Promoting Green Local Currency Bonds for Infrastructure Development in ASEAN+3

Promoting Green Local Currency Bonds for Infrastructure Development in ASEAN+3

APRIL 2018

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Contents

Tables, Figures, and Boxes

Foreword

The Asian Development Bank (ADB) is working closely with the Association of Southeast Asian Nations (ASEAN) and the People’s Republic of China (PRC), Japan, and the Republic of Korea—collectively known as ASEAN+3—to develop local currency bond markets and facilitate regional bond market integration under the Asian Bond Markets Initiative (ABMI). ABMI was launched in 2002 to strengthen the resilience of the region’s financial system by developing local currency bond markets as an alternative source to foreign-currency-denominated, short-term bank loans for long-term investment financing.

This study was undertaken under ABMI with generous financial support by the Government of the PRC. Building on the study to promote the use of local currency bonds for infrastructure finance, ASEAN+3 policy makers are exploring options to promote green local currency-denominated bonds to meet the region’s infrastructure development needs.

Financing infrastructure projects with green local currency-denominated bonds is highly desirable for the following two reasons. First, financing infrastructure projects with long-term local currency bonds instead of short-term bank loans denominated in foreign currency would make the projects less vulnerable to currency and refinancing risks, especially as they generate revenue in the local currency. Without costly hedging, which may not be available for longer-dated tenors in all currencies, an exchange rate depreciation can increase debt service requirements relative to local currency revenue, potentially threatening the viability of a project. Second, ASEAN+3 has a significantly large demand for infrastructure but is exposed to a range of climate conditions and extreme events. Because of this, green bonds supported within the framework of ASEAN+3 would not only help meet the long-term financing of the region, but could become an effective investment tool to finance its transition to a low-carbon region.

The study was prepared by A. Michael Andrews and Brent Sutton, under the direction of A. Noy Siackhachanh, senior advisor, Economic Research and Regional Cooperation Department (ERCD). Additional guidance and assistance was provided by Richard D. Supangan, senior economics officer, ERCD. A.N. Siackhachanh and R. Supangan participated in some of the fieldwork for the project. Jürgen Conrad, head, Economics Unit of the ADB Resident Mission in the PRC and Danhui Li and Xuan Rong of the ADB Resident Mission participated in some of the fieldwork in the PRC. Margarita Tirona provided research assistance and logistical support. The authors are grateful to the many country officials and market participants who shared their insights and perspectives.

Yasuyuki Sawada

Chief Economist and Director General

Economic Research and Regional Cooperation Department

Asian Development Bank

Executive Summary

Green bond markets provide financing that can help support a global transition to a sustainable development path. Green bonds are debt securities whose proceeds are used to finance projects or assets with positive environmental benefits. The defining features of green bonds are: (i) the issuer commits to investing the proceeds in projects or assets meeting explicit eligibility criteria (often called the green bond framework); (ii) the proceeds are segregated from other funds available to the issuer; (iii) the issuer provides ongoing reporting on the use of the proceeds and, where possible, the environmental impact of the investments; and (iv) prior to issuance the bond is often evaluated or certified by an independent external reviewer attesting to the veracity of its green claim.

Entities issue green bonds to improve their reputation and broaden their investor base. Issuing green bonds demonstrates a commitment to improving the environment. Green bonds are especially attractive to responsible investors who consider both financial and nonfinancial factors in their investment decision-making process. These investors may not have previously purchased an issuer’s conventional bonds. Investors buy green bonds to align their portfolios with responsible investment mandates, as well as to earn a competitive rate of return. Governments promote green bond markets to increase the amount of long-term financing available to support national commitments under the Paris Agreement and the United Nation’s Sustainable Development Goals.

The first green bond was issued in 2007 and the market has grown rapidly since then. The size of the green bond market was about $180 billion in 2017. Estimates vary because data providers use different inclusion criteria. Some unlabeled green bonds are included if the data provider believes the proceeds fund environmentally beneficial projects and some labeled green bonds are excluded if the data provider does not believe the bond is funding projects with a positive environmental impact. Such classification discrepancies are common in financial markets.

A Primer on Green Bonds

Green bond markets have emerged largely in the absence of a formal public policy framework. Instead, the market has been guided by industry-developed norms and voluntary standards. The most important ones are the Green Bond Principles (GBP) and the Climate Bonds Standard (CBI Standard). In most countries, any issuer can call their bond green, although investors and other stakeholders will only accept them as such if they are issued in accordance with industry norms such as the GBP. As of the middle of 2017, only the People’s Republic of China (PRC) and India had issued mandatory national green bond standards, though more countries are expected to follow suit.

The GBP are voluntary guidelines on the issuance of green bonds. They are overseen by the International Capital Market Association, an industry group. Compliance with the GBP requires issuers to (i) specify that proceeds will be used for environmentally beneficial projects and assets, (ii) set out a clear process for project evaluation and selection, (iii) keep the proceeds separate from other funds available to the issuer, and (iv) report regularly on the use of the proceeds and the environmental impact of funded projects and assets. The GBP also recommend that issuers obtain an external review to confirm alignment with the principles.

