The S&P Green Project Bond Index: Capturing a Deeper Shade of Green

The S&P Green Project Bond Index: Capturing a Deeper Shade of Green Summary CONTRIBUTORS Julia Kochetygova Senior Director, Global Equities and Strategy julia.kochetygova@spdji.com Vishal Arora Director, Index Research & Design vishal.arora@spdji.com Anadi Jauhari, CAIA Senior Managing Director, Emerging Energy and Environment Group anadi.jauhari@emergingenergy.com Green project bond indices can serve as the basis for environmentally friendly and sustainable investments by tracking bonds that fund projects with clear environmental benefits, mitigating the impact of climate change without reliance on a green label. In the future, a large number of green project bonds may be issued without the green label due to the nature of the underlying green assets being financed. It is conceivable that some issuers may also label their green project bonds as green bonds if such labeling provides differentiation and funding benefits. The S&P Green Project Bond Index (GPBI) complements the S&P Green Bond Index (GBI), and together these indices serve as market benchmarks for the evolving green bond universe. By applying a rigorous, transparent set of criteria related to the green assets being financed, it is possible for the S&P GPBI to identify clearly a slice of the fixed income market that is green, but not green labeled. By tracking bonds that fund climate and environmental projects, the S&P GPBI has the potential to meet investor demand for liability matching, inflation protection and stable returns, while meeting environmental objectives. Introduction S&P Dow Jones Indices and InfraCredit 1 jointly developed the S&P GPBI. This research paper describes how infrastructure and project finance may grow over time and eventually attract environmentally sensitive long-term institutional capital into renewable energy and energy efficiency assets that are indisputably green. This paper also discusses the role that the S&P GPBI may play in this process. Green Project Bonds to Provide Capital at Scale The recent rapid growth and the continued maturation of the green-labled bond market coincides with increased issuances in another segment of the global fixed income market. This segment is largely unlabeled at this time and is potentially several times larger in size and scope than the green-labeled bond market. This segment comprises the financing of infrastructure and related projects that directly mitigate greenhouse gas RESEARCH 1 InfraCredit is the credit and research affiliate of Emerging Energy and Environment Group, an alternative investment firm specializing in clean energy and infrastructure investments. October 2014

(GHG) 2 emissions based on their primary revenue-producing activities, while also having the capacity to issue long-term debt. Such GHG mitigation projects, consisting primarily of renewable energy generation and energy efficiency-related assets, account for the dominant share (greater than 90%) of the currently estimated global climate finance flows (approximately USD 359 billion in 2012 3 ). However, according to the World Bank, this amount is still insufficient to meet the climate change-related investments required (estimated at over USD 1 trillion pa) to keep global temperatures within acceptable limits. Some of these GHG mitigation assets may have been funded through a variety of related ways, including public or private funding, corporate or multilateral balance sheets, labeled or unlabeled bonds, or asset or infrastructure project finance. However, over time, S&P Dow Jones Indices and InfraCredit believe that the vast amount of capital required to support the buildout of climate mitigation infrastructure will likely finance stand-alone renewable energy generation and energy efficiency projects in the form of single-project finance assets, portfolios or pooled vehicles. Rapidly declining costs of renewable energy deployment globally, as a result of technological improvements along with innovative financing structures and national policy measures that support clean infrastructure investment, will continue to fuel the development of such projects, potentially attracting long-term institutional capital. Recent infrastructure buildout patterns in the countries that are memebers of the Organization for Economic Cooperation and Development (OECD) and major emerging markets 4 suggest there has been over USD 4 trillion invested in renewable energy and energy efficiency assets since 2007. Green Project Bonds and Green-Labeled Bonds: The Key Differences are Climate Benefits and Credit-Cash Flow Linkage While the green labeling standards provide the foundation for the green-labeled bond market, the standards governing the financing of clean energy projects and infrastructure via nonrecourse asset financing structures are well established. Such structures link revenue and cash flow to the assets being financed, which is a market practice that ensures investment discipline in capital formation. Notably, this deviates from the structure of greenlabeled bonds, where the use-of-proceeds and the proceeds ring-fencing labeling criteria do not necessarily imply revenue- or issuer credit-quality linkage to the specific green asset that is being financed. Green project bonds finance wind, solar and hydro power, energy efficiency and other clean energy assets, with cash flows from such assets acting as the primary source of repayment of bonds. Such assets often have long economic lives, with cash flows (often inflation-linked) supported by long-term offtake contracts with strong counterparties. These asset characteristics have the potential to meet the financial objectives of institutional investors, while also providing environmental benefits. Potential issuer segments where such a cash flow and credit linkage exists include asset-backed securities (ABSs) and municipal bonds, along with corporate high-grade and subinvestment-grade bonds. Bonds may be placed publicly or privately. The Need for the S&P GPBI The creation of the S&P GPBI follows the launch of the S&P GBI in order to capture a broader swathe of the global fixed income market. The rationale for the development of the S&P GPBI rests on the following key considerations: 1. The S&P GPBI represents a small but growing subset of the fixed income market that can be characterized as green based on the nature of the assets financed. Predominantly unlabeled at the present time, this segment will likely include issuers in the form of investment vehicles, special purpose entities (SPVs) and pure play green corporates, whose activities directly reduce GHG emissions without requiring independent verification and which have stand-alone credit profiles. Over time, this segment 2 IFC Definition and Metrics for Climate-Related Activities, April 2014. According to IFC, GHG direct mitigation is achieved in two ways: putting less GHG s in the atmosphere (i.e., by producing more clean energy), or absorbing the existing GHG s from the atmosphere (i.e., forestry and land use). 3 Climate Finance Is Flowing, but It Isn t Enough Yet, The World Bank, September 5, 2014. Feature Story. www.worldbank.org/en/news/feature/2014/09/05/climate-finance-is-flowing-but-not-enough-yet 4 Green Transition Score Card, 2014 Mid-Year Update, Green Bonds Growing Infrastructure, Ethical Markets. 2

