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Week 42: Are green bonds making a real difference?
In this issue: ▸ The story of green bonds ▸ Paying a "greenium" and other concerns ▸ What are the benefits of green bonds?
I hope everyone is doing well. And that you are ready for this week’s edition of ‘ESG on a Sunday’.
This week we take a deep dive into green bonds.
Are these financial instruments really making a tangible, real difference for the planet? How are they constructed? How are they used? Who wants to buy them and why?
Well, this story will give you some of the answers to these questions. And also raise some new ones.
Let’s starts at the beginning
In 2008, the World Bank issued the first labelled “green bond”. Before that, in 2007, the European Investment Bank (EIB) issued a bond targeting climate change initiatives. This frontrunner to the “green bond” was labelled “climate awareness bond”.
Since then, the climate-aligned bond market – which includes not only instruments labelled as green bonds but also bonds from issuers that derive the bulk of their revenues from green business lines – has grown substantially.
Prominent innovation or financial engineering?
One of the most prominent financial innovations in the area of sustainable finance over the past ten years has arguably been the development of green bonds. And the growth of the green bond and other ‘labelled bonds’ markets (e.g. sustainability and social bonds). Or is this just normal financial engineering?
Green bonds and climate bonds have received increasing attention over the past few years as key instruments to finance the transition towards a low-carbon economy. From being a niche at its creation in 2007, the market has grown significantly, with new types of investors and issuers participating in its expansion. The green bond market is attracting new issuers and a more diversified base of investors.
However, the size of the green bond market remains small compared to the challenges it is meant to address and to the overall traditional bond market. So it is like ESG equity investments back in 2003. Back then they were niche and very small compared to mainstream market.
Green bonds are growing in all regions
While issuance has grown across every region, Europe was the main driver behind the substantial increase in 2019 volumes of green bonds.
European issuance reached USD 116.7bn, up 74% from 2018. Asia-Pacific, which saw nearly a third (29%) of year-on-year growth, remained the second largest region, although North America’s 46% growth began to close the gap between the two.
Above: Growth of green bonds by region, 2015-2019. Source: Refinitiv.
The top issuers are Chinese financial institutions ICBC and Industrial Bank. French banks Crédit Agricole and BNP Paribas rank third and fourth, with a combined total of USD 4.5bn. In 2019, Saudi Arabia debuted and certified a climate bond coming from the Islamic Development Bank. This deal allocated USD 1.1bn to renewable energy and energy efficiency for buildings.
Who would have believed this 5 years ago?
All relevant and interesting data on market growth and players can be found here, and some of the names are very interesting.
Before we move further into the topic, I think we need to get some definitions and frameworks straight so we are all on the same page.
Green bonds – definitions and frameworks
What are green bonds? Green bonds are fixed-income instruments aimed at financing environmental and sustainable development projects. Their proceeds are used exclusively to finance or refinance, partially or in full, new and ongoing green projects, in particular, infrastructure investments. Green bonds differ from a traditional obligation (a “vanilla bond”) by the detailed reporting of its use of proceeds and the “green” nature of the projects.
What kind of green bonds are there? Currently, we have 4 types of green bonds: 1) Conventional bonds invested in green projects; 2) Green bonds guaranteed by income, 3) Project-specific obligations; and 4) Securitised green bonds.
What are the characteristics of green bonds? The essential characteristic of green bonds is to associate the use of proceeds to specific environment-friendly projects. Green bonds address climate change mitigation and adaptation goals, answering the growing awareness of systemic climate damage by investors, insurers, banks, and governments.
How do bonds differ from traditional investments? The key difference between bonds and other forms of traditional investments, such as stocks or derivatives, is that bonds do not actually grant the owner any ownership stake in a company or government. As a result, bonds tend to be more stable forms of investment, both for the loaner and the loanee, because the value of the money loaned does not fluctuate with the market or the success of the business.
For the two parties that are involved in the initial financing of a bond, the values of the bond and interest do not change. Instead, a secondary bond market responds to changes within industries and businesses. If investors are not able to buy bonds during their primary financing with the face-value price, they can buy any bonds being sold through this secondary market.
How does the secondary market work? Within the secondary market, the sellers of the bonds can set prices and premiums based on a bond’s volatility and maturation date. This allows for financial interactions with bonds even after they are first released to investors.
How are green bonds different from normal bonds? With generic corporate and municipal bonds, the money raised can be distributed at the company or government’s discretion. This is where Green Bonds stray from the pack. Rather than just being loans for companies, money generated from green bonds are “required” to be used for environmentally friendly projects.
These may include focusing on energy efficiency, pollution prevention, sustainable agriculture, fishery and forestry, the protection of aquatic and terrestrial ecosystems, clean transportation, sustainable water management, and the development of environmentally friendly technologies.
What kind of frameworks define green bonds? There are several non-binding frameworks that define green bonds. The Green Bond Principles (GBP) are voluntary guidelines for the issuance of green bonds developed by the International Capital Markets Association (ICMA). The Climate Bonds Initiative (CBI) is an international charity trust focused on investors. It has developed a standard of climate bond certification, which helps investors and governments to classify and prioritise investments that effectively address climate change.
Additionally, many national and regional jurisdictions have developed their national green instrument taxonomies. Several countries (e.g. UK, China, Mexico and Morocco) and regional organisations (e.g. EU and ASEAN member states) have adopted green bond guidelines and they have formed taskforces.
Some programs are also helping to both sustain and go beyond green bonds. Such initiatives are the Taskforce for Climate-related Financial Disclosures (TCFD), the United Nations-World Bank Group Roadmap for a Sustainable Financial System, and the High-Level Expert Group for Sustainable Finance.
