Financing Global Climate Change Projects Using Bonds


Many people in the world suffer from the negative effects of climate change and other sustainability- and environment-related issues; however, the situation can be even worse in the future if serious action is not taken today (Schaeffer et al., 2012). The necessary action consists not only in reducing the environmental impact but also mitigating the negative effects of climate change and adapting to them. Further, essential modifications are required to create better infrastructures and energy sources so that the development of humankind does not undermine the development of further generations. However, these initiatives can be expensive to implement, and a major concern is finding financing for climate change projects. Sachs (2014) proposed the use of bonds (so-called green bonds or, in specific cases, climate bonds); the funding associated with them is to be used for improving the environment and sustainability or climate change mitigation and adaptation. Flaherty, Gevorkyan, Radpour, and Semmler (2016) further speculate on the advantages and disadvantages of green bonds. Upon reviewing the concepts of climate change and green bonds, it will be argued that green bonds should be used as a way to finance climate change projects because the use of these bonds increases available finance; allows the current generation to implement changes with future generations, which will benefit from the changes, paying for them; extends investors’ access, and facilitates the overall development of domestic capital markets and financial systems.

Climate Change and Climate Bonds

The need for financing climate change projects is justified by the widespread recognition that climate change is a serious threat to the future of humankind. It is now widely acknowledged that the effects of industrial production (e.g. in the fossil fuels industry) include the change of climatic patterns, which leads to many adverse consequences, including desertification, the rising level of water in the ocean (which presents the threat of floods), the deteriorating quality of air, water, and soil, and the decrease in biodiversity. All this eventually results in increased costs in agriculture and industry. However, climate change issues are associated with not only global warming but also unsustainable development (Schaeffer et al., 2012). Sustainable development can be defined as technological development that does not undermine further development; this can be achieved through two components. First, it should be ensured that lesser amounts of resources are used than the amounts that can be expected to be renewed and become available as the use of resources progresses. Second, it should be ensured that less waste is produced than the amount that can be taken up by nature, processed and reused, or recycled. Therefore, unsustainable development uses resources faster than they are renewed and produces waste faster than it is recycled. Current development, with the lack of use of renewable resources and with excessive waste, is considered unsustainable.

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However, with the evident benefits of shifting to sustainability, a major concern is that the shift is costly. The adoption of new sources of energy and new ways of production requires significant changes in infrastructures that some industries and sectors may not be able to afford. This is why, within recent decades, a lot of academic attention has been dedicated to finding new solutions in terms of financing. Many authors, including Sachs (2014), proposed the use of bonds as a method of financing. These so-called green bonds (or climate bonds in a narrower sense) are financial instruments that allow financing sustainability-related projects; particularly, they may be applied to climate change mitigation and adaptation efforts. Several important benefits of the instrument can be identified to be used as arguments for using green bonds as a solution to the problem of financing in the climate change context.

Increased Finance

A major issue to be addressed in climate change mitigation and adaptation is the availability of finance for green projects. While for some of them, the necessity of implementation may be recognized and confirmed, there may be a lack of funds, and this is particularly true for comprehensive projects, e.g. aimed at changing current infrastructure or building facilities that can contribute to more sustainable development, such as waste management plants or renewable energy production facilities. Bonds are an appropriate solution; moreover, the increased availability of finance that they offer will help attract more human resources, as more people might be interested in implementing green projects if the availability of funds for them is secured.

Green bonds function like regular bonds: an issuer sells a bond to an investor under the condition that the issuers’ debt will be repaid along with interest; the date by which complete repayment should be finalized is the bond maturity date. Various schemes and schedules of repayment have been designed (Flaherty et al., 2016), including repaying the entire principal debt at once or creating a schedule of regular payments (in the latter case, penalties may be established for early repayment; in all cases, penalties are established for not completing the repayment process by the maturity date). The bond market is developed today and adjusted for many different industries; therefore, it is not proposed to create a new financial instrument to make more funds available for green projects; instead, it is proposed to use a currently existing instrument and employ it for solving environmental issues.

