By Hilary Schmidt, International Banker
Climate-linked bonds, innovative financial tools designed to address the growing challenges of climate change, are fixed-income assets that are linked to climate-change solutions. Typically issued by governments, supranational organisations and corporations, the payouts of such bonds are determined by various measurable climate variables, such as average temperatures or greenhouse-gas (GHG) concentrations; they also give investors hedges against long-term climate risks. As per normal bond instruments, moreover, the issuing entity guarantees to repay the bond over a certain time period, along with a fixed or variable coupon rate.
The term climate bond is also often used interchangeably with the term green bond and other sustainability-linked bonds. But while green bonds normally raise finances for projects that cover a wide range of environmental, sustainable and socially responsible objectives, climate bonds more narrowly hone in on projects that directly reduce carbon emissions and the impacts of climate change. Sustainability-linked bonds, meanwhile, have even broader objectives; they are typically issued by companies seeking to fund corporate activities in order to achieve a self-imposed sustainability objective.
The majority of climate bonds issued to date have been use-of-proceeds bonds that require the issuer to allocate the funds raised from such a bond issuance to financing specific causes—in this case, typically climate-related programmes, such as renewable-energy projects. The Climate Bonds Initiative (CBI), an international organisation working to mobilise global capital for climate action, has identified three types of use-of-proceeds climate bonds:
- Project bonds, whereby the funds raised from the bond issuance are placed in a separate company or special purpose vehicle (SPV) for a particular project.
- Asset-backed securities, whereby the money is allocated to a portfolio of cash flows that are securitised in one bond, such as a portfolio of loans to renewable-energy projects.
- Covered bonds, whereby the investor has dual recourse to the issuer’s balance sheet (typically a bank) and also a pool of high-quality assets (usually mortgages).
In 2007, the Climate Awareness Bond (CAB) was issued by the European Investment Bank (EIB) as the world’s first green use-of-proceeds bond—before the launch of its inaugural Sustainability Awareness Bond (SAB) in 2018. While the former focused on projects contributing substantially to climate-change mitigation, the latter extended this coverage across a broader range of sustainability objectives beyond climate-change mitigation and social-sustainability objectives. According to the bank, CABs introduced “a groundbreaking approach to sustainable finance by enabling greater clarity and accountability through dedicated use-of-proceeds”.
On October 4, 2024, the EIB surpassed the €100-billion mark in total issuance of CABs and SABs. As such, climate-linked bonds are regarded as a crucial plank of the movement towards a net-zero economy that emits no greenhouse gases or is able to offset its emissions. “By directly linking financial returns to climate outcomes, climate-linked bonds provide a strong incentive for issuers to align their actions with climate change mitigation goals,” according to the European Central Bank (ECB). “The instrument not only signals a government’s commitment to addressing climate risks but also offers investors a mechanism to hedge against the long-term economic consequences of climate change.”
For investors, the benefits of climate-linked bonds are manifold. For one, they offer a hedging strategy against climate risks whilst also aligning their investment strategies with long-term climate objectives. According to a working paper on climate-linked bonds published on October 31, 2024, by the Dutch central bank, De Nederlandsche Bank N.V. (DNB), institutional investors such as pension funds, insurance companies and sovereign wealth funds lack significant diversity in their choices of effective climate-hedging instruments.
“It is well understood that investors currently lack effective climate hedges. Existing strategies for mitigating climate risk often involve sophisticated and costly dynamic rebalancing in response to climate news,” the paper’s authors and DNB economists Dirk Broeders, Daniel Dimitrov and Niek Verhoeven wrote, suggesting that climate-linked bonds offer a more efficient solution for this purpose. “The coupon adjustment mechanism, when structured to respond to temperature rises, sea level rises, or water levels in rivers, provides investors with an extra return if the global transition to a low-carbon economy does not occur in a timely and efficient manner, and higher intensity of heat waves, floods, or similar natural catastrophes materialises.”
On the other side of the transaction, moreover, climate-linked bonds present attractive investment opportunities for issuers, such as governments and other state-level organisations, as they can benefit from issuing the bonds at the price premiums and attractive yields that are commonly observed among the sustainability-linked bonds in high demand. Such favourable terms should thus incentivise governments to advance agendas that seek to combat climate change, with the issuance of a climate-linked bond also deemed a transparent and accountable way to do so.
By linking the government’s financial obligations to climate-related variables, the bonds encourage sustained and robust policy efforts across successive administrations, the paper also noted. “By aligning sustainability objectives with financial considerations, the instrument internalizes, at least partially, the existing climate externalities,” according to the authors. “In the absence of adequate climate mitigation measures, through climate-linked bonds, governments directly face the consequence of elevated greenhouse gas concentrations, as the coupons or face value on their issued debt adjust as a form of penalty.” As such, the paper added, this mechanism “aligns ex-ante the economic interests of governments with the imperative to implement effective climate policies that would reduce long-term physical risks due to climate change.”
Ultimately, therefore, creating a market for climate risks through the issuance of these bonds brings with it crucial benefits for combating climate change. The DNB paper outlined three specific advantages:
- Closing the information gap: Through market pricing and the size of the climate-risk premium, climate-linked bonds can bridge the information gap for future climate risks. “Incorporating these bonds into the financial system embeds climate risk into government balance sheets, clarifying and formalising the government’s role in tackling climate-related issues, especially during major external shocks,” the paper noted.
- Reducing the incentive gap: These bonds can close the incentive gap by aligning a government’s financial interests with climate action. Issuing significant climate-linked debt can enable governments that successfully mitigate climate change to lower their future fiscal obligations by paying lower coupons on the debt. The earlier and stronger a government’s climate-transition policies are, the greater its influence to mitigate the impacts of specific climate variables and the lower its payments linked to the bond will be.
“Financial markets can help address this issue because a credible climate policy will alter the expected path of the climate variable, which will be immediately reflected in the current bond prices, allowing governments to finance themselves at lower yields,” the paper observed.
- Reducing the insurance gap: Climate-linked bonds provide an opportunity for investors, such as insurance companies, to hedge against climate risks, thereby making explicit the backstop of government support in the event of large natural disasters. “Consequently, private parties, in particular insurers and re-insurers, will be more inclined to take on some climate risk on their balance sheet, knowing that implicit government protection against tail risks is now made explicit,” according to the paper.
But one key “gap” still exists: the funding gap. For instance, the European Commission (EC) has calculated that climate investment is falling short by between €550 billion and €912 billion per year. And while state-level programmes, such as the European Green Deal and NextGenerationEU, can alleviate some of this funding shortfall, some believe that the resources pledged by European nations are considerably lower than the relevant investment needs—perhaps even less than half of what is required.
Simply put, Europe faces a large climate-investment gap, according to economists Irene Monasterolo, Antonia Pacelli, Marco Pagano and Carmine Russo. They jointly recommended in a February 2024 research paper that climate bonds be issued by the European Stability Mechanism (ESM), a Luxembourg-based, permanent rescue fund set up in 2012 to provide loans to financially distressed euro area countries.
“These bonds would be funded by selling greenhouse gas emission allowances via the Emissions Trading System, extended to cover all sectors,” the paper titled “A European Climate Bond” noted. “Access to the resulting funds would be conditional on countries’ performance on the implementation of climate projects. European climate bonds would meet the demand for a safe, liquid and green asset while accelerating climate investment and increasing its resilience to sovereign crises, as well as the greening of both investors’ portfolios and monetary policy.”