Improving risk-return profile: Increasing returns or reducing risks

Climate-themed investments can have risks, or be perceived as risky, due to the lack of financial track record and technological risks. While the risk will fall over time also without policy intervention, time is of the essence when it comes to climate change investments, and therefore policy intervention to speed up this process and alter the risk-return ratio for investors is warranted.

The risk-return ratio for investors can be improved in two main ways:

  • Increase returns: Particularly by providing strong price signals
  • Decrease risks

Reducing risks is particularly relevant for green bond structures where the returns are directly linked to the performance of the underlying green assets.  To date, the risk of the majority of green bonds issued have been determined by the issuing entity, rather than the underlying green assets, which has allowed the market to progress without specific risk-reducing mechanisms from governments. However, to achieve the necessary scale and allow expansion of green bond issuance to other entities and structures, de-risking mechanisms are crucial.

Policy actions

To increase returns, there are several types of strong price signals government can put in place that could underpin green bond issuance:

  • Carbon price
  • Feed-in-tariffs
  • Power purchase agreements (PPAs)

To reduce risks, a wide range of tools is available:

  1. Guarantees: These can be provided by directly by governments, or by green investment entities and green banks. For example, the European Investment Bank’s Project Bonds Initiative provides credit enhancements for bond issuance to address the policy objectives of the EU’s Connect Europe program.
  2. First-loss provisions: Also these can be provided directly by government or by green banks. Junior or mezzanine debt from a development institution can enable green bond issuance from investors at a suitable investment grade to attract private capital. Examples would be Fannie Mae in the United States with housing loans, and the Green Deal Finance Warehouse in the U.K. with residential energy efficiency loans.
  3. Insurance: A government - or multi-government - supported enterprise, a green monoline, could insure green securities. Additionally, a policy risk insurance facility for clean energy would be valuable in reducing risks to investors: The policy support required for some clean energy itself introduces risk that the policy support will be removed. Regional or national facilities can be set up to insure this risk and hence de-risk these investments.
  4. Financing systems with low payment default risk: By putting in place legislating that enables financing systems with low-risk for payment default for renewable energy and energy efficiency loans, governments reduce the risks to investors in securities backed by these loans. An example of this is the Property Assessed Clean Energy scheme in the US, where low-carbon projects are repaid through property tax. This structure has been successfully used to back the issuance of green securities.