Financing the New Era of Green Economy in India

INTRODUCTION

Climate change and consequent environmental disasters pose significant threats to developing countries. The shift to sustainable systems, climate-resilient infrastructure, and the delivery on sustainable development goals (SDGs) are recognized as an imperative and part of the transition to a low-carbon economy.

Green bonds are designed to have a positive influence on the environment by reducing CO2 emissions and energy consumption. The projects that green bonds support are frequently related to energy efficient buildings, renewable energy, and clean technology. When compared to traditional options, these emit less CO2 and consume less energy. Green bonds have traditionally been used to fund climate-change mitigation measures such as renewable energy investment to minimize the use of fossil fuels in power generation, low-carbon buildings, and clean transportation. The funding of climate-change adaptation and resilience projects has gotten more attention in the last three years, especially since the occurrence of extreme weather events and related disasters has emphasized the susceptibility to flooding, wildfires, and droughts. Economic vulnerabilities have also been identified because of analysis into the financial consequences of such climate-related concerns.

Green Bonds are a type of bond instrument where the proceeds or an equivalent amount will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible Green Projects and which are aligned with the four core components[1] of the Green Bond Principles (GBP). There are currently four types of green bonds – a) Standard Green Use of Proceeds Bond - a standard recourse-to-the-issuer debt obligation aligned with the GBP, b) Green Revenue Bond: a non-recourse-to-the-issuer debt obligation aligned with the GBP in which the credit exposure in the bond is to the pledged cash flows of the revenue streams, fees, taxes etc., and whose use of proceeds go to related or unrelated green project, c) Green Project Bond: a project bond for a single or multiple green project for which the investor has direct exposure to the risk of the project with or without potential recourse to the issuer, and that is aligned with the GBP, and d) Green Securitized Bond: a bond collateralized by one or more specific green project, including but not limited to covered bonds, Asset based Securities (ABS)[2], Mortgage backed Securities (MBS)[3], and other structures; and aligned with the GBP. The first source of repayment is generally the cash flows of the assets.

HISTORY

The green bond market has experienced steep growth over the last decade in both corporate and government/supranational issuers. Multilateral development banks were instrumental in the early establishment of the green bond market. In 2007, the European Investment Bank (EIB) marketed a EUR 600 million Climate Awareness Bond (CAB)[4], the first of a series, focusing on renewable energy and energy efficiency. In 2008, the World Bank (IBRD) began its marketing of green bonds with a USD 300 million issuance as part of the World Bank's climate financing initiative, while the International Finance Corporation (IFC) issued an initial green bond in 2010 and a USD 1 billion bond in 2013. This was a landmark issuance that paved the way for future advances in the asset class. Since then, financial, and non-financial companies, supranational entities, and sovereign governments have issued green bonds. The first corporate issue took place in 2013.

DRIVERS

Each country has unique characteristics that can impact how the green bond market develops. To examine them in depth requires an understanding of the country's specific green finance potential, debt financing conditions, and domestic and international investor demand for the country's green debt. Sustainable finance policies and frameworks, green bond issuance momentum, capital market growth, and governance and political stability are all major factors of green bond market potential.

OPPORTUNITIES FOR MARKET GROWTH

The regulatory landscape surrounding green finance and sustainability-related disclosures has also been quickly evolving, particularly after the 2015 Paris Agreement. With the rise of the green bond market and its widespread acceptance, an increasing number of legislative measures are emerging, with the goal of replicating recent success in leading markets like the EU. These initiatives frequently have a common structure and provide frameworks in terms of i) a taxonomy that unifies the definition of qualifying "green" assets and activities, and ii) a framework for green bond labelling that adheres to the jurisdiction's taxonomy.

The advent of jurisdiction-level initiatives and frameworks is a prerequisite for the green bond market's continued development and expansion. The growing interest by institutional investors in investing in green assets is one of the demand-side drivers of the fast growth of green bonds and of other labelled transition instruments. In such an evolving and fast-moving landscape, central banks are likely to play a key role in the future, both in terms of preparation and the adoption of green central banking principles to complement current monetary policy interventions.

Green bond issuance is motivated by several incentives for issuers, including i) diversifying their investor base, ii) accessing a larger and more stable investor base, and iii) signaling a strong commitment to realistic decarbonization initiatives. These incentives are intended to offset the higher expenses of third-party verification and better post-issuance reporting.

Large investors are exploring investments in operating assets in the renewable energy sector that are generally stress-free and may repatriate surplus cash flows to investors in a tax-efficient way. Green energy projects produce income during the first year of operation due to the short gestation time. Furthermore, there is no reliance on fuel, and the government provides several incentives for the renewable energy sector.

BARRIERS TO SCALING UP

Green bond markets emerge and mature at varying rates depending on a variety of factors, including policy and regulatory issues (for example, policies that create demand for green projects) and macroeconomic conditions (e.g., interest rate developments and the credit cycle). These requirements will vary depending on the countries where green bonds have been issued, as well as the sub-national, national, and regional markets that make up a worldwide investor base for green bond demand.

A common list of barriers to green bond market growth may include:

a)?????Lack of a pipeline of infrastructure projects corresponding to a long-term governmental commitment to low carbon development

b)?????Lack of commonly accepted green definitions.

c)?????Investors with limited capacity to analyze green investments

d)?????Scale and mismatch among projects, bonds, and institutional investors.

e)?????A lack of suitable aggregation mechanisms; unstandardized projects and cash flow instability

f)??????Low credit ratings for potential green bond issuers and green projects, especially in emerging economies.

