How Green Bonds Work

The energy business is one that is extremely capital intensive. Conventional energy companies have capital budgets that are in the tens of billions of dollars. Globally, the International Energy Agency has estimated that total capital investment in energy infrastructure over the past four years ranged from $1.5 to $1.8 trillion each year.

Likewise, the global transition to renewable energy has required – and will continue to require – large capital investments. According to BloombergNEF, over the past decade, globally those investments have ranged from $250 billion to $350 billion each year. However, that number is expected to increase dramatically in the next three decades as the world attempts to rein in rising carbon dioxide emissions.

Where will this money come from? A major oil company will pay for capital expenditures out of existing cash flow. But that isn’t an option for a smaller renewable energy company that is trying to make a multi-billion dollar capital expenditure.

To date, sources like conventional debt and equity have provided the bulk of financing for renewable energy projects. But those sources can take many forms.

The Rise and Fall of the Yieldco

Several years ago, an instrument called a yieldco gained in popularity as a financing tool for renewable energy projects. The yieldco was created as a renewable energy investment analogue to the master limited partnership. U.S. Internal Revenue Code Section 7704 states that at least 90% of an MLP’s income must come from qualified sources, and Section 613 further requires qualifying energy sources to be depletable resources or their derivatives such as crude oil, petroleum products, natural gas and coal. Renewable energy is not considered to be a qualifying energy source, therefore the yieldco structure was formed as a pseudo-MLP.

Like MLPs, yieldcos were meant to provide a predictable tax-deferred yield in exchange for cheap equity capital. They differed from MLPs in that they were not automatically exempted from corporate income taxes, but accelerated depreciation provisions of the tax code and other tax breaks offered to renewable power producers would mean that they were able to report net losses for five years at least, while using cash flow to pay investors.

The yieldco era began to heat up in July 2013 when NRG Energy spun off its subsidiary holding solar generating assets into NRG Yield. Then TransAlta Renewables listed on the Toronto Stock Exchange in August 2013, and Pattern Energy Group listed simultaneously on the NASDAQ and Toronto Stock Exchange the next month.

In 2014, several more solar PV yieldcos launched. TerraForm Power was spun off from SunEdison. Abengoa Yield was formed by Abengoa. First Solar and SunPower jointly launched 8point3 Energy Partners.

But all of these yieldcos except TransAlta Renewables (which still exists) suffered steep losses following their IPOs. Debt for each of these offerings was quite high relative to a comparable midstream MLP. Perhaps due to a combination of the 2015-2016 meltdown in the energy sector and a lack of track record for these new investment vehicles, the market was not kind to these offerings.

Most of the yieldcos have subsequently been absorbed by other companies. A recent example is the acquisition of Terraform Power by the MLP Brookfield Renewable Partners. However, the yieldco as it was originally envisioned has largely gone by the wayside.

The “Green Bond” has demonstrated more staying power.

Green Bonds 101

The green bond market started before the yieldco phenomenon, and it has only grown stronger. The European Investment Bank (EIB) circulated the first bond — the “Climate Awareness Bond” — in 2007. Since then, the cumulative market size has grown to $754 billion U.S. dollars through the end of 2019, with $259 billion in green bonds being issued just in 2019.

Green bonds work similarly to conventional bonds, with some key differences. In general, an issuer offers a bond with a defined interest rate. Traditional bonds will not generally specify exactly how the funds are to be used, but green bonds offer much more transparency on the use of the funds. Thus, bondholders can be certain their funds will be used to finance renewable investments.

A bond differs from stock in that you own no actual equity in the company or project making the offering. However, if the issuer runs into financial difficulty, bondholders are paid back before stockholders. Thus, the risk is lower than with stocks, but so is the potential reward.

The first green bonds were issued by development banks and international agencies, but eventually that evolved into including private companies and local governments. In 2019, green bonds were issued by 506 entities. The top three issuing countries in 2019 were the U.S. ($51.3bn), China ($31.3bn), and France ($30.1bn).

How does one buy a green bond? Probably the easiest way — and one in which you can further spread your risk — is to buy into one of many green bond mutual funds. These are investments that pool multiple green bond offerings from around the world. For example, the Calvert Green Bond Fund had 166 holdings as of 10/31/2020. The largest holding — at 3.8% of the portfolio – is a 1.75% interest rate bond issued by France.

The green bond market is expected to continue growing robustly. In a recent interview with Bloomberg TV, Frans Timmermans, executive vice-president of the European Commission, said that rising demand for green bonds may create a $266 billion opportunity for the EU. He added:

“If you see organizations like BlackRock making this really enormous change into the green economy, if you see them all waiting for us to come up with green bonds because they want to be part of this — I believe this is the moment to do this.”

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