The role of policymakers in scaling the green bonds market

The trillions of investment we need to transition to a low-carbon and climate resilient economy must happen quickly; emissions are increasing to a relentless drumbeat. Existing climate finance mechanisms, such as carbon markets, are not going to achieve the rapid change we need. So far, governments have focused on putting in place policies for green in the real economy - such as feed-in-tariffs. While necessary, there are many other options policymakers can make use of in the financial sector to unlock private sector investment flows into climate mitigation and adaptation that remain underutilized.  

Governments have throughout history used various forms of “capital steerage” to shift investment into areas of urgent policy priority
For instance, most of the urban infrastructure that developed countries take for granted – from sewers to railways to aviation and to highways – depended on active government steps to ensure necessary capital investment. Capital steerage has involved tools ranging from policy and regulation to credit enhancement, guarantees, and tax credits. At times it has involved special deals, like agreeing real estate concessions in mid-19th century America so railroad companies had the extra incentive to connect the West Coast (a model copied for the Copenhagen Metro only a few years ago). In the 1990s the German government tweaked regulation of the Pfandbrief market to promote bank lending to housing and public sector projects in newly integrated East Germany.

Bonds: covered, asset-backed, sovereign, housing, war, highway, railroad — even sewer bonds — have been the recurring financial instrument of choice underpinning such capital steerage. The use of bond finance has been enormously successful. Vast infrastructure projects have been completed; hundreds of thousands of unemployed people or de-mobbed soldiers have been re-integrated into economies; finance has been democratized in many sectors. We now face the defining challenge of our times: a global switch away from carbon-dependency to a rapid transition to a low-carbon and climate resilient world. Our opportunity is that this is about investment, not cost.

Governments’ role is not to fully fund, but to enable the climate finance we need. That means sorting out economic and energy planning and then to reduce key risks — notably government-related policy risk — enough to deliver secure long-term investment returns. That’s how to channel private capital towards low carbon investment: capital Steerage.

To attract private capital, climate investments must fit with the investment preferences of the investors. As institutional investors account for the largest share of the capital pools, and bonds account for the largest share of their investment portfolios, this is where we see the largest potential for climate investments. The investments in this space are large-scale and relatively low-risk, low-return investments.

Governments can use capital steerage tools and instruments to create a deal flow that fit these size and risk investment preferences, but that is also green. A key point to emphasize is that it is largely green infrastructure we need, and governments have played a role in mobilizing capital for various infrastructure investments for centuries. Therefore, many existing and well-proven tools can be used by policy makers to increase investment in green through the bond market.

Policies both on the demand side and supply side of green bonds play a role to grow the green bonds market and increase investment in climate solutions. There is a high demand for low risk investments, as institutional investors with relatively low risk-return profiles dominate the bond markets. However, green investments are often perceived as a “novelty”, which means higher risk is attached to the investments, and investors therefore require higher returns – or become reluctant to invest. In order to reduce the perceived risk, governments needs to put in place policies to reduce the risks and make them investment grade.

The Climate Bonds Initiative has identified a range of policies for policymakers to support the growth of a green bonds market.