The role of bond markets in accelerating the energy transition

Context

Realising clean energy ambitions in emerging economies requires a considerable scaling up of investment flows. As clean energy projects, like most large infrastructure projects, are typically funded by debt-heavy capital structures, this translates into the need to augment existing debt capital flows - largely sourced from banks and non-bank financial institutions (NBFIs).

The challenges constraining debt capital flows to this sector vary by country. In many emerging economies, underdeveloped banking and financial sectors, or local bankers’ lack of familiarity with clean energy projects, restrict the scaling up of domestic debt financing. Even in countries with better developed financial systems, constraints such as asset-liability mismatches in financing long-term infrastructure projects, and regulatory limits on sectoral credit exposure, limit expansion in debt capital flows.

A possible solution for easing constraints pertaining to existing debt capital flows is offered by bonds, debt instruments in which the issuer (borrower) makes regular interest payments (usually fixed-rate in the Indian context) to the lender (investor), in addition to repaying the principal at maturity. In contrast to illiquid bank loans, bonds are tradable instruments usually listed on capital markets. This liquidity facilitates the participation of long-term institutional investors such as pension and insurance funds.

Bonds can help refinance primary debt issued by banks and NBFIs to clean energy projects, freeing up this capital for further lending. Refinancing primary debt for operational projects helps lower the cost of capital (since operational projects have lower risks) for borrowers and therefore, the burden of debt repayment. In addition, fixed-coupon bonds provide greater certainty over debt repayment to borrowers than loans (usually floating rate) from banks or NBFIs. Green bonds are a category of bonds that are eminently suitable for clean energy debt financing, since the proceeds of these issuances are earmarked for clean energy and climate change-related end uses.

Relevance and impact

Indian clean energy markets exemplify the bond market’s potential role in clean energy financing. Attaining India’s clean energy ambitions requires considerably larger investment flows than current levels. For example, to achieve India’s Paris Agreement targets, annual investment flows in the renewable energy sector will have to be scaled up from USD 11 billion (2014–2018) to around USD 30 billion.[1][2] Similarly, investment flows must be scaled up in more nascent clean energy segments such as electric mobility.

Besides asset-liability mismatches and sectoral exposure limits, a high proportion of non-performing assets on bank balance sheets and liquidity constraints for NBFIs in the wake of a bond default by a systemically important institution in 2018 hamper debt flows to clean energy. The bond market, including the subset of green bonds, could help ease the constraints on debt capital flows and bridge the gap between existing and desired capital flows to clean energy.

Who should care?

• Clean energy developers/equity investors
• Domestic banks and NBFIs
• Institutional investors (pension funds, insurance funds, and mutual funds)
• Ministry of Finance, Government of India
• Securities and Exchange Board of India (SEBI)