However, there are also opponents of the use of bonds for financing climate change mitigation and adaptation issues. First of all, their argument is that, while bonds are, in fact, a developed financial instrument, it is not particularly true that they can be used for financing green projects in a way similar to financing other types of projects. The main difference is that green bonds are long-maturity bonds. Flaherty et al. (2016) wrote, “It does not seem to be sufficient to delay the repayment of bonds 5-10 years, as the climate benefits of investment will not be realized in such a short period” (p. 7-8). Indeed, in the bond market, what issuers and investors normally deal with is maturity that is noticeably shorter than that necessary for green bonds. Sachs (2014) admitted that this specific characteristic of green bonds and climate bonds was a challenge, and further research was needed to explore how long-term climate bonds can be phased in the market. Such research was presented by Flaherty et al. (2016); upon establishing that the two major factors affecting the bond market are the inflation rate and the interest rate, the authors showed research findings according to which, despite the low level of both rates and despite a recognized decrease instability, investors were still willing to purchase long-term bonds. This confirms that climate bonds can be used successfully.

Another major point of criticism is that climate bonds may not be as effective as other financial ways of addressing climate-related issues, e.g. carbon dioxide concentration in the atmosphere. One of the widespread strategies in this regard is the use of carbon taxes, i.e. taxation of fossil fuels, especially the producers of such fuels, to reduce emissions (Campiglio, 2016). However, there is a significant difference between the two mitigations instruments—carbon taxes and climate bonds. The former increases the burden on the fossil fuels industry and ultimately raises the costs for consumers, while the latter avoids such a negative effect. Sachs (2014) argues that the correct combination of taxation and transfer as part of the use of climate bonds can become a Pareto improvement both for the current generation and the future ones, i.e. a type of improvement in which the situation of some is improved without damaging the situations of others.

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Current and Future Generations

An important advantage of using green bonds is that repaying is delayed. Sachs (2014) particularly stresses that it should be recognized that shifting to “greener” (i.e. more sustainable) development today means that the current generation pays for modifications from which mostly future generations will benefit (because they will be able to continue developing sustainably), and this situation is not fair in a sense. It is true that the previous generations and the current ones are responsible for the unsustainable pattern of development, including the energy industry (Schaeffer et al., 2012), and the climate situation, including the high concentration of carbon dioxide in the atmosphere and the greenhouse effect. However, the burden of environmental challenges should not be imposed entirely on people who live and work today. Although they may suffer from many disadvantages of climate change, their efforts aimed at mitigating negative effects and adapting to the new climatic conditions are rather aimed at the future because climatic changes and global infrastructure modifications require a lot of time, and the effects of mitigation and adaptation initiatives are delayed.

Besides, the current generation may be unable to afford all the necessary costs. The general idea in this regard is that, with the use of bonds, the current generation will receive resources to implement changes, while the future generations will pay for it in the form of taxation. Flaherty et al. (2016) claim that green bonds are an instrument through which “[t]he current generation remains financially as well off as without mitigation while improving environmental well-being of future generations” (p. 2). To ensure this, however, the mechanism should be properly adjusted; otherwise, the debt may not be repaid, and the effectiveness of green bonds will be decreased.

The justifiability of this approach has been questioned. Not only will the people referred to in this framework as the future generations live in a world in which greener infrastructures are adjusted, and sustainable development is ensured (should this world be achieved by the efforts of the current generation), but also they will commit to more sustainable behaviors. Today’s environmental challenges are largely due to the everyday activities of people and their unwillingness to adopt greener practices; some do not want to experience inconveniences by consuming less water than they do, switching to a car that produces fewer emissions, or limiting themselves to just one car in a family, using less environmentally harmful packaging materials than plastic, and doing other things that they know would be more sustainable than what those people currently do. The future generations, on the other hand, in case of sustainability is achieved, will be more environmentally aware and responsible; why will they have to pay for climate change mitigation and adaptation measures taken long before those people are born?