may grow in size as investors gain confidence in the associated climate benefits and as these issuers gain size and credit capacity to raise long-term debt. 2. The green project bond market complements the green-labeled bond market and offers investors the opportunity to track the green-unlabeled segment, especially when the issuer incentives to procure a label may be weak. 3. The green project bond market has the potential to offer investors the ability to diversify across maturity, credit quality and asset types, while still retaining the ability to have asset-level visibility on environmental benefits. 4. Given the asset- and credit-quality linkage that green project bond issuers generally exhibit, green project bonds are likely to be at or near investment-grade and longer in tenor compared to the highly rated, medium tenor green-labeled bonds. The green project bonds ability to address long-term investor objectives of liability matching, inflation protection and stable, uncorrelated long-term yields creates the potential to attract long-term capital at scale. 5. The green project bond market, due to a direct and clear link between financing and climate effect, also provides an alternative to the green-labeled bond market, especially for those investors who believe the current green labeling standards are weak and are creating issuer incentives for greenwashing. Such investors think that more policing and stricter measurement protocols are required. 6. As the labeled and unlabeled segments of the market evolve, investors are likely to see opportunities in the unlabeled universe to meet their desired risk/return ratio and blend these with more highly rated green-labeled bond segments. Green Project Bond Selection Criteria: Asset-Specificity and the Low Hanging Fruit of Climate Benefits While there are multiple types of projects that directly address the GHG reduction or absorption criteria 5, our analysis focuses on renewable energy and energy efficiency projects either as single assets or as portfolios of assets. The twofold criteria adopted in the development of the S&P GPBI include the following: Assets must have clear and established environmental or climate benefits. It is widely accepted that renewable energy generation and energy efficiency assets contribute to direct GHG mitigation. S&P Dow Jones Indices and InfraCredit believe that the existence of clear environmental benefits, as in the case of renewable energy and energy efficiency assets, provides a way to define assets as green whether or not they are green labeled. Clearly, the extent of GHG mitigation or the effect of a green asset will vary depending on the location of the asset (a wind farm in Texas is not equivalent in its climate impact to a wind farm in Mexico or India), and this needs to be made clear by the company or through project documentation. Nonrecourse, asset-specific project finance structures must ensure that proceeds are directed at green assets. Revenue- and credit-quality linkage must ensure that the source of repayment is the cash flow from the green assets, operated within the project or a project portfolio. Some bonds, however, could have revenue linkage at the project portfolio level rather than at the individual project level, which is acceptable for inclusion in the index if all constituent assets in the project portfolio are green (in such cases, the credit quality will be based on that of the entire project portfolio). For corporate pure play green issuers in the S&P GPBI, we make an exception because such companies, the primary revenue-producing activities of which are projects that directly mitigate GHG emissions, are at the stage of development where they have the capacity to issue long-term debt. 5 IFC Definition and Metrics for Climate-Related Activities, April 2014. IFC considers renewable energy, energy efficiency, agriculture, forestry and land use, waste management and transport efficiency as the primary direct sectors of GHG mitigation. 3

