Islamic equivalent of bonds. However, as opposed to conventional bonds, which merely confer ownership of a debt, Sukuk grants the investor a share of an asset, along with the commensurate cash flows and risk. As such, Sukuk securities adhere to Islamic laws sometimes referred to as Shari'ah principles, which prohibit the charging or payment of interest.

vii Source: Task Force on Climate-related Financial Disclosures

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