The largest green bond issuers are multilateral development banks and commercial banks. Green bonds have also been issued by national and subnational governments, public agencies, state-owned enterprises, and nonfinancial corporations. The most common type of green bond is a general obligation bond, where the bond is backed by the overall creditworthiness of the issuing entity and not by the green assets it funds. Green bonds have also been structured as project bonds, revenue bonds, asset-backed securities, covered bonds, and sukuk (Islamic bonds).

Issuing green bonds entails higher administrative expenses than comparable conventional bonds. Like a conventional bond, an issuer must determine the size, currency, tenor, coupon, and legal structure of the issue, and comply with appropriate securities regulations. For green bonds, the issuer must also commit staff time to prepare a green bond framework setting out how the proceeds will be invested, manage the allocation of proceeds, and develop an appropriate reporting program. Prior to issuance, the issuer generally, but not necessarily, engages an external reviewer to confirm that the bond is aligned with the GBP or other international or national standards. After issuance, the issuer must provide regular reporting on the use of the proceeds and, increasingly, on the environmental impact of the projects and assets. Depending on the size, tenor, previous experience of the issuer, and extent of post-issuance reporting, the added cost of green bond issuance is between 0.1 and 7.0 basis points. While some issuers have been able to offset this cost by issuing a green bond at a lower yield relative to a conventional bond, the prevailing view among market participants is that there is no systematic difference between the yield on green bonds and comparable conventional bonds.

External reviews take several forms. The most common are second opinions, an assessment by an independent firm with environmental experience as to the credibility of an issuer’s green bond framework. Such an assessment provides support for an issuer’s claim that proceeds from the bond will fund projects and assets with positive environmental impacts, but they do not provide independent measurement of the expected or actual benefits. The cost of a second opinion is generally between $15,000 and $50,000, with the actual cost depending on the time to complete the work, scope of engagement, location of issuer, previous work with the issuer, and other business the external reviewer has with the issuer. Other types of external reviews are verification and certification, assurance, and green ratings.

Investors in green bonds can be divided between institutional investors and retail investors, asset owners and asset managers, foreign investors and domestic investors, and conventional investors and responsible investors. The distinction between conventional investors and responsible investors is an especially important one. Conventional investors are those whose investment decision-making processes focus on financial factors, such as profitability, cash flow, and debt levels. This information is provided in the financial statements of entities issuing public securities. The decision-making processes for responsible investors include both financial factors and nonfinancial factors, commonly referred to as environmental, social, and governance (ESG) factors. Environmental factors focus on an entity’s environmental footprint such as carbon emissions; social factors deal with the treatment of employees, consumers, and communities; and governance factors address organizational structures. Information on ESG factors is available from some issuing entities and specialized research firms. Both conventional and responsible investors hold green bonds, but they are especially attractive to responsible investors because the proceeds from green bonds focus on projects and assets with positive environmental impacts.

A precise breakdown of who owns the outstanding stock of green bonds is not known. Placement details from green bond issuers indicate that they are largely held by institutional investors—including asset managers, pension plans, insurance companies, and banks—in proportions similar to conventional bonds. The main difference from conventional bonds is that green bonds are more likely to be held by investors with responsible investment mandates. Based on a small sample of issuer disclosures on investor type, about 45%–65% of green bonds appear to be placed with investors with responsible investment mandates. This is a much higher percentage than their respective share of globally managed assets, which is about 25%. Most of the green bonds held by responsible investors are in broad ESG mandates—green bond funds total only about $1 billion.

Several green bond indices have been created since 2014. The most widely used is the Bloomberg Barclays MSCI Green Bond Index, which is composed of about 150 green bonds issued in multiple currencies. Three other widely used indices are the S&P Green Bond Select Index, the Bank of America Merrill Lynch Green Bond Index, and the Solactive Green Bond Index. Chinese renminbi-denominated bonds are explicitly excluded from the Bloomberg Barclays MSCI Index and the S&P Green Bond Select Index. The ChinaBond Green Bond Index Series and the Central University of Finance and Economies (CUFE)-CNI Green Bond Index Series provide measures of the PRC’s green bond market.

Dedicated green bond listing boards have been established at a number of securities exchanges. The Luxembourg Stock Exchange and the London Stock Exchange have the largest number of green bond listings. The Singapore Exchange also lists green bonds. Both the Shanghai Stock Exchange and the Shenzhen Stock Exchange list green bonds on a pilot basis. Issuers of green bonds must meet the same listing requirements as conventional bonds, as well as additional requirements to confirm their green status, usually an external review confirming alignment with the GBP or other international or national standards. While a majority of green bonds are listed on at least one exchange, most trading occurs off exchange.

ASEAN+3 Experience with Local Currency Green Bonds

The PRC is unique among Association of Southeast Asian Nations (ASEAN)+3 countries in that it has a large green bond market and national standards governing green bond issuance.¹