S&P GPBI Characteristics Issuer Type, Composition and Size of S&P GPBI Bonds The S&P GPBI includes three types of debt: bonds issued by SPEs to finance or refinance a green project; ABSs issued to securitize future cash flows from pools of green assets; and certain corporate bonds issued by pure play green companies to finance or refinance the buildout or acquisition of green assets. These pure play bonds must be issued by companies that have 100% of their revenue coming from green activities, such as renewable electricity generation and energy efficiency. All such bonds can be green labeled or unlabeled (the labeled issues will overlap with components of the S&P GBI). The universe of issuers in the S&P GPBI is quite small at the moment; in September 2014, it only included 22 bonds, but it is expected to grow over time. The vast majority (13) were project bonds, along with eight corporate unlabeled bonds and one corporate labeled bond. Pricing information was not available as of Sept. 1, 2014, for a handful of ABS transactions that would have qualified for inclusion in the S&P GPBI. These ABS issues may be added to the index later. Green project bonds that any country issues in any currency are eligible for inclusion in the S&P GPBI. Currently, the U.S. has a dominant position (see Exhibit 1). Because of the long-lived nature of the financed assets, there is a long lead time necessary to provide for repayment of bond, and therefore, the maturity of the bonds in the S&P GPBI is typically at least 20 years, far longer than what is common in the S&P GBI (see Exhibit 2). The typical issue amount of bonds in the S&P GPBI is almost USD 400 million (see Exhibit 3). Exhibit 1: S&P Green Project Bond Index Value Composition by Currency 7% 5% 3% 2% 0% USD GBP CAD EUR SEK BRL 83% Source: S&P Dow Jones Indices LLC. Data as of Sept. 1, 2014. Charts and tables are provided for illustrative purposes. Exhibit 2: Maturity Characteristics of the S&P Green Project Bond Index 23% 2-5 Years 53% 3% 21% 5-10 Years 10-20 Years 20+ Years Source: S&P Dow Jones Indices LLC. Data as of Sept. 1, 2014. Charts and tables are provided for illustrative purposes. 4

Exhibit 3: S&P Green Project Bond Index Characteristics Index Name S&P U.S. Issued High Yield Corporate Bond Index S&P U.S. Investment Grade Corporate Bond Index Constituent Count Average Outstanding Amount (USD) Weighted Coupon Weighted Modified Duration Weighted Years to Maturity Weighted Yield to Maturity 2,690 603,616,582 6.98 4.86 6.51 5.98 6,593 807,576,157 4.45 6.39 9.52 2.82 S&P U.S. Bond BMI 10,905 1,718,450,843 3.13 4.83 6.33 2.01 S&P Green Bond Index 163 245,337,997 2.04 4.70 6.23 1.60 S&P/BGCantor 7-10 Year U.S. Treasury 17 31,227,641,325 2.42 7.75 8.68 2.30 Bond Index S&P Green Project Bond Index 22 396,718,360 6.20 7.27 16.42 5.33 Source: S&P Dow Jones Indices LLC. Data as of Sept. 1, 2014. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results. Distribution of Credit Ratings As opposed to the S&P GBI, which is dominated by high-investment-grade issuers, the S&P GPBI provides exposure to a mix of investment- and subinvestment-grade bonds, with a small fraction of the bonds being unrated (see Exhibit 4). As a result of this mix, the average coupon rate is three times higher than the average coupon of the S&P GBI (approximately 2.0%). The coupons for S&P GPBI bonds may fall into fixed, zero and fixed-to-float categories (provided they are fixed and one month prior to their float date). Exhibit 4: Credit Rating Distribution of the S&P Green Project Bond Index 7% 9% 7% 3% B- 42% 29% 30% BB BB- BBB Below Investment Grade Investment Grade BBB- Not Rated 51% Not Rated 22% Source: S&P Dow Jones Indices LLC and Reuters. Ratings have been presented in accordance with the S&P Dow Jones Indices rating scale. Data as of September 2014. Charts and tables are provided for illustrative purposes. Benchmarks to the Historical Performance of the S&P GPBI For comparative analysis of the S&P GPBI and the S&P GBI, we used the set of indices with the closest maturity, location and credit profile: the S&P U.S. Bond Broad Market Index (BMI), the S&P U.S. Issued High Yield Corporate Bond Index, the S&P U.S. Foreign Issued High Yield Corporate Bond Index, the S&P U.S. Issued Investment Grade Corporate Bond Index, the S&P U.S. Foreign Issued Investment Grade Corporate Bond Index, and the Barclays Global Aggregate Bond Index. The S&P GPBI has performed well compared with most of its peers, only lower than the high-yield indices (see Exhibit 5). 5