Realizing this injustice, the proponents of green bonds emphasize that those people of the future will be the ultimate beneficiaries of these measures. Also, the burden will not be placed on them entirely since issuing bonds is proposed as one of the methods of financing climate change projects, albeit a major one, but not the only one. In addition, Sachs (2014) explains that the repayment is finite and will not doom humanity to endless climate change mitigation indebtedness. It is proposed to issue climate bonds for mitigating and adapting to the greenhouse effect consequences; there is a clear criterion for evaluating success: once the level of greenhouse gases in the atmosphere is low enough to not cause climate change and stable, the income tax should be reduced. Overall, given that a mechanism of controlling income tax is well-designed, the counterargument about the green bonds’ unfairness in terms of future generations is weak.

Investors’ Access

One more argument in favor of the use of climate bonds is that it is capable of attracting more investors to the area of climate change mitigation and adaptation by raising their access to green projects and initiatives. It is estimated that the transition to a model of development and energy use in which the level of carbon dioxide concentration in the atmosphere can be considered safe will take approximately a total of ten trillion USD of investment in sustainable technology and infrastructure by 2030 (Flaherty et al., 2016, p. 6). This amount is more than half of the nominal GDP of the United States. It should be recognized that it cannot be attained through separate, uncoordinated investments; instead, what is needed is to create a sustainable network of investors.

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Again, what is important in this regard is the familiarity of bonds as a financial instrument. For example, foreign investors will need less time and resources to explore and manage the framework in which they invest in environmental projects; it means that the investment opportunities are extended for them through the use of mechanisms that are widely used in other industries. Of course, the stakeholders will have several financial considerations that are specific to climate bonds, e.g. the long-term maturity discussed above (see Increased Finance); however, this is not a principal difference from other types of bonds but rather a non-essential one, although it requires being properly considered.

When discussing the use of green bonds in the context of investment, one should pay special attention to investment incentives and the likely or encouraged distribution of investment. A key aspect of investor interest is that project activities are efficient, i.e. maximum effectiveness is achieved with a given volume of resources. However, the efficiency and effectiveness may vary among different places in which the same project may be implemented. For example, improving the quality of water or preventing deforestation, which is the green initiative, can be rather costly in developed countries in which complicated infrastructures and interests may be involved; in some developing countries, on the other hand, it may be simpler to implement these projects because fewer elements are involved; even creating new infrastructure elements may be less challenging than modifying existing ones. Based on this, Williams, Jones, and Pickin (2017) claim that investors are more likely to invest in projects in which mitigation and adaptation goals are achieved with lesser input, i.e. in which attained impact per unit of currency is the highest. In developing countries, project costs may be significantly lower than in developed ones, and this enhances investment opportunities and investor interest.

However, the opponents of the use of green bonds may argue that other important investor-related considerations are ignored—these include investor trust and investor confidence. For example, a project, for which financing with the use of green bonds is proposed, deals with creating a facility to produce a certain type of renewable energy. Although much research has been dedicated to this area, much less is known today about the effectiveness of renewable energy than it is known about the effectiveness of more conventional types, such as fossil fuels, because the latter has been produced for a considerably longer period. Moreover, the long-term maturity of green bonds can be expected to decrease investor trust (Campiglio, 2016). However, Arezki, Bolton, Peters, Samama, and Stiglitz (2016) showed that financing with green bonds is consistent with the investment strategies of government-owned investment funds, pension and mutual funds, and insurance companies. Their combined assets under management allow creating appropriate investment conditions, which is why the relevance of arguments about the lack of investor interest should not be overestimated.

