Green bonds’ are the new black – the fashionable face of an unfashionable asset class. At the start of March, the Italian government launched Europe’s largest green bond debut. At €8.5bn (£7.3bn), the bond was almost 10 times oversubscribed. The UK, German and French governments plan to follow suit, launching green bonds to help reach zero-carbon targets. The market has exploded over the past five years, and now presents a diverse and credible alternative for ESG-focused investors.
Green bonds are debt instruments used exclusively to finance environmental projects. They first came to market in 2007 but operated at the periphery of fixed-income markets until 2015 when issuance took off. The Climate Bonds Initiative reports issuance rising an average of 60% a year since then, with the cumulative debt in the market rising from $104bn (£75bn) to more than $1trn today.
Green bonds cover areas as diverse as renewable energy, energy efficiency and green buildings, pollution reduction, clean transportation, sustainable water and sustainable agriculture. More recently, ‘transition bonds’ have made an appearance – these explicitly support the transition to renewable energy – as well as ‘social bonds’, which help tackle key societal issues such as education, health, poverty and/or target a specific facet of the population. Completing the picture are ‘sustainability-linked bonds’, where the money does not have to be spent on green projects but is instead linked to a company’s sustainability ambitions and targets.
Abundant issuance
While issuance has been abundant across the board, David Katimbo-Mugwanya, manager of EdenTree’s Responsible & Sustainable Sterling and Short Dated Bond funds says the Covid-19 pandemic has accelerated the issuance of social bonds in particular.
“It has brought to light the pressing need for funding towards projects addressing societal needs beyond climate change,” he continues. “In fact, they have become a key plank of the strategy to confront the pandemic, funding projects with social impact in an attempt to tackle the global outbreak’s adverse consequences, including unemployment, and mitigating the lack of access to essential services, such as quality healthcare.” As an example, the African Development Bank launched its $3bn Fight Covid-19 bond last year.
In targeting explicit projects, green bonds address an important problem facing fixed-income investors concerned about environmental, social and governance (ESG) issues. Unlike equity investors, bondholders are not considered owners of a company and therefore have less leverage in forcing change. This has left fixed income trailing equity in the ESG stakes. Green bonds open up the ESG fixed-income market, however, and companies such as Amundi, BNY Mellon and Robeco have launched green bond funds over the past 12 months.
There is standardisation in the market and checks and balances exist to ensure green bonds are truly ‘green’. The International Capital Markets Association has created the voluntary Green Bond Principles, and green bonds generally conform to their transparency and disclosure guidelines.
“We track any bonds labelled as ‘green’ and check their credentials as per our methodology,” says Climate Bond Initiatives senior communications & digital media officer Leena Fatin. “We can then see if one qualifies as an instrument that should be included in our database.”
‘Use of proceeds’
Nevertheless, says Katimbo-Mugwanya, investors in the sector can face the same ‘greenwashing’ problems as their equity counterparts. In particular, he warns, investors need to be careful with ‘use of proceeds’ bonds, where a bond’s coupon interest and principal repayments originate from the issuer’s general cashflow rather than from revenues generated by the designated green projects.
“While the use of a green bond’s proceeds should be clearly stated, it is important also to consider the wider company’s business activities,” he explains. “In our view, focusing mostly on how the proceeds of green bonds are used could make investors more susceptible to ‘greenwashing’ as the green bond label could falsely suggest these values represent a company’s wider sustainable practices and/or products, which may not always be the case.”
This may prove particularly important over the next few years, when market-watchers are predicting an explosion in green bonds in the face of significant demand. Global accords, such as the Paris COP21 agreement, and new regulations specifically targeting sustainability considerations, such as 2020’s European Union Taxonomy, are playing a vital role in creating investor interest in the market. Up to this point, fixed-income investors had been starved of ESG options.
Research from Swedish bank SEB expects around $500bn in green debt issuance in 2021. The EU’s €750bn Next Generation Fund is also likely to create demand, while new countries are coming to the market with green bonds, including emerging markets such as China and India. In March this year, Public Power Corporation, Greece’s main power utility, raised €650m in Europe’s first sustainability-linked high-yield bond sale. This will all help diversify the market and offer more choice, yet investors need to ensure high demand does not lead to a dilution of green objectives.
Corporate green bonds
The market for corporate green bonds may be small but it is also growing. Apple’s $1.5bn green bond issuance in 2016 was the catalyst, while French multinational utility EDF issued a €2.4bn green bond last year, designed to double the group’s renewables capacity.
The market is likely to receive a further boost from the inclusion of green bonds in the EU’s quantitative easing programme. “In late September 2020, the European Central Bank added sustainability-linked bonds to the universe of securities it considers acceptable for the purposes of collateral and eligible for outright purchase via its monetary policy initiatives,” says Katimbo-Mugwanya. “This includes its ongoing asset purchase programmes and its Pandemic Emergency Purchase Programme from January 2021 onwards.”
This demand has brought its own problems for the sector, however, with worries over the level of so-called ‘greenium’ – the premium green bonds can attract over their ‘brown’ rivals. “Research shows green bonds provide the issuer a benefit in terms of pricing,” says Climate Bond Initiatives’ Fatin. “The most recent example of this is the performance of Germany’s so-called ‘twin bonds’, the green version of which priced with a greenium, maintained a lower yield in the secondary market, and exhibited lower volatility compared with its vanilla twin.”
In most cases, it is only the ‘green’ element making the difference. “There is no reason why a bond being green should impact its price, since green bonds rank on an equal footing with bonds of the same payment rank and issuer,” points out Fatin. “There is no credit enhancement to explain pricing differences and issuers of green bonds often incur costs such as second-party opinions and certification, although these are typically negligible. Green bonds and vanilla equivalents are subject to the same market dynamics, such as supply, rate expectations, geopolitical issues and the fallout from global pandemics.”
Weight of money
‘Greenium’ is not necessarily a problem so long as demand holds up – and, given the weight of money heading towards the green bond sector, this seems likely. The Climate Bond Initiative reports buyers are jostling for allocations and “multiple sovereign issuers mentioned investors had gone to extreme efforts to demonstrate their green credentials”. (Incidentally, green investors tend to be awarded higher allocations by issuers). Nevertheless, it does push down yields at a time when fixed-income returns are already low.
“There has been a lot of issuance in the green bond market and it is developing quickly,” says John Fleetwood, director of responsible and sustainable investing at Square Mile Investment Consulting & Research. “It means investors know the capital will be used for the purposes they want and it is easier to demonstrate where the money has gone. In terms of risk, they will look similar to a government bond – the only problem is, in the current climate for fixed income, the financial returns are low.”
Green bonds may be the fashionable face of fixed income but they do not have it within them automatically to address the wider market’s inherent problems of low yields. Equally, investors will need to be careful to ensure there is no dilution of their social or environmental objectives as demand rages and issuance explodes. That said, they do at least offer a welcome array of choice in an asset class that has, until recently, offered slim pickings for ESG-focused investors.
