In 2007, the European Investment Bank issued its first green bond, a EUR 600 million equity index-linked security, whose proceeds were used to fund renewable energy and energy efficiency projects. A year later, the World Bank followed suit, and by 2017, over $155 billion worth of public and corporate green bonds had been issued, paving the way for the Seychelles government to issue the first ever “blue bond” last year— a $15 million bond to fund marine protection and sustainable fisheries.
The success of these instruments reflects the fact that investors are increasingly conscious of the social and environmental consequences of the decisions that governments and companies make. They can be quick to punish companies for child labor practices, human rights abuses, negative environmental impact, poor governance, and a lack of gender equality. Pair this with an increase in regulatory drivers post-2008 crisis, and a deepening understanding of the impacts of climate change and associated risk to performance, and we begin to see more clearly the need for investment models that will better address investors’ concerns.
The result has been an increasing demand for integrating Environmental, Social, and Governance (ESG) criteria into investment decisions. In the beginning of 2018, $11.6 trillion of all professionally managed assets—one $1 of every $4 invested in the United States—were under ESG investment strategies, a sharp increase from 2010, when the amount was close to just $3 trillion overall.
Inevitably, the financial services sector has responded with a host of innovative financial instruments, some like those mentioned above, others quite different. The through-line that ties together these new investing models and strategies is quite simple: While they have generated competitive returns, it so happens that they all positively benefit society as well. Essentially what investors want is the performance promise of financial engineering combined with the assurance of a better tomorrow.
Many of the innovations have been driven by a collaboration between public, private, and philanthropic institutions. At The Rockefeller Foundation, we recognize the value of engaging private capital markets for societal good and have stepped in to fund the research and development of new instruments that can bring capital to cause. We have increasingly seen, firsthand, how readily these instruments meet not just investor needs but also values, and how interrelated the two can be.
Let’s look at some particularly interesting examples.
Risk-sharing Impact Bonds
Fixed income is one of the largest asset classes as determined by asset owner allocation and market size. Compared to the other asset classes it has the lowest expected returns, hence also has the lowest cost of capital. At $4 trillion the US municipal bond market is one of the largest fixed income markets globally.
Climate change is becoming increasingly important for the US municipal finance sector. On one hand US cities need to raise more capital to implement environmental projects – many of them based on innovative climate solutions – to protect their economies and communities from the effects of climate changes – e.g. green infrastructure to manage flooding, waste to energy micro-grid to prevent power outages during hurricanes. On the other hand, if they do not show meaningful results, they won’t only risk economic losses from disasters but also risk seeing an increase in their overall cost of borrowing. Rating companies such as Moody’s are increasingly assessing climate riskas a negative factor when assessing credit ratings.
Environmental impact bonds – in many ways an extension of green bonds market – offer a solution to this problem, because they can draw in investors interested in taking on the environmental risk in exchange for potential monetary reward. These securities are municipal bonds that transfer a portion of the risk involved with implementing climate adaptation or mitigation projects from the public agency on to the bondholder. A good example is a $25 million bond issued by the municipal water board in Washington, D.C. in 2016.
The water board used the bond to fund the construction of green infrastructure to manage storm water runoff and improve water quality. The return to investors is linked to the performance of the funded infrastructure, which allows DC Water to hedge a portion of the risk associated with both constructing green infrastructure and, once it’s in place, how well it works. Another such bond is currently under development by the city of Atlanta, for approximately $13 million worth of green infrastructure projects in flood-prone neighborhoods on the city’s west side.
In the case of the DC Water bond, investors receive a standard 3.43 percent semi-annual coupon payment throughout the term of the tax-exempt bond. Towards the end of a five-year term – at the mandatory tender date – the reduction in stormwater runoff resulting from the green infrastructure is used to calculate and assign an additional payment. If the results are strong (defined in three tiers; tier 1 being best performance) the investors receive an additional payment ($3.3 million) – bringing their interest rate effectively to 5.8 percent. If the results are as expected, there is no additional payment. And if the infrastructure underperforms, the investors owe a payment to DC Water ($3.3 million) – bringing the interest rate to 0.8 percent.
Financially Passive, Socially Active Funds
One of the most interesting of the new generation of ESG-driven financial innovations can be seen in the Exchange Traded Fund (ETF) sector, where we are starting to see the passive investment movement linked to activism on key social and environmental issues through in ESG-themed ETFs. The first ESG ETF, iShares MSCI USA ESG Select ETF, was launched in 2005, and the model has caught on so quickly that today there are at least $11 billion in assets under management across 120 ESG funds globally; stateside, the growth of assets in ESG funds is up over 200 percent from the past decade. BlackRock recently predicted that the investment in ESG funds will rise to more than $400 billion over the next ten years.
A good example is the NAACP Minority Empowerment ETF, or NACP. Issued by Impact Shares, a non-profit fund manager, the specific criteria for the index, which includes companies such as Microsoft, Pepsi, and Verizon, are identified and compiled by the NAACP. The criteria assess the levels of social activism, equal opportunity, and diversity of workplaces within each company. These criteria are measured and tracked by the fund’s ESG research provider Sustainalytics. The index is then constructed from the top 200 scoring companies by Morningstar, which uses a weighting methodology that maximizes exposure to companies with high scores on the NAACP criteria, while maintaining risks and returns similar to the Morningstar US Large-Mid Cap Index.