07 Oct 2019
07 Oct 2019
For some investors, bonds are synonymous with ‘boring’. Necessary, useful, and dull. However, for those who care about climate change and preserving the environment, green bonds can be exciting. Tackling climate change is expensive, and green bonds are accelerating the financing necessary to bring the fight home. They’re also rapidly being snapped up by investors, who are cottoning on to the fact that the environmental benefits don’t have to come at a premium. Environmental concerns aside, green bonds can also be an attractive investment in their own right.
Because green bonds are a reasonably new investment, they suffer from the perception that they’re a niche option. The reality is that they’re now hitting the mainstream. In 2018, new issuance of green bonds hit $168 billion, skyrocketing from just $42 billion back in 2015.1 And with 2019 set to be a record year for new issues with estimates as high as $250bn,1 it’s becoming increasingly clear that green bonds are here to stay.
This rapid market growth can be traced back to the Paris Agreement in 2015. That’s when 195 leaders agreed to “stabilise greenhouse gas concentrations in the atmosphere at a level that will prevent dangerous human interference with the climate system” (UNFCCC, 2017).
The Paris Agreement is based on nationally defined contributions: each country quantifies and states greenhouse gas reduction targets. The goal is to limit global warming to 2 degrees Celsius above pre-industrial levels. But change on this scale costs money. According to the OECD, $6.3 trillion is needed annually until 2030 to meet global climate goals. That puts finance at the heart of the drive for change.
As things stand, the market for green bonds stands at $626 billion.1 It’s estimated that new issuance will need to climb to $1 trillion per year in the early 2020s if the green financing goals set by international agreements are to be met. Green bonds are truly a growth market.
Source: Climate Bonds Initiative, as at 30/08/2019
With the growth of green bonds has come a rise in the murky practice of ‘greenwashing’ – companies making their products or services seem greener than they really are. Investors are increasingly switched on when it comes to ascertaining how ‘green’ any given product truly is. Because issuers self-label their green bonds, there is a risk of ‘greenwashing’ whereby bonds don’t actually live up to the rigorous standards expected of such products. Because of this, investors are paying much closer attention to how ‘green’ a bond really is.
Green bonds are easier than most to quantify, because of the ‘use-of-proceeds’ principle. A company cannot simply slap a ‘green’ label onto a new issue. First and foremost, the issuer needs to earmark the proceeds raised for eligible environmental projects. The issuer also needs to meet other criteria, and to comply with the Green Bonds Principles. This is a framework put in place by the International Capital Markets Association (ICMA). And although the Principles are voluntary, an issuer needs to adhere to them to have a realistic chance of ‘green’ accreditation.
As well as ensuring the funds raised are allocated solely to eligible green projects, the issuer must also carefully track the proceeds of the issuance. Later on, the issuer reports back to the subscribers on metrics of impact measurement – in other words, how the proceeds were used and how the green projects benefited.
As we mentioned, the Green Bond Principles reflect the criteria that should be met if an issuer is to be considered ‘green’. But meeting them doesn’t guarantee accreditation. First, a second opinion is often sought, from agencies such as Vigeo Eiris, among others. Then certification and accreditation are often the remit of the Climate Bonds Initiative (CBI). This gives the investor the reassurance that their prospective investment truly is ‘green’
Investments that promote environmental sustainability often attract criticism from those who believe that ethical concerns come at the cost of financial performance. Or, to put it more plainly, that ‘you get what you pay for’. Surely the environmental benefits ramp up the price, making green bonds more expensive than their ‘vanilla’ counterparts?
But the reality is somewhat different. Studies by the Climate Bonds Initiative have found that green bonds tend to behave very similarly to ‘vanilla’ bonds in the primary market. In a pricing analysis over H2 2018, 63 USD and EUR denominated green bonds greater than USD500m in size were studied, representing approximately one third of the total labelled green bonds issued over that period.
In the prevailing challenging market conditions, many green bonds achieved higher oversubscription and higher spread compression compared to vanilla equivalents, particularly in EUR. The CBI study observed that where yield curves were available, this did not necessarily translate into a price premium (or ‘greenium’), with most of the bonds having a normal new issue premium. Furthermore, green bonds appear to perform well in the immediate secondary market, particularly the EUR-denominated.2
So, there is no significant evidence of green bonds being issued at a ‘greenium’ and pricing inside their yield curve (i.e. offering a lower yield) in the primary market. It appears that many green bonds are actually priced in line with their vanilla bond yield curve.2
Taken together, the evidence above suggests that it doesn’t really matter if your primary concern is environmental sustainability or financial returns. Green bonds stand up to scrutiny in both respects, and are a worthwhile option for those looking for an attractive addition to their portfolio.
1Source: Climate Bonds Initiative, 30/08/2019.2Source: Climate Bonds Initiative, Green Bond Pricing in the Primary Market July-December 2018, Harrison, C.
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