Incentives schemes paired with a pressure to invest green have transformed the market for green bonds. Green bonds are fixed-income instruments that go towards funding projects for the climate and environment – a neat way of making a return on income whilst supporting a very important cause. Without incentives, institutional investors may see these as less valuable, with there only being one motivation for purchasing, which would be to appear ESG friendly. Governments are well aware of the necessity of green investments in order to fund transformational projects – be it by research and development or through funding physical capital. As a result, they have employed a variety of incentives and programmes to allow these bonds to thrive.
As covered in one of our previous articles (link), COVID-19 has helped accelerate the drive towards green bonds through the strong performance of ESG funds and the greater focus on sustainability.
The moral incentive to invest green is painstakingly clear; the UK’s goal to become ‘carbon-zero’ by 2050 is ambitious but is rooted in the understanding of the dire need to shift away from fossil-fuels and look for sustainable alternatives for the long-term. The multitude of problems facing society over the next few decades span widely from clean water to pollution to global warming; without institutional change these issues will only become worse, leaving future generations an even worse situation. It is imperative for finance to be raised for the green projects which will allow governments to meet the agreements made in the 2015 Paris Summit.
The UK’s Green Finance team in 2018 made various recommendations on how ‘the Government should provide short-term incentives to pump prime the green consumer loans and green mortgage markets’. (2) One of these suggestions is green tagging to point out whether the activities the investment is financing is ‘green’, ‘brown’, or ‘neutral’ in order to make the impact of the bond more clear. Compared to ESG criteria, this has a greater focus on the environment in particular – although the recent rise in popularity of ESG as a rating may mean green-tagging is no longer as relevant. They also suggested that the UK’s private sector was not in a strong enough position to naturally be able to boost investment into technological innovation. This would be as a result of a lack of funders to provide the initial investment, putting off investors further down the line for larger investors so there is ‘a smaller pipeline of later-stage deals’. The suggested solution to this is a Green Investment Accelerator to fund projects at their early stages, similar to the Innovate UK Investment Accelerator for health, life sciences, and infrastructure systems. This materialised in the £40 million Clean Growth Fund announced in May 2020 (3); in the long-run this will mean there will be many more projects which will have made it to the later-stage investments, providing more opportunity for investors to finance revolutionary projects. The government has also created a sovereign green bond (on the recommendation of the Green Finance Team) (4) called the Green Gilt, providing more security through the backing of the government and therefore encouraging greater investment.
Governments around the world have provided financial incentives to stimulate investment into these green bonds through a tax credit, tax-exempt, and direct subsidy bonds.
Tax Credit Bonds
Tax credit bonds are where the returns of a bond are through tax credits rather than through interest payments – this allows those issuing the bonds to not have to pay any interest for their debt as it is the government volunteering these tax credits. Those who are holding the bonds benefit from lowering their tax liability and in some cases are able to receive some tax-free interest. For example, since the introduction of the solar Investment Tax Credit in the USA in 2006, private equity has invested $68bn into solar energy. (1)
Tax Exempt Bonds
Tax-exempt bonds mean that those holding bonds do not have to pay income tax on any interest from green bonds. The incentive is relatively common in the USA and is also used to finance wind projects in Brazil.
Direct Subsidy Bonds
Direct subsidy bonds allow those issuing green bonds to get additional cash from the government in order to subsidize their net interest payments. Examples of these include the USA’s Clean Renewable Energy Bonds and Qualified Energy Conservation Bonds.
One of the key strategic growth areas for green projects is offshore wind-farming; without the on-land complaints of being a sight-sore and rapidly decreasing costs in the last few years, more governments are trying to use them in order to shift their consumption onto renewable energy sources. The main downside is the unreliability, a negative which is considerably decreased through the farms being offshore and thus having access to the stronger winds in the sea. This growth opportunity has been reflected in the markets – Denmark’s Orsted has seen its share price double over the last year.
Whilst financial incentives are important, as humans, we should also feel an ethical obligation towards investing in environmental projects. Increasing awareness and making it compulsory for funds to reveal how ‘green’ their portfolio is may increase the cause’s appeal to the moral compass more effectively. Taking a lead from the UK’s NUDGE unit, the government could also partially focus its efforts on considering how to use behavioural economics to frame investments such as the Green Gilt.
Environmental criteria are becoming increasingly relevant in choosing investments, as society becomes more conscious about their decisions. High-profile campaigns by groups such as Extinction Rebellion have brought heavy media attention to how widespread environment-damaging investments are – for example, Trinity College Cambridge’s oil investments with its one trillion pound portfolio. Financial incentives have proved effective in influencing decisions, contributing to the creation of various ‘green’ investment funds such as the Schroder ISF Global Energy Transition (5) (managed by Mark Lacey) which focuses on renewable energy through investing in firms such as First Solar and LG Chem. The UK government’s efforts towards encouraging such investment is still in their early days so it is hard to judge its performance – however, the commitment to implementing policy suggestions have been proven and the UK could help lead the case for green finance.