A Potential Path for Alleviating Currency Risk in Emerging Market Green Bonds – Center on Global Energy Policy at Columbia University SIPA

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Executive Summary

A large gap exists between the financing needed for the energy transition and what is being invested. Green bonds are flourishing as one of the main sources to close this financing gap, with over $2.5 trillion issued globally thus far. However, emerging market and developing economies (EMDEs) haven’t fully capitalized on the growth of this asset class: the share of EMDE (excluding China) green bonds denominated in local currencies within the total green bond universe remains minuscule. While some EMDE issuers can sell a bond denominated in dollars and hedge by swapping the dollar exposure into the local currency of the underlying projects, the cost of doing so is usually prohibitive.

This report, part of the Financing the Energy Transition initiative at the Center on Global Energy Policy at Columbia University SIPA, adds to ongoing discussions of how to encourage a greater flow of green financing from international investors to emerging economies. Toward that end, it explores a blended finance structure wherein an intermediary takes on the local currency risk of an EMDE green bond, effectively converting it to a dollar bond that settles internationally, to potentially stimulate more issuances and expand the pool of international investors with access to these bonds.

Key takeaways from this report include the following:

• A mismatch exists between the currency in which EMDE issuers would prefer to sell green bonds and the currency of denomination demanded by many international investors. To potentially help address it, the intermediary discussed in this report absorbs the local currency risk between the two parties. By converting interest and principal payments to dollars, this structure would allow the EMDE sovereign or corporate to issue a hard currency bond indirectly, avoiding the exchange rate risk while paying its domestic market interest rate to all investors.
• If the currency risk is managed properly, such as by diversifying across a number of EMDE currencies and employing a euro hedge—as back-tested in this report—the intermediary could likely mitigate much of the risk.
• In addition to avoiding the exchange rate risk, though, clear monetary incentives may be needed to convince EMDE governments to undertake the complex tasks of creating green bond frameworks and sourcing applicable projects along with bearing the added expenses of issuing green bonds that, at the same time, limit their flexibility in using the bond proceeds (as opposed to issuing conventional bonds). A guarantee on interest-rate payments by philanthropies and donors could be a relatively low-cost impetus making these bonds more affordable for emerging economies to issue.
• For low-income economies with environmental projects that may not add up to the minimum size needed to issue a bond, the structure could be extended into regional bonds, with the intermediary pooling projects across countries without requiring governments to directly coordinate with each other.
• The blended finance structure discussed in this report requires an intermediary with deep expertise in bond and currency markets. While multilateral development banks, development finance institutions, and the like may be natural fits, these institutions have historically been highly risk-averse and therefore would likely require a shift in thinking to assume the intermediary role.