Green Debt
What is Green Debt and how does it help in sustainability?
The Green Debt refers to a special kind of debt, in which the borrowed funds are primarily used to finance environmentally beneficial projects. So, besides providing a financing option, this debt also creates a positive impact on the society.
The borrower will usually notify the purpose for borrowing the funds, and the timeline for fully utilizing the raised money. The regulatory bodies in the region often prescribe the categories of projects that are considered to be ‘Green’.
Just like any other debt, the green labelled debt also involves frequent interest payments from the borrower to the lender. Usually, the interest rate for Green Debt is slightly lower than the interest rate for a normal type of debt, with similar borrowing terms.
Working of Green Debt
The main idea behind Green Debt is to make financing available for the borrowers who are willing to implement projects that offer environmental benefits. That is why, Green Debt is an important type of ESG Debt Security.
The borrower could also take a normal type of debt for executing the green project. But the general lenders might not have the capability to judge the riskiness of such green projects, and they might charge a higher interest rate. Whereas the Green Lenders might better understand the proposed green project, and they could offer the funds at best terms.
Example: Suppose that a private company wants to make technical improvements, through which the carbon emissions will reduce by 50% in their manufacturing process. The funds required to implement the project could be taken in the form of Green Debt.
Once the cash is received, it could be used immediately to start implementing the technical changes. The borrower will slowly repay the debt in a defined duration. Depending on the agreement, a security might or might not be given as a collateral for this particular debt.
So, the borrower gets access to funds for the project, whereas the lender makes a financial gain through the interest amount. Besides this, completion of the project will help the environment, by reducing the carbon emissions.
Green Debt instruments
The interest rate for Green Debt is usually few Basis Points lower than the interest rate for other types of debt that have been issued for similar duration. This slightly compensates the borrowers for the high cost of green projects. For the lenders, it offers both financial returns and social returns/gratification.
Depending on the lending and repayment conditions, there are different ways to issue this kind of debt. The 2 main types of Green Debt securities have been mentioned below.
- Green Loans: In this case, the borrower gets the funds from a lender (or a group of lenders). The interest rate for the loan is directly negotiated between the 2 parties. The provided loan could also be secured through a collateral.
- Green Bonds: These are financial securities that allow the borrower to easily raise funds from the open market, by issuing bonds to the investors. The Coupon Rate and maturity date of the bond are usually notified before the bond issuance. Also, once these instruments have been distributed, they could easily be traded in the secondary market.
Issuance of Green Debt
Many Banks, International Organizations, Social Entities, Mutual Funds, Insurance companies etc. provide Green Finance to the borrowers. There are also other types of lenders that specialize in providing this kind of finance.
The lent funds have to be primarily used towards performing environmentally beneficial development. The Green Lending can help to improve the ESG Rating of borrowers and lenders. So, this debt is used by many entities who have defined their sustainability goals.
Example: A Thematic Mutual Fund might have targets to invest a certain portion of funds in Sustainable Finance products. So, the Mutual Fund might decide to purchase the Green Bonds that are being issued by a private company.
Sovereign Green Debt
When a debt is taken directly by the government, or if the debt is backed by a government guarantee, then it is considered to have a very low risk of default. This is because the government has promised to make repayment of the principal and interest on the debt.
The capital that is raised by the government is usually large in size. The government could borrow this by taking loans from large organizations, or by issuing bonds to the investors. For example, the Sovereign Green Bonds (SGrBs) are a very popular way for the central government to raise funds for green projects in India.
Usage of funds
The most unique feature of Green Financing is that the raised capital can only be utilized for very specific purposes, that offer environmental benefits. The funds could be used to finance a future project, or to re-finance the current / past project.
The regulatory bodies in the region usually prescribe the broad goals, which should be targeted by the Green Borrowers. Some common focus areas of the Green Projects are:
Reducing carbon emissions
Generation, usage and storage of renewable energy
Development, conservation and maintenance of water resources
Cleaner fuels in public transportation
Deployment of energy efficient systems
Preserving the Biodiversity and natural resources
Making infrastructure resistant to climate change
Etc.
There could be multiple projects that could be implemented through Green Borrowing. So, before the funds can be raised, the borrower usually publishes the framework used for evaluation and selection of the projects to implement.
In addition to the details of the expenditure, the borrowers also disclose the timeline for using the funds. For example, a specific project for reducing the carbon footprint might have to be implemented within 2 years, after taking the Green Debt.
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