A Change of Heart on Investing in the Climate

When State Street Global Advisors, the investment management arm of State Street Corp., offered its first “high-quality green bond strategy” last month, it gave institutional investors a chance to hold segregated accounts that invest in fixed income instruments raising financing for projects meant to battle climate change.

The move followed that of Nikko Asset Management of Japan, which in March announced that it had raised $640 million for its Nikko AM World Bank Green Funds, the first fund dedicated to investing in green bonds issued by the World Bank.

With an estimated $1 trillion a year in climate change mitigation and adaptation investments needed until 2050, according to estimates by the International Energy Authority, tapping the deep pockets of institutional investors is important for financing large climate change investments. And given the volatility of financial markets, bonds are a lower-risk option.

But up to now, many institutional investors have been turned off by the lack of investment-grade green bonds and the small size and lack of liquidity of the market.

In the past three years, the opening of the green bond market has been led by multinational development banks and other supranational organizations, like the World Bank and the European Investment Bank, which have issued low-risk triple A-rated bonds, yielding rates comparable with U.S. Treasury bonds.

To date, about $12 billion worth of such bonds have been issued, still a very small amount compared with the overall size of the bond market and the need to finance projects that address climate change. A few green corporate bonds have also been issued, but the number of highly rated companies in a position to issue such bonds remains limited.

“Most outstanding green bonds are purchased in private placements and constitute part of investors’ buy-and-hold strategies,” said Christopher McKnett, head of environmental, social and governance investing for State Street Global Advisors. “Bonds issued by supranationals, multilateral development banks and multilateral financial institutions are among the most liquid fixed income securities available, and issuers maintain buyback provisions as a liquidity backstop.”

State Street Global Advisors’ high-quality green bond strategy, he added, “potentially provides a platform for a mainstream investor to access green fixed income investing at larger scale that will potentially drive better pricing and facilitate greater liquidity due to the aggregation of buying power.”

Mr. McKnett said that the bond strategy “can be implemented in a separately managed account” and that “we do hope to aggregate demand to eventually support a commingled fund in order to accommodate smaller investors or those investors that prefer a commingled structure.”

Beyond liquidity, concerns about the true “green” nature of the underlying projects green bonds help finance has been another important issue for investors. And, again, bonds issued by multilateral institutions have an edge.

“It’s easy enough to screen for the bonds issued by the World Bank or other multinational institutions because most investors trust those. But when it comes to corporates it’s not so simple,” said Sean Kidney, executive chairman of the Climate Bonds Initiative, an investor-focused nongovernmental organization set up to promote large-scale investment in the low-carbon economy.

To solve the problem, the Climate Bonds Initiative has developed a “green” certification, which will function as a screening tool for investors interested in the market, and should help increase the pool of bonds available for funds.

The nongovernmental organization announced the details of its certification, called the Climate Bond Standard, on Nov. 24, which allow for certification of bonds backed by or linked to low carbon assets, especially project development bonds, corporate bonds linked to a pool of loans of compliant assets and bonds issued by securitization of individual loans to finance physical assets or equity investments in physical assets.

Mr. Kidney says bonds complying with the standard will be certified as “climate bonds,” a mark that will help assure investors and governments of their contribution to the delivery of a low-carbon economy. Third-party verifiers will review proposed bonds to confirm that they comply with the standard.

Mr. Kidney estimates that $14 billion to $30 billion worth of bonds backed by investments related to climate change solutions have already been issued internationally, and the new standard will at first focus on certifying those existing bonds that meet its requirements.

“The new standard allows for a new fixed income asset class to emerge and grow — one that will be focused on recognizing the investments needed to deliver a low-carbon economy by 2050 and on limiting the risk of dangerous climate change,” he says, adding that “when you’re talking about building a low-carbon economy, it should not be just about mitigation but about adaption as well. Water investments in North Africa might be considered climate adaptation bonds. Adaptation would look at infrastructure for disaster risk reduction, flood defenses or forestry conservation.”

“We want to show investors they can already start exposing themselves to that market because a larger pool of climate change bonds exists. They don’t need to wait for the market to develop further. Our current interest is in retrospectively certifying these bonds and new issuances to provide integrity to the current market,” he says.

Jack Ehnes, the chief executive of the California State Teachers’ Retirement System, a large U.S. pension fund with $150 billion under management, and a member of the Climate Bond Standards Board, said that the teachers’ pension fund was looking for investment-grade returns in instruments that also address climate change. He believes the Climate Bond Standard gives the pension fund the methodology that will allow it to know that “the investment opportunities put before us will be the right ones on which to build a low-carbon economy.”

“The idea of this certification is that it will provide environmental credibility for the issued bonds. It will allow funds to focus on this market so it develops,” Mr. Kidney said.

Mr. Kidney added that his organization, which has been “enthusiastic” about State Street Global Advisors’ new green fund, had discussions establishment of climate bond funds with at least two other large fund managers.

State Street Global Advisors’ fund “is a significant development for institutional investors looking to invest into that climate bond market. If you’re an institutional investor, this fund gives you access to a more liquid format for buying and holding the actual bonds,” Mr. Kidney said.

But Peter Cook, senior investment officer at the IFC Climate Business Group, issued a word of caution, noting that institutional investors usually only come to the market for large-size bonds of $500 million or above. To work, the fund itself will need to be quite large, he said, noting that the pipeline of deals and assets to justify the fund may not yet be there.

However, he added, the new green seal of approval should help investors understand what really is green for the day when the pipeline is there.