Facilitation of Development

Finally, green bonds should be used in financing environmental projects because these bonds are capable of positively transforming the capital markets and financial systems of those countries in which such projects are implemented. This development may go beyond green projects; Williams et al. (2017) recognize several benefits of the green bond market that allow such a positive contribution. First of all, its issuance rates are sufficient to generate and sustain market interest; the depth of the market allow macroeconomic factors to affect important investment indicators, such as interest rates and their dynamics, the level of investable funds, and investor interest associated with other financial indicators, such as the level of inflation. Second, the market is broad; the investor base is characterized by the presence of both domestic and international issuance, and the investments are systematized and coordinated in a network approach. It is also important that there is diversity among investors, as this increases the chances of various projects to be implemented, i.e. more different environmental issues can be addressed.

Third, the authors see a strong green bond market as one independent from public sector funding; initiated with the support of public funding, it should eventually achieve the point of self-sustainability. Fourth, these positive dynamics can improve the development of the financial system overall. Finally, repeat issuance makes the process continuous and maintains a high level of outstanding issuance; while Sachs (2014) regarded the development of the green bond market in a discrete-time model, Flaherty et al. (2016) proposed a continuous model, and it particularly demonstrated how the longevity of this market can be ensured. Finally, it has been described what concerns green bonds may cause in investors (see Investors’ Access); if those issues are properly addressed, the green bond market will improve the overall investor confidence in a country. This is particularly so because green bonds have challenging aspects, and addressing them effectively will help develop strategies to, for example, properly maintain investor trust in other markets. Methods of improving confidence include using the work of established rating agencies and independent reviewers.

A possible counterargument is that, instead of developing the financing systems, green bonds disrupt them because of long-term maturity and a long time horizon, especially in terms of achieving actual climatic improvements. In this regard, it should be noticed that green bonds still constitute a small portion of the bond market (Flaherty et al., 2016); besides, their mechanisms are the same as those for bonds aimed at non-environmental initiatives. Also, Williams et al. (2017) stress the importance of collaboration between public funding and domestic private funding; in this collaboration, the latter receive particular benefits because “[b]y giving companies the ability to borrow domestically in local currencies, domestic capital markets can also reduce currency mismatches for borrowers, thus reducing risk” (p. 5). This process of recycling domestic capital in projects aimed at local improvement of the environment and mitigating and adapting to the effects of climate change is therefore beneficial in terms of not only sustainability but also financial development of a country.

Conclusion

It has been shown that the use of green bonds as an instrument for financing climate change mitigation and adaptation projects provides more investment opportunities, makes more funding available, avoids imposing too heavy burdens of environmental issues on the current generation, helps improve investor interest, and facilitates the development of capital markets and financial systems. Certain disadvantages are recognized, too, such as a long time horizon, but it is also acknowledged that properly designed mechanisms of issuance will turn challenges into opportunities and will help develop other sectors as well. To prevent further damage from climate change and environmental issues, more green projects should be financed, and issuing green bonds has been confirmed to be an effective way of providing such financing.

References

Arezki, R., Bolton, P., Peters, S., Samama, F., & Stiglitz, J. E. (2016). From global savings glut to financing infrastructure: The advent of investment platforms. Web.

Campiglio, E. (2016). Beyond carbon pricing: The role of banking and monetary policy in financing the transition to a low-carbon economy. Ecological Economics, 121(1), 220-230.

Flaherty, M., Gevorkyan, A., Radpour, S., & Semmler, W. (2016). Financing climate policies through climate bonds. Web.

Sachs, J. (2014). Climate change and intergenerational well-being. In L. Bernard & W. Semmler (Eds.), The Oxford handbook of the macroeconomics of global warming (pp. 248-259). Oxford, UK: Oxford University Press.

Schaeffer, R., Szklo, A. S., de Lucena, A. F. P., Borba, B. S. M. C., Nogueira, L. P. P., Fleming, F. P., … Boulahya, M. S. (2012). Energy sector vulnerability to climate change: A review. Energy, 38(1), 1-12.

Williams, J., Jones, A., & Pickin, S. (2017). New markets for green bonds: A guide to understanding the building blocks and enablers of a green bond market. Web.

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