Want to Build Low-Carbon Infrastructure? Try Local Currency Green Bonds

By Ingrid van Wees

Bonds that reduce foreign exchange risk are a great way to finance environmentally friendly infrastructure in developing Asia.

Leading climate experts at last year’s COP23 conference in Bonn highlighted that we have only three years to safeguard our climate. There is no more room for delay in implementing the 2015 Paris Agreement on climate change.

One of the milestones to be achieved by 2020 is to expand the green bond market to at least 1% of the global bond market, currently about $90 trillion. For this to happen, sovereign issuers must be completely on board.

In Asia, as elsewhere, the green bond market is now on policy makers’ radar. This is why ADB is supporting an initiative led by the People’s Republic of China (PRC) to issue more green bonds within the Association of Southeast Asian Nations (ASEAN), based on key principles like harmonization, quantification, and transparency.

Pushing for more ASEAN member countries to issue green bonds is part of a broader effort to mobilize more investment to address the climate challenge.

ADB estimates that developing Asia needs to invest an annual $1.7 trillion until 2030 to build climate-resilient, sustainable infrastructure. Of this amount, $200 billion per year alone should be allocated to adaptation, and $41 billion more for climate-proofing vulnerable infrastructure. These amounts far exceed levels of investments achieved to date.

So, where can we find more money to build low-carbon infrastructure in developing Asia?

The public sector to date provides 90% of the region’s overall infrastructure investment flows, mainly sourced from tax revenues. The rest is covered by multilateral development banks like ADB and the private sector, which only accounts for 0.4% of total investment.

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We can mobilize other sources of funds such as retail savings, pensions or insurance funds to complement loans from banks, which are reluctant to support infrastructure projects that are often sub-investment grade and have long tenors.

For some of these investors it is important that the investment risk is mitigated for example by using a blend of concessional and commercial funds, as proposed in the ADB report Catalyzing Green Finance.

Another option is to leverage local currency bond markets, which are attractive for infrastructure investments that only earn in local currency because they reduce the foreign exchange risk.

Significant progress has been made in the PRC, India, and some ASEAN countries. In ASEAN+PRC, local currency bounds outstanding by the second quarter of 2017 exceeded 70% of GDP, a significant jump from the average 58% over the past 5 years.

Many governments already directly finance infrastructure investments by issuing government bonds. Viet Nam issues bonds specifically to mobilize funds for public infrastructure projects. Such bonds could certainly be used for financing green projects, and therefore could be tagged as green bonds.

If other Asian governments start doing the same, there is enormous potential for rapid growth in the region’s sovereign green bond market. They should follow the example of Fiji, which last year became the first Asian sovereign issuer of a FJD100 million ($48.13 million) green bond.

Sovereign issuers in developing Asia see green bonds as an opportunity to set a benchmark for other domestic issuers, and increase liquidity through a growing local currency green bond market.

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Issuing green bonds also demonstrates the sovereign’s commitment to meeting its Nationally Determined Contributions to reduce greenhouse gas emissions under the Paris Agreement in the medium term. This, in turn, encourages green business and shows citizens that their government is taking environmental issues and climate change seriously.

Finally, green bonds allow tapping into new segments of long-term capital like environmentally conscious groups of people, and thus help diversify the investor base. There are however some challenges on both the supply and demand sides.

On the supply side, developing Asia’s local currency green bond market is still characterized by a lack of liquidity, limited diversification of bond structures, and the absence of a large regular stream of bankable projects.

On the demand side, consistent demand from socially responsible investors is still pretty much restricted to Japan and only recently the PRC. This hampers the market’s growth potential.

Initiatives in advanced economies in Europe and the United States to decarbonize endowment, pension or sovereign wealth funds—whether for economic reasons or to promote socially responsible investments—are yet to gain traction in developing Asia. Mandatory requirements to diversify domestic investment portfolios are likewise missing across the region.

Sovereign governments could increase the pool of dedicated funds available to invest in green (and social) bonds by enacting regulations that integrate environmental, social, and governance (ESG) factors into the investment process and mix.

But there are reasons to be optimistic. The publication in March 2017 by the PRC government of its green bond guidelines created impetus that helped the market to take off.

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For a long time, ADB has been supporting its developing member countries to issue more green bonds. Based on our experience, sovereigns looking into issuing green bonds should take into account 5 fundamental concerns:

  1. Green bond proceeds need to be used within a strong framework. Sovereigns that normally borrow in capital markets for general budgetary purposes should develop a robust green bond framework based on transparency to shore up investor confidence. The framework should be developed in consultation with key stakeholders like dealers, second opinion providers and rating agencies.
  2. Sovereign issuers should set the standard for third party verification and/or third-party audit of their green bonds.
  3. Treasury departments should collaborate with relevant government agencies to establish a green bond framework, and require investment managers to acquire knowledge and a license on impact investments and ESG factors to ensure credibility.
  4. Sovereigns should create an enabling environment for other issuers to follow suit, including guidelines/standards coupled with fiscal support measures such as tax incentives. A good example is the green bond grant scheme proposed by the Monetary Authority of Singapore.
  5. Efforts to promote green bond markets and national strategies for sustainable low- carbon development should be clearly linked.

There is a lot of potential for growth in the local currency green bond market in developing Asia, as long as sovereigns establish an enabling environment, and strong frameworks are applied. The key constraint will likely be the number and size of bankable green investments.