Making Capital Markets work for Impact Investments

Finance in Motion Director Diego Stapff explores how capital market instruments, such as green and thematic bonds, have the potential to create measurable and scalable impact.

More and more private investors are seeking impactful assets. Besides a financial return, they want their investments to have a positive effect on the environment and/or society. Rising global challenges have sparked mainstream interest in financing viable solutions. However, investment opportunities that meet this demand are typically neither standardized, nor listed in public markets, and thus generally difficult to access for most private investors. Because their intent reaches beyond mere harm avoidance to focus on generating significant positive impact, impact investments are often structured through bilateral agreements tailored to meet the specific needs of a small subset of investors, mainly institutional impact investors and development banks: the consequence is that impact assets have so far remained largely beyond the reach of mainstream capital markets. 

This disconnect between impact investments and capital markets is particularly detrimental to developing countries where impactful companies and projects would enormously benefit from long-term financing via international capital markets.

Scaling up impact investment to the required levels won’t happen if capital markets remain at the sidelines. What is needed are capital market solutions that (a) offer reliable information on the actual impact of the underlying project, and (b) comply with the requirements for capital market transactions, in particular for trading on a stock exchange. In this context, green bonds and thematic bonds – if adequately structured – offer an attractive pathway from capital markets to impactful projects for a wider audience of international private investors seeking impact.

Green bonds generally provide reliable information for capital market investors. The International Capital Market Association (ICMA) Principles, Guidelines and Handbooks, which most green bond issuers abide by, propose disclosure standards for impact-relevant information. They cover descriptions and commitments regarding the projects to be financed and their expected impact, the impact metrics to be published, the internal governance and controls related to proceeds allocation, and the external and independent reviews to be commissioned. Importantly, following the bond issuance, they call for issuers to make regular reports available to all market participants, allowing investors to follow up on actual resource allocation, impact already achieved as well as updated estimations, ideally, with external verification.  

Green bonds are mobilizing significant volumes of capital, also towards emerging markets: but there is still plenty of work to do. According to the Global State of the Market Report 2022 published by the Climate Bonds Initiative (CBI), the issuance of GSS+ bonds (i.e., green, social, sustainability, sustainability-linked and transition bonds) peaked in 2021 by reaching USD 1.1 trillion and then declined to USD 858.5 billion in 2022 (following a general contraction of the global bond market amid raising interest rates). In the same report, we see that the cumulative volume of GSS+ bonds issued exceeded USD 3.7 trillion in 2022. While these figures point to rapid growth since the first green bond was issued by the European Investment Bank (EIB) in 2007, with a particularly steep increase over the past 5 years, the share of GSS+ bonds remains low, representing only 5% of total global issuances in 2021 and 2022. Issuances also remain strongly concentrated among developed countries, as well as sovereigns, multilateral organizations, and development banks.

The success of the green bond market depends on establishing high impact standards. By maintaining and further developing robust standards for sector initiatives, sector players, and market rules, the main stakeholders create an eco-system in which investors can make informed decisions. Here, institutions like CBI have been instrumental at the global level by generating and sharing knowledge, and by establishing the first green bond certification (the Climate Bonds Standard). Other important examples are the initiatives to establish platforms for sharing standardized information on green bonds and their impact, such as the Green Bond Transparency Platform developed by the Interamerican Development Bank (IDB) and the LGX Datahub of the Luxembourg Stock Exchange.

Regulators also play an increasingly important role in defining the ‘rules of the game’ for sustainable finance. In 2020, the EU Taxonomy Regulation established common categories and definitions with the aim of  mobilizing more investments towards impactful projects. Other countries promptly followed, with Colombia, Indonesia and South Africa introducing their own green taxonomies. In addition, regulation directly addressing green bonds, such as an EU Green Bond Standard, is in the works.

In developing countries and emerging markets, development finance institutions (DFIs) are instrumental in supporting such sector initiatives and, at the transaction level, in originating green bonds based on best-impact practices. They are also proving successful in mobilizing private institutional investors.

Already, a promising architecture of local service providers (in the areas of training, advisory, research, and certification services) has emerged in regions like Latin America, to support issuers in the structuring of green bonds to finance projects that are both relevant at the local level and compliant with global best practices.

Advised by Finance in Motion, the LAGreen Fund leverages high impact credentials to support the development of the green bond market in Latin America. Serving as an anchor investor for new bond issuances, LAGreen not only facilitates market entry but also enables issuers to build trust and connect with private investors who cannot access the market directly. The fund provides technical assistance to improve impact credentials, for example by working with issuers to develop internal systems for selecting impactful assets and producing comprehensive, relevant, and transparent impact reports. Besides a diversified pool of assets, fund investors have the added benefit of a first loss cushion provided by the European Union and the German Federal Ministry of Economic Cooperation and Development (BMZ). LAGreen also engages with key market participants and sector players to support research and development. The first-ever reports on the state of the sustainable finance markets in Peru and Colombia, for instance, were produced in partnership with the Climate Bonds Initiative (CBI). LAGreen has the potential to make significant strides in this young market by helping to expand the bond offering, promoting high-impact credentials, and creating opportunities for new investors to participate.

Yes, capital instruments can deliver significant impact, if done right. Instruments like green bonds are proving very effective not only at connecting capital markets with impact investments, but also – and more importantly – scaling up the volume of funding available to impactful projects. We are still at the beginning; however, further growth will depend on trust. That is why the role of sector players in establishing and promoting high standards and best practices should not be underestimated. The commitment of individual issuers and early-stage investors to maintaining a high bar will be key to broadening the path for others to follow.