India has pledged to reduce its carbon emission intensity by 33-35% by 2030 as part of its intended nationally determined contributions (INDCs) to address the challenge of tackling climate change. India also aims to achieve 40% cumulative electric power installed capacity from non-fossil fuel-based energy resources by 2030. In addition to policy and technology measures, achieving such an ambitious target will require significant financial resources.
Achieving India's target of adding 175 gigawatt of renewable energy (RE) capacity by 2022 will necessitate an investment of US$200 billion. Assuming a debt-equity ratio of 3:1, the sector will require close to US$150 billion by way of debt. Some studies indicate that paucity of funds for the sector and the consequent higher interest rates in India drive up the cost of RE by 24 – 32% in the country as compared to costs in US and Europe. Similarly, the overall size of the EE market in India is estimated to be around US$ 11 billion. Till date, less than 10% of this market has been tapped through Energy Service Company (ESCO) mode.
The [green bond] issuer publicly states that it is raising capital to fund projects, assets or business activities with environmental benefits...
Current funding mechanisms for RE and EE projects include equity, government subsidy/incentive schemes, specific funds set up by government agencies or donors, trade credit, and commercial finance. However, there are some critical factors inhibiting the flow of credit from financial institutions. There is a limited understanding of the different kinds of risks affecting RE and EE projects. Loans in this sector often have to be custom designed, owing to considerable differences in business models and heterogeneity in project design. This increases the transaction costs for financial institutions. Further, there is the issue of asset-liability mismatch for commercial banks, since RE and EE projects typically have longer gestation periods.
In this context, green bonds can expand the pool of available investors and therefore help in bringing down the cost of funds. A green bond, like any other bond, is a fixed-income financial instrument for raising capital through the debt capital market. The key difference between a "green" bond and a regular bond is that the issuer publicly states that it is raising capital to fund projects, assets or business activities with environmental benefits, such as RE, EE or electric mobility projects. Thus, these bonds appeal to regular investors as well as other investors such as bilateral or multilateral agencies, other institutional agencies, high net worth individual (HNI) investors etc. who focus on use of proceeds and their friendliness to the environment, in addition to the yield offered. Green bonds, therefore, have considerable potential to provide large quantum of long-term debt capital for RE and EE projects. Some investors may also agree to a comparatively lower yield as long as the projects contribute to sustainability in a meaningful way.
Green bonds can expand the pool of available investors and therefore help in bringing down the cost of funds.
The green bonds market has been growing exponentially as evidenced by a more than 200-fold increase in issuance in the eight years since the first issuance in 2008. The total labeled green bonds issuance in 2016 was US$ 118 billion. While US, Germany and Netherlands have been the top countries in terms of issuance, new markets are coming up across the world. Seven new markets joined in 2015—Brazil, Denmark, Estonia, Hong Kong, India, Latvia and Mexico, adding nearly US$ 3.2 billion to the market.
India is emerging as a significant green bond market and was among the top issuers in its debut year (2015) itself. Out of the total Indian labeled green bonds proceeds in 2016, 60% was allocated to RE projects, 17% to low carbon transportation, and 14% to EE and green buildings.
In January 2016, the Securities and Exchange Board of India published its official green bonds requirements for Indian issuers making India the second country (after China) to provide national level guidelines. An increasing number of Indian institutions, including banks and corporates, have shown interest in issuing such bonds to mobilize long term resources for climate mitigation projects.
Out of the total Indian labeled green bonds proceeds in 2016, 60% was allocated to RE projects, 17% to low carbon transportation, and 14% to EE and green buildings.
For this trend to continue and the green bonds market to expand, however, several issues need to be addressed in terms of policy support as well as structuring of bonds. In order to minimise the cost of funds, for example, various strategies for risk mitigation and credit enhancement can be considered. Credit tranching is one such mechanism, in which a senior–subordinate structure is established wherein cash flows received from the underlying assets are allocated to different sets of investors based on different priority levels to which they subscribe to. The tranche with the highest seniority has the first right on cash flow. Over-collateralisation is another arrangement in which the value of assets supporting an asset backed security (ABS) will be greater than the outstanding principal owed to ABS investors. Therefore, in the event of a default, excess assets can be used to repay investors. There are also external methods such as third party guarantees in which a competent third party guarantees to meet the loan obligations should the borrowing party default on its repayment obligation.
Since green bond investors tend to be "buy and hold" investors, the secondary market for green bonds can be thin. As the market matures and expands, this dynamic will change. Liquidity generally adds depth to the market and encourages wider participation from both lenders as well as borrowers.
Thus, policy interventions, which can help nurture the bond market in general, will also add depth to the green bond market in India, given the large amount of investments that will be required to meet the country's RE and EE targets.
In this context, the Reserve Bank of India introduced a number of measures in August 2016 to develop the corporate bond market in India:
a) It raised the ceiling limit for partial credit enhancement to 50% of issue size from the earlier limit of 20%
b) It allowed banks to issue rupee denominated bonds overseas under the extant framework of incentivising issuance of long-term bonds by banks for financing infrastructure and affordable housing
c) In order to encourage activity in the corporate bond market, the RBI allowed brokers to participate in corporate bond repo market
d) To facilitate direct trading in corporate bonds, RBI in consultation with SEBI, decided to allow foreign portfolio investments (FPIs) to transact in corporate bonds directly without involving brokers.
A strong standards and certification process that clearly establishes green credentials can mitigate the risk of green washing—the superficial or insincere display of concern for the environment.
While all of these measures are geared towards adding depth to the bond market in general, their effect will also rub off on individual segments of the market such as green bonds. In order to provide a further boost to green bonds, there is a need for validation of "green" projects. A strong standards and certification process that clearly establishes green credentials can mitigate the risk of green washing—the superficial or insincere display of concern for the environment. Similarly, initiatives geared towards developing credit enhancement products such as loan loss reserves and credit guarantees will go a long way in supporting the market in initial stages and diversifying the issuer base.
A healthy capital market will be critical to achieving India's ambitious climate mitigation targets, and green bonds can act as an effective instrument in channelising the much-needed private capital.
Views expressed are personal.