A key missing piece of the puzzle of low carbon finance is the bond markets. Worth around $100 trillion, the world’s public bond markets are the dominant source of capital, but tapping into them means attracting the institutional investors who manage an estimated $88 trillion.

Green infrastructure investments offer opportunities for institutional investors that are a good fit with their long-term liabilities. The increased maturity of low carbon technologies, business models and companies means the risk is falling, and is therefore becoming more suitable to the risk-return profiles of institutional investors. Institutional investors are themselves also increasingly concerned about climate change and broader sustainability issues, so they are now looking for ways to address these.

EU policymakers can also do much to support the expansion of green asset-backed securities

Markets are increasingly connecting these dots. Over the past 10 years, various programmes have been developed around the world to use bonds to channel capital to address environmental challenges. The London-based Climate Bonds Initiative has identified over $502bn-worth of bonds that in 2014 related to climate change solutions.

Some $50bn of these have been marketed as green or climate bonds, where the proceeds had been earmarked for green projects. They have to meet certain reporting requirements over the use of the proceeds, but otherwise green bonds are structured no differently from normal ones.

Projects financed by green bonds include renewable energy development, energy efficient buildings, environmental investments that improve water supply, and low-carbon transport. A key point is that the green credentials of a bond are based on the projects or assets linked to its issuance, not the green credentials of the entity issuing the bond. This means a wide range of issuers can issue green bonds, whether they are a national government, a city or municipality, a multi-national development bank, a commercial bank or a corporation.

A rapid scaling-up of investment in green bonds requires a deal flow of opportunities attractive to institutional investors

The green bond market has grown fast, with issuance up from $11bn in 2013 to over $36bn in 2014 and $100bn expected for this year. This means exciting opportunities for investors, and substantial room for growth as green bonds are still relatively small. At the same time, green bond issuance is very small indeed compared to the trillions needed for climate change mitigation and adaptation.

A rapid scaling-up of investment in green bonds requires a deal flow of opportunities attractive to institutional investors, as their investment choices are influenced by the opportunities offered to them. This means offering a vast amount of green bonds that have appealing risk-return profiles. Many low-carbon investments are increasingly attractive thanks to technological developments, but for those that are still too risky, policymakers can step in to improve the risk-return of green compared to normal bonds. The rationale for this is not just curbing climate change as there is a strong economic long-term case for green investments. It’s called investment, not cost, for a reason.

As the timing of climate investment matters to minimise climate change and its impacts, we cannot wait for the risk-return profile of low-carbon investment opportunities to improve on its own. Investment opportunities need to be created at a much greater speed, but so far policymakers have made only limited use of their policy toolbox to do this. Even though there are many available policies in the real economy like feed-in-tariffs, there are few examples of financial tools and instruments used explicitly to support low-carbon investments. Under-utilised options for policymakers include credit enhancements, investor tax incentives, banking regulation and monetary policy, all of which are complements, not alternatives, to existing low-carbon policies in the real economy.

China has recently released policy proposals that include green tax incentives

Those involved in making green policies should look to other areas where financial policies, tools and instruments have successfully mobilised large-scale private sector investment, notably in infrastructure. The majority of low-carbon investment needed, such as in low-carbon transport and renewable energy, is actually infrastructure investment that just happens to be green.

Some countries around the world are starting to take these opportunities. China, for example, has recently released policy proposals that include green tax incentives and preferential capital requirements for banks with a high share of green assets. Here in Europe, of the tools and instruments available to policymakers, the Climate Bonds Initiative has three main proposals for supporting low-carbon investment through the green bond market: standards, credit enhancement and green securitisation.

Standards setting out green criteria establish the green credentials of a bond, yet currently no common standards exist. There are the Green Bond Principles that provide a best practice framework, but they do not provide clear definitions of what is or isn’t green. The only industry effort to address this challenge at present is the Climate Bonds Standard and Taxonomy, whose development involves some 40 international organisations, and is overseen by the Climate Standards Board, which represent investors with more than US$34 trillion of assets under management.

Once green standards are in place, policymakers will be able to provide credit enhancement for green bonds. There are still too few credit enhancement programmes in place for green investments, although examples now include the green guarantee scheme of the U.S. Overseas Private Investment Corporation, which has supported solar projects in Chile. Credit enhancement schemes in areas like SMEs and infrastructure could easily be applied, with modifications, to low-carbon investments. This would include integrating climate priorities in existing schemes and setting up green schemes that copy credit enhancement structures in other areas. In the EU, this could include widening the scope of the Project Bonds Initiative, credit enhancement programme for infrastructure projects. It should do more through earmarking a minimum percentage for climate investments, and by including renewable energy investments that are currently excluded from it. Additionally, a separate green scheme modelled on the Project Bond Initiative model could be set up.

EU policymakers can also do much to support the expansion of green asset-backed securities, which are green bonds backed by a pool of loans or other revenue-generating financial assets, such operating solar farms. Green asset-backed securitisation would allow banks to get loans to green projects off their balance sheet by packaging them and selling these securities to investors. Similarly, utilities can get operating renewable energy assets off their balance sheets. The easier it is for banks and utilieis to get green assets off their balance sheet, the more likely they are to make more green investments. Green securitisation is also crucial because the aggregation would enable smaller scale low-carbon projects to gain access to institutional investors.

Asset-backed securities fell dramatically in popularity after the 2008 financial crisis, but now there is again policy support in the European Commission and the European Central Bank (ECB) for securitisation, albeit in a simpler and better-regulated form. Policymakers can support green securitisation by supporting the development of standard contracts and agreements for low-carbon assets because this facilitates the robust pooling of loans into large-scale securities. The EU Commission and the European Investment Bank (EIB) could enable green securitisation either by setting-up or supporting an aggregation/warehousing facility along the lines of the EIB’s proposed Renewable Energy Platform for Institutional Investors (REPIN).

The Luxembourg-based EIB could apply credit enhancement tools to the securities, and a longer-term option, once the deal flow of green asset-backed securities becomes more established, would be for the ECB in Frankfurt to mandate that a given share of their asset-backed securities purchase programmes should be allocated to green securities.

The green bond market can contribute substantially to increasing low-carbon investment to a scale needed to tackle climate change while ensuring that investors are offered attractive returns. The green bond market’s rapid growth shows there is an appetite for the concept, so policymakers should now step in to support its growth.