Despite these challenges, it is important to note that the market is developing toward a more standardized manner of measuring and reporting the impact of green bonds. The International Capital Market Association (ICMA) is working to develop impact reporting templates for green bond issuers at the project and portfolio levels. ICMA has also created optional recommendations for energy efficiency, renewable energy, water, and wastewater projects.

MARKET POTENTIAL IN INDIA

Despite unprecedented challenges in 2020, the green bond market proved resilient, and achieved a key milestone in cumulative issuance of US$1 trillion since 2007, with issuance of US$280 billion in 2020.

India has the second-largest number of outstanding green bonds (US$10.8 billion) among developing economies, and it has continuously been the second-largest issuer after China. India's green bond issuance declined drastically in 2020, from US$3.2 billion in 2019 to US$916 million in 2020[5]. According to Bloomberg, green loan issuance more than quadrupled from US$1.5 billion in 2019 to US$3.6 billion in 2020, indicating that bank financing was more attractive than bonds.

According to a CEEW-CEF analysis[6], India raised $15.6 billion in green bonds between 2014 and the first half of 2021, with renewable energy developers issuing roughly $11.2 billion (Greenko, ReNew Power, Adani Green Energy, Azure Power, JSW Hydro, Continuum Green Energy, Hero Future Energies, and NTPC). Most of the bonds issued have a term of 5-10 years (53 percent), while $5 billion in developer-issued green bonds will mature in 2024. Due to the longer tenure of institutional loans used to finance construction and project power purchase agreements (PPAs), developers are expected to refinance these bonds when they expire or even sooner, most likely through fresh green bond issuance.

In September 2021, Power Finance Corporation Ltd (PFC), the leading NBFC in the power sector, successfully issued its first Euro 300 million 7-year Euro Bond[7]. The 1.841 percent yield achieved is the lowest yield an Indian issuer has ever locked in on the Euro markets. This is a landmark moment for PFC, with a slew of firsts. Furthermore, it is the first Euro bond issuance from India since 2017 and the first Euro issuance by an Indian NBFC. The issuance drew many institutional investors from Asia and Europe, with 82 entities participating and being oversubscribed 2.65 times.

PRICING

Initial green bond issuance coupon rates were as high as 8% but have since been oscillating between 4% and 6%. These coupon rates are fixed interest rates established through a market book-building activity. As a result, they represent the developer's true borrowing costs. Investors normally get interest payments twice a year, with the principal amount returned in a bullet repayment at the end of the maturity period. Coupon rates for green bonds issued by Indian developers have been slightly higher than those for non-green bonds issued by corporations, which average approximately 4%. The average spread for 2021 is nearly 60 basis points lower than the average spread for all issuances, implying that developers were able to refinance their portfolios at lower prices in 2021. However, this trend has fluctuated throughout the years and continues to be indicative.

WAY FORWARD

International markets have been largely agnostic to the nature of the portfolios refinanced through green bonds. While there is still a pressing need to transition to low-carbon, climate-resilient development, and growth, achieving the Sustainable Development Goals will necessitate effort on all fronts. Capital markets are major investment drivers and a critical link between the private sector and development initiatives in India, and they are fundamental to the country's energy transition. Governments alone cannot provide the funding necessary for cost-effective technology and innovative solutions to urgent global concerns that will accomplish these sustainability goals. Mobilizing investments from private markets adds an impetus to accentuate the drive. The urgency and scale of the energy transition necessitate a greater infusion of capital into green assets and infrastructure from both the public and private sectors. Green financing mechanisms are likely to play a significant role in channeling these funds efficiently. Green bonds in international markets present an opportunity to enhance developers’ access to capital.

As India scales up its RE capacity to its 2030 target of installing 450 GW of renewable energy, institutional lenders are approaching their sectoral lending limits for the power sector. Developers must seek out new funding sources to maintain the required pace of capacity addition. While rating agencies have emphasized the weak financial condition of state utilities as a problem, demand in Indian green bonds has remained robust. This is because markets normally ensure repayment through financial covenants that strictly monitory debt service coverage and capital expenditure reserves. Green bonds are catalyzing a trend in the bond market toward sustainability and corporate social responsibility. As a result, all stakeholders, including developers, consumers, and policymakers, must see green bonds issued on the foreign market as complementary to domestic institutional debt. As investors gain confidence in green bonds, they begin to look for alternative investments and opportunities that go beyond climate related themes.

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Note: Views are personal.

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[1] a) Use of Proceeds, b) Process for Project Evaluation and Selection, c) Management of Proceeds, and d) Reporting

[2] An asset-backed security (ABS) is?a type of financial investment that is collateralized by an underlying pool of assets—usually ones that generate a cash flow from debt, such as loans, leases, credit card balances, or receivables

[3] Mortgage-backed securities, called MBS, are bonds secured by home and other real estate loans. They are created when a number of these loans, usually with similar characteristics, are pooled together

[4] OECD Green Bonds Report

[5] Emerging Market Green Bonds Report 2020

[6] Financing India’s Energy Transition Through International Bond Markets

[7] https://pib.gov.in/PressReleaseIframePage.aspx?PRID=1755380