Exhibit 5: Comparative Returns 300 250 200 S&P U.S. Issued High Yield Corporate Bond Index S&P U.S. Foreign Issued High Yield Corporate Bond Index S&P Green Project Bond Index 150 100 S&P U.S. Issued Investment Grade Corporate Bond Index S&P U.S. Foreign Issued Investment Grade Corporate Bond Index S&P Green Bond Index 50 S&P U.S. Bond BMI 0 Dec. 31, 2008 Mar. 31, 2009 Jun. 30, 2009 Source: S&P Dow Jones Indices LLC and/or its affiliates. Data as of Sept. 10, 2014. Index performance is based on USD total return index levels. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results. These charts and tables may reflect hypothetical historical performance. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance. The S&P GBI is performing largely in line with its high-investment-grade profile (see Exhbit 6). The exception is that it has a higher standard deviation in the long run, which should not be the case under normal circumstances. The reason for this might be that during times of high volatility, these bonds, which are of high credit quality, have been traded more frequently than others. Exhibit 6: Index Comparison Index Name YTD 1-Year 3-Year 5-Year Index Return (%) Sep. 30, 2009 Dec. 31, 2009 Mar. 31, 2010 Jun. 30, 2010 Since S&P GPBI Index Inception (12/29/2006) S&P Green Project Bond Index 9.3 10.3 8.2 10.2 8.5 S&P Green Bond Index 2.3 5.3 0.8 4.3 - S&P U.S. Bond BMI 4.2 4.9 2.7 4.2 4.9 Portfolio Standard Deviation (%) Sep. 30, 2010 S&P Green Project Bond Index 3.4 4.3 4.5 4.4 5.9 S&P Green Bond Index 3.2 4.0 7.4 8.2 - S&P U.S. Bond BMI 2.3 2.4 2.9 3.5 4.2 Sharpe Ratio (Using U.S. Treasury Bills) Dec. 31, 2010 Mar. 31, 2011 Jun. 30, 2011 Sep. 30, 2011 Dec. 31, 2011 Mar. 31, 2012 Jun. 30, 2012 Sep. 30, 2012 S&P Green Project Bond Index 2.71 2.42 1.80 2.30 1.28 S&P Green Bond Index 0.70 1.32 0.10 0.51 0.52* S&P U.S. Bond BMI 1.81 2.00 0.90 1.14 0.91 *The data is from the Inception date of the S&P Green Bond Index, which is 11/28/2008. Source: S&P Dow Jones Indices LLC and/or its affiliates. Data as of Sept. 10, 2014. Index performance is based on USD total return index levels. Charts and tables are provided for illustrative purposes. Past performance is no guarantee of future results. These charts and tables may reflect hypothetical historical performance. Please see the Performance Disclosures at the end of this document for more information regarding the inherent limitations associated with back-tested performance. Dec. 31, 2012 Mar. 31, 2013 Jun. 30, 2013 Sep. 30, 2013 Dec. 31, 2013 Mar. 31, 2014 Jun. 30, 2014 Barclays Global Aggregate Index 6

Conclusion Showing slightly different performance patterns, the S&P Green Bond Index and the S&P Green Project Bond Index appear to complement each other. The S&P GBI, which includes primarily top investment-grade credits and packaged portfolios of high-profile, geographically diverse mid-to-long-term projects, offers an opportunity for mainstream investors who are hoping to get insight into the green fixed income market without taking project risks. The S&P GPBI, which includes mixed levels of credit quality and longer-term credits, may appeal more to direct green investors. Over time, we may see the opportunity for these two groups converge, as the green fixed income market could become either predominantly labeled or predominantly unlabeled, depending on market preferences. 7

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