This is an extract from a recent report “Unlocking Green Finance for India’s Urban Local Bodies through Municipal Green Bonds” by Council on Energy, Environment and Water (CEEW).
Role of urban local bodies
Urban local bodies (ULBs), comprising the third tier of governance in India, have a crucial role to play in this context, both because of their position within the government and nature of work. As per the Ministry of Panchayati Raj’s Local Government Directory, there are close to 5,000 ULBs in India. These are broadly categorised as follows: 253 municipal corporations (MCs) for larger urban areas, 1,907 municipal councils (municipalities) for smaller urban areas, and 2,429 notified area councils or Nagar panchayats for transitional urban areas. ULBs can be classified into three broad categories: MCs, municipalities, and nagar panchayats. These bodies usually ensure last-mile service delivery of crucial public goods. They also provide a range of civic services that coincide with infrastructure in sectors categorised as green.
Financial challenges faced by ULBs
The ability of ULBs to effectively address the increasing pressure on services by a growing population, combined with the need to step up climate adaptation investments, is hampered by certain challenges. These are a need for more financial resources and lack of institutional capacity. The financing challenge can be further broken down into two categories. The first relates to fiscal governance and management, which includes a lack of financial autonomy, outdated accounting standards, and little transparency in reporting credible financial data. The second relates to the state of revenue and expenditure. On the revenue front, this includes a lack of adequate revenue channels, insufficient devolution of revenue sources, and an over-reliance on few revenue sources and grants, coupled with inefficiency in capitalising on existing revenue channels.
Exploring municipal bonds as a solution
With respect to the state of revenue and expenditure, borrowing has historically accounted for a small fraction of ULB receipts. Within borrowings, municipal bonds (muni bonds) have an even smaller share. Among the diverse solutions to the financing challenges faced by ULBs, stepping up the issuance of muni bonds (and their subset of municipal green bonds or ‘muni green bonds’) is one way to mobilise resources. Muni bonds are generally of two types: revenue-obligation bonds and general-obligation bonds. General-obligation bonds are paid with the overall revenues of ULBs, whereas servicing revenue-obligation bonds are tied to the cash flows of specific projects.
State of muni bond market in India
Since 1997, there have been 50 muni bond issuances in India, amounting to $850 million. These issuances have been concentrated in certain geographies, with only 10 MCs accounting for 27 of the 50 issuances. Further, all 50 issuances can be traced to ULBs in just 8 states. The pricing of these issuances varies immensely. There are significant differences in coupon rates even among comparable muni bonds – up to 318 basis points (bps) in certain cases. ULB revenues in India are quite low, as a percentage of the GDP, compared to other peer countries. Indeed, the cumulative revenue stagnated at around 1 per cent between FY12 and FY18. In contrast, local governments in Mexico and Thailand generated revenue totalling 2–4 per cent of their GDP in the same period.
Challenges in the muni bond market
Although India’s muni bond market has existed since the late 90’s, it still remains at an incipient stage of market maturity. Factors impeding its growth have cut across both entity and systemic levels. At a systemic level, they have included political challenges; regulatory, hurdles and inconsistencies; a lacklustre track record; the absence of liquidity in the muni bond market; and the crowding out of bonds through alternative sources of capital expenditure such as grants, state guaranteed loans, and loans by development finance institutions (DFIs).
Promising emergence of muni green bonds
Within the muni bond market, muni green bonds are increasingly gaining traction. Muni green bonds are use of proceeds bonds. This means that capital raised through their issuance needs to be directed towards activities specified as green. The Securities and Exchange Board of India circular on green debt securities provides detailed guidance on which activities may be considered green. To delve deeper into the evolution of muni green bonds, CEEW narrowed the data set of 50 issuances since 1997 to those since 2015. This resulted in 19 issuances. This set was further reduced to 18 through the exclusion of an outlier.
Key insights and takeaways
The key findings from CEEW’s analysis of this data set of 18 issuances (the subset) with an aggregate value of Rs 28.64 billion are as follows:
- Four of the last seven muni bond issuances, amounting to Rs 6.94 billion (around 25 per cent of the subset) were green-labelled, indicating that muni green bond issuance is on the rise.
- Eleven bonds worth Rs 16.75 billion (around 58 per cent the value of all the bonds) could have been potentially labelled green (green potential) based on the specified use of proceeds. However, they were not, thus representing missed opportunities.
- The potentially labelled green bonds were issued with coupons that had an average spread of 1.60 per cent sovereign yield, versus a much lower spread on the green-labelled ones, at around 1.11 per cent (by about 50 bps). This indicates that the labelling appears to be associated with a lower cost of borrowing.
- Spreads for non-green muni bonds (three bonds) at 2.28 per cent were found to be much higher than both green-labelled (by 117 bps) and potentially labelled green (67 bps). This indicates that even in the absence of labelling, the green end-use appears to be associated with a lower cost of borrowing.
- Combining the findings from points 1 and 2 highlights that around 83 per cent of all bond proceeds in the subset were directed towards green end-use, whether labelled as such or not.
- Applying this finding to conservative third-party estimates of the cumulative muni bond market potential by CARE Ratings and the World Bank, in general, suggests that the potential for muni green bonds is $2.5–6.9 billion, over different timelines in the next 5–10 years. Clearly, policy and regulatory initiatives introduced in 2015 have renewed the outlook on municipal financing. CEEW’s analysis suggests that municipal green bonds are fast emerging as a preferred route for municipal financing.
Way forward: The RISE framework
Against this backdrop, how can the emerging segment of muni bonds, including muni green bonds, be catalysed to tackle India’s municipal-level financing challenges? At the outset, it is equivocally acknowledged the paltry level of muni green bond issuances to date is in stark contrast to their potential. Drawing on its analysis of past muni bond issuances, as well as stakeholder interactions, CEEW propose a fourpoint action plan. RISE (Reform, Identify, Strengthen, Engage) will empower ULBs, particularly MCs, to access muni bond (especially muni green bond) markets more. The action plan is summarised as follows:
- Reform financial and accounting practices and own revenue streams.
- Identify infrastructure requirements and debt/bond issuance potential.
- Strengthen internal capacity in terms of finance and sustainability.
- Engage with stakeholders, such as financial intermediaries and public institutions (e.g., government bodies, investors, regulators and DFIs)
Access the full report here.
