A recent report co-authored by HSBC and the Climate Bonds Initiative, titled Bonds and Climate Change: The State of the Market in 2013, is a strong indication that the climate for climate bonds has improved. In the report, HSBC estimates that to transition to a low-carbon economy, $10 trillion needs to be invested globally between 2010 and 2020. At the same time, many global investors now consider the carbon footprint of prospective investments as a part of their analyses when just a few years ago this was a concern for only a fringe segment of investors.

How else is the climate for climate bonds different? Many changes are afoot.

More Stringent Definition of Climate Bonds

Thanks to the Climate Bond Initiative, a climate bond now must meet strenuous criteria for how its proceeds are ultimately invested to receive the “climate bond” label. This emphasis on actual use of proceeds marks an important analytical shift away from considering a bond “green” based solely on its stated intention to use proceeds to lower carbon output. Standard setting around nomenclature now allows investors to buy a bond marked “climate bond” with confidence that it will meet the rigors of investment policy statements and charters. Furthermore, diligent and continuous evaluation by the Climate Bonds Initiative ensures that an issuer’s claim to be a “green bond” is accurate. By comparing a firm’s revenue breakdown and description of “use of proceeds” on Bloomberg with company disclosures, as well as other market sources, the Climate Bonds Initiative is able to affirm that climate bonds meet tough underwriting standards.

Improving Liquidity and Credit Quality

Early in the history of climate change investing, bond financing was a distant second to equity financing. Climate change investments were perceived as too risky and too volatile to generate the steady stream of cash flows that bond investors covet. But now we seem to have reached a tipping point, with climate-themed bonds totaling $346 billion globally. What’s more, fully 89% of these bonds are considered investment grade, with approximately $163 billion considered benchmark-type investment grade. This amount is double the amount outstanding at year-end 2012.

With both of the classic concerns of bond investors — liquidity and credit quality — improving, investors are beginning to turn their attention to more hierarchical needs. What additional steps need to be taken for climate bonds to evolve further?

Public Sector Support of Climate Bonds Market

Public sector support is already in place in the climate bonds market, for example:

• Some governments provide credit enhancement to certain bonds
• Governments are investing in climate bonds directly

What else could be done to help mature the climate bonds market? The authors of “Bonds and Climate Change” suggest:

• Providing tax incentives
• Providing retail pension incentives
• Providing discount rates for green mortgages based on improved credit scores stemming from lower monthly utility bills for borrowers
• Allowing climate bonds to have a risk preference rating under Basel III standards

Diversification of Industries and Geographies

More diversity is needed. By far the most represented industry in the world of climate bonds is transportation, which is estimated to account for 76% of the entire universe. That’s because railroads, the classic technology solution of the nineteenth century, has found new life in the transformation to a low-carbon emissions economy. Railroads are far and away the cleanest, most scalable transportation technology excluding coal transportation. Compared with railroads, energy and climate finance represent 11.8% and 9.2% of the climate bond universe, respectively. Investors will doubtless want additional industry breadth from the climate bond universe going forward.

Geographic diversity is also a challenge. China dominates the low-carbon bond universe at 36.7%, or $127 billion. A distant number two is the United Kingdom (UK) at $50 billion. For the climate bond universe to be considered deep and broad, and to generate additional investor interest, more geographies will likely need to be represented.

What’s Next for Climate Bonds

Although they have clearly turned a corner, in order for the market to be considered fully mature some key additional positive factors need to be put in place, such as:

• Greater scale – in particular, this would help with creating portfolio benchmarks
• Aggregation – to allow for securitization, standardization of climate bonds needs to be put in place so that they may be aggregated
• Assurance – the Climate Bonds Initiative is already providing due diligence for the space, but additional assurance of the qualification of bonds as definitive “climate bonds” should be provided by other parties to attract new investors and, ultimately, greater deal flow

In just the last two years, climate bonds have moved beyond the existential question of “to be, or not to be.” Still, some more important mile markers need to be surpassed before these instruments become a truly a mainstream product. Even supporters still have questions and doubts. For example, enthusiasts believe that the asset class remains very small relative to others, especially US dollar-denominated climate bonds. In addition, greater participation from non-governmental entities and pure-play climate issuers — that is, conglomerate-type corporate issuers — is a watershed moment that still has not shed water. Even so, climate bonds seem here to stay.

Photo credit: ©iStockphoto.com/sharply_done

Originally published on CFA Institute’s  Enterprising Investor.