There is a new breed of bond in the fixed income world. It’s different, it’s bold – it’s the so-called “green bond” market. As the drive towards environmental, social and governance (ESG) investing continues to gather pace, policymakers and investors alike are waking up to the importance – and benefits – of green bond investing.
Evolution of the green bond market
Like any other bond, green bonds are fixed-income securities that aim to raise funds for new and existing projects through the debt capital market. Typically, the bond issuer will raise a fixed amount of capital from investors over a set period of time. They then repay the capital with an agreed level of interest payments until the bond matures. Green bonds are no different, with one exception: projects have environmentally sustainable benefits at their core.
ESG and socially responsible investing (SRI) have been around for some time, but the concept of green bonds is relatively new. The World Bank and European Investment Bank (EIB) sowed the seeds back in 2007. Growth was slow in the early years, but the message to the private sector was made clear: it’s now down to financial markets and institutions do their bit in the battle against climate change.
The year 2013 was an important one for green bonds. Issuance exploded, mainly driven by the issuance of corporate green bonds. There’s been no looking back since. Large institutional investors are showing interest, and international support for green bonds is mounting. And the burgeoning demand is being met, primarily by banks issuing green bonds to finance their own sustainable credit lines. Companies are always looking for ways to become greener too. Apple Inc. is the most recent company to hit the green headlines with a US$1 billion issue – its second within the last 12 months.
But it’s not just banks and companies getting involved. Municipalities and even governments are joining the party. In December last year, Poland issued the first ever sovereign green bond. France followed with a €7 billion (US$7.8 billion) raise in January – the largest single green bond sale to date – and Nigeria, Bangladesh, Morocco and the Philippines are all lining up for issues this year.
It’s not just banks and companies getting involved…municipalities and even governments are joining the party.
From strength to strength
The green bond market currently stands at around US$200 billion in size. While still a minute fraction of the fixed-income universe, this figure reflects a doubling of growth annually since 2013. The trend is expected to slow marginally this year, although rating agency Moody’s Investors Service still expects issuance of US$120 billion. This exceptional growth is indicative of the rising recognition of climate risks, as well as the raw appetite for ESG-themed strategies and green bonds.
The Paris Agreement of December 2015 was a key milestone in the green bond movement. Agreed upon by more than 190 countries, the global action plan aims to limit global warming to well below two degrees by 2100. U.S. President Donald Trump recently withdrew the U.S. from the climate deal, sparking outrage among government bodies and policy makers globally. But while many will see this as a blow, Trump’s decision to bet against science and diplomacy is motivating the private sector to take over where the government is failing. Indeed, in the two weeks following the president’s decision to exit the agreement, the market responded by issuing bonds worth US$7.2 billion. Additionally, the U.S. is just one of the many countries that have signed up, and the rest of the world has rallied in further support of the Paris Agreement since Trump’s decision.
A growing and diversifying market
Source: Bloomberg, April 2017.
The Green Bond Principles
The four Green Bond Principles have been introduced by the Climate Bonds Initiative. These are designed to promote transparency and integrity in the development of the green bond market and consist of the following: (1) Use of Proceeds; (2) Process for Project Evaluation and Selection; (3) Management of Proceeds, and (4) Reporting.
Measuring the “greenness” of a project isn’t always easy. Despite the good intentions behind the principles, the lack of strict criteria is a concern, as is the fact there is no monitoring mechanism to ensure compliance. The integrity of the market has held firm thus far, but the risk of ”greenwashing” – whereby unsuitable projects are financed by green bond issues – is growing.
China, which led the way for green bond issuance last year, is a good example. A third of its issuance did not meet the internationally acknowledged definition of “green.” The reason is that the Chinese have their own rules around what constitutes a green bond; they allow issuers to use up to 50% of the proceeds to repay outstanding bank loans and to invest in general working capital. Internationally, at least 95% of proceeds are expected to be linked to green projects or assets.
Progress is being made, though. The Financial Stability Board (FSB) has put together a taskforce on climate disclosure with the aim of ensuring companies become more transparent around business activity in relation to climate change. As the market develops, so too will industry practices and standards.
Does green = lean?
ESG-themed strategies and green bonds aren’t just there as a public relations exercise to make companies look good. They need to perform well and deliver positive returns. But does going green mean sacrificing returns? In short, no.
A recent meta-analysis1 looked at 2,200 individual studies examining the relationship between ESG criteria and investment performance. The results confirmed that there is a significant relationship between companies adopting ESG principles and financial outcomes. Results were particularly noticeable for companies in North America, emerging markets and non-equity asset classes.
Financial performance is correlated to ESG factors
By asset class:
Source: Friede, Busch and Bassen. Sponsored by Deutsche Asset & Wealth Management Investment and the University of Hamburg School of Business, Economics and Social Science, 2015. Past performance does not indicate future results.
Conclusion – win win
Financial markets can help crack the climate challenge by meeting the growing demand for low-carbon projects around the world. Innovative financial tools like green bonds are driving more capital to these important projects and will likely continue to do so. The market is still in its nascence, and with that comes certain hurdles, notably the fact it is small and therefore illiquid compared to larger markets. But clear industry standards and more robust market data should accelerate the use and availability of green bonds. Liquidity levels will subsequently rise, making green bonds an increasingly attractive way to invest.
1 Friede, Busch and Bassen. Sponsored by Deutsche Asset & Wealth Management Investment and the University of Hamburg School of Business, Economics and Social Science, 2015.
Companies are mentioned for illustrative purposes only.
Fixed income securities are subject to certain risks including, but not limited to: interest rate (changes in interest rates may cause a decline in the market value of an investment), credit (changes in the financial condition of the issuer, borrower, counterparty, or underlying collateral), prepayment (debt issuers may repay or refinance their loans or obligations earlier than anticipated), call (some bonds allow the issuer to call a bond for redemption before it matures), and extension (principal repayments may not occur as quickly as anticipated, causing the expected maturity of a security to increase).
Foreign securities are more volatile, harder to price and less liquid than U.S. securities. They are subject to different accounting and regulatory standards, and political and economic risks. These risks are enhanced in emerging markets countries.