The EU Technical Expert Group (TEG) on Sustainable Finance published the Green Bond Standard in 2019, which defines more restrictively green bonds as “any type of listed or unlisted bond or any other capital market debt instrument issued by a European or international issuer, as long as three requirements are met: the issuer’s ‘Green Bond Framework’ needs to explicitly affirm the alignment with the EU-Green Bond Standards (GBS); the proceeds will finance or re-finance ‘Green Projects’; and the alignment of the EU-Green Bond Standard is verified by ‘an accredited External Verifier’.”
It is far from simple and easy to navigate this space and its future growth will require much, much more clarity.
This paper does a brilliant job of describing all the elements and provides a comprehensive overview of the green bonds filed.
Paying a “greenium” and other concerns with green bonds
Rapid growth of green bonds has come with rising risks. Increasingly, some large investors are warning about potential dangers in the green bond market. In particular, they have raised concerns about the so-called “greenium” – a premium that buyers or issuers may pay for costlier green bonds – and the relative shallowness of the green bond market.
As issuance has risen, green bond issuers have become more diverse. Today, a growing proportion of green bonds are issued by individual cities, national governments, and corporations. The explosive growth in green bonds has been driven, in large part, by the growth of ESG investing. However, some investors have raised questions about its long-term sustainability.
The chief investment officer of Japan’s Government Pension Investment Fund (GPIF) – the world’s largest pension fund – has described green bonds as a “passing fad.” According to the GPIF’s Hiro Mizuno, green bonds are unlikely to become mainstream investment products because of the costly and complex issuance process involved.
Conceptually, green bonds should have the same credit rating and coupons as their issuer’s other fixed income instruments, as they are backed by the same balance sheet. However, their issuance requires a significant amount of additional disclosure compared to traditional bonds. This is because green bonds must demonstrate their “green” credentials – particularly if they want to be certified as “green bonds” under various protocols, such as the International Capital Market Association’s (IMCA) widely referenced Green Bond Principles.
The process of demonstrating their environmental impact, which may involve periodic audits of their activities, imposes an additional cost on green bonds. Green bonds are therefore more expensive to issue than traditional bonds. This, coupled with the fact that green bond issues are typically heavily oversubscribed by investors searching for sustainable investment options, has led some to anticipate the existence of a “greenium”, i.e. – as mentioned earlier – a premium on an issuer’s green bonds compared to their traditional ones.
As Bloomberg has reported, there is little evidence of a consistent “greenium” in bond markets. Instead, green bonds typically trade on the same terms as an issuer’s traditional bonds. That’s why Mizuno questions the sustainability of green bonds, which cost more to issue but neither attract nor offer a premium.
A second concern, and one raised by several large institutional investors, is that there are relatively few green bonds issued each year. While issuance has grown rapidly, it still accounts for less than 1% of total global bond issuance. This means that the pool of green bonds is shallow, which has potentially negative implications for liquidity.
Low performance and not enough focus on green projects
Performance is of course another important aspect of green bonds. A recent study of green bonds issued between 2013 and 2017 found that the yields of green bonds are on average two basis points lower than those of comparable conventional bonds.
And a 2020 study clearly indicates that things in this field are not as they appear.
Green bonds are designed to be a familiar and low risk financial instrument that allows both investors and issuers to contribute to sustainability mandates at relatively low cost. Yet in the latest study the authors wrote: “Our respondents do not judge green bonds to play a large role in shifting capital from unstainable to sustainable investments”.
Nevertheless, green bonds are perceived to provide incentives to issuers to raise the “green ambitions” of specific projects and their organisations.
Overall, when market actors reflect on the impact of green bonds in practice, they tend not to highlight the actualisation of green projects. Instead, they emphasise the mainstreaming of sustainability consideration into the ways investors and issuers interact with each other and internally within their organisations.
However, because green bonds are marketed in terms of metrics such as renewable energy generated, emissions avoided, or waste managed, green bonds risk giving market outsiders the impression that they are more impactful that they actually are in terms of shifting capital.
Not that innovative, and not really reducing emissions
The reality is that as a financial tool green bonds are a quite conservative innovation.
They do not appear to be unlocking new sources of capital for green investment or making green investments financially viable when they otherwise would not be.
But are green bonds at least decreasing CO2 emissions?
Well, current labels for green bonds do not necessarily signal that issuers have a lower or decreasing carbon intensity, measured as emissions relative to revenue. At least, not directly, according to this study.
So what are the benefits of green bonds?
First, let’s be clear: Green bonds do offer benefits, and despite a tough time during COVID-19, the green bond market is likely to continue to grow over the next decade.
That’s good, because despite their shortcomings green bonds still promise to be an important source of capital for much-needed climate initiatives, and a source of investment opportunities for ESG investors and funds.
However, as you’ve seen, its growth creates potential challenges for both investors and bond issuers.
The good news is that the green bond market has grown rapidly since the issuance of the first green bond in 2007, and demand for green bonds is higher than supply. Most of these bonds focus on climate change.
The bad news is that green bonds still accounted for less than 0.2% of all bonds issued last year, and only 3-5% of the proceeds of these green bonds can, in turn, be traced to climate resilience (approx. USD 12 billion).
There is thus a vast opportunity to grow the resilience bond market which in my mind is probably the area where they could make biggest and most real difference.
Monitoring the development and formalisation of the green bond market will be a key action item for any sustainable economist.
Is the fashion industry a stranded asset?
This week I had the pleasure of being on Michael Schragger’s “Big Closets Small Planet” podcast in a discussion about the fashion industry and how sustainable it is (or isn’t). Is the fashion industry one gigantic stranded asset?
That’s it for now. I hope you enjoyed this deep dive into green bonds!
Best regards, Sasja