The first green bond was issued by the World Bank back in 2008. Since then, as climate-related issues have grown in prominence, the market for green bonds has increased dramatically, broadening out to include debt with social and sustainability-linked orientation.
The Bank for International Settlements (BIS) estimates the size of the market for green, social, and sustainability (GSS) linked bonds has multiplied four times since the beginning of 2019, reaching around US$2.9 trillion by mid-2022. While green bonds still account for the lion’s share of GSS issuance led by private sector borrowers, sovereign issuance has picked up recently with more than 38 nations issuing GSS debt, including New Zealand, which launched its 2034 green bond in November last year.
Actions by regulatory agencies, in particular in Europe (such as EU’s Sustainable Action Plan and the ECB’s Eurosystem corporate bond purchase programmes) have played a peripheral role in the growth of the GSS market, but the greatest driver behind the expansion of the green bond market has been the growth of ESG funds, and the inclusion of such bonds into fixed-income benchmarks such as the Barclays Global Aggregate Index.
Healthy investor appetite has allowed borrowers to sell green bonds at yields lower than their conventional debt – a feature known as a ‘greenium’. Investors who publish carbon footprint numbers can be incentivised to accept a lower-yielding green bond in their portfolios, as inclusion affords a reduction in the carbon footprint via the lower Scope 3 Category 15 greenhouse gas emissions numbers of a green bond compared with that of a conventional bond from the same issuer.
Investors publishing carbon footprint numbers can be incentivised to accept lower-yielding green bonds in portfolios.
Although this greenium has shrunk from a peak of 15 to 25 basis points to low single digits, negating some of the financial incentives, there are indirect business benefits for borrowers as such issuance may enhance an organisation’s green credentials – commonly called the ‘green halo’ effect. Studies by the US Federal Reserve indicate this ‘green halo’ may, in the short term, lower an issuer’s weighted average cost of capital while playing a useful role in signalling with regard to a borrower’s intentions and commitment in addressing environmental issues.
Market matures, but criticisms remain
The International Capital Markets Association (ICMA) first published a set of voluntary, non-binding guidelines called the Green Bonds Principles (GBP) in 2014, providing borrowers instruction on: how proceeds should be used; the process for project evaluation/selection; the management of proceeds; and (impact) reporting. Typically, the four principles are articulated prior to issuance via a green bond framework. European regulators have also introduced their own green bond standards (EU GBS), which have more stringent reporting requirements than ICMA’s green bond principles.
Although many issuers follow these principles and standards, they’re not legally binding and there aren’t financial penalties for noncompliance with the (in many cases loose) impact reporting metrics outlined in the framework.
The lack of any regulatory ‘stick’ increases the risk of bonds losing their ‘greenness’ over their life, a good example being the US$6 billion of green bonds issued by Mexico City Airport Trust (MCAT) in 2016/17. These green bonds were intended to finance the building of a new airport. The MCAT bond ticked all the boxes, getting external assurance on its GBPs, and obtaining the highest score (GB5) in Moody’s green bond assessments. However, in 2018, the Mexican Government halted work on the airport causing Moody’s to slash its green bond assessment to its lowest level (GB1). The MCAT bond incident added to claims of greenwashing in capital markets with green bonds simply being virtue signalling tools that didn’t deliver net positive environmental outcomes.
John Young.
To counter these criticisms, green bond issuers need to address the following: First, what evidence is there that a green bond leads to the scaling up of green activities that would not have occurred without it? And, do the projects that are financed by green bonds have clear and identifiable benefits (ie, are they transparent and measurable)?
On the issue of scaling up (termed ‘additionality’) the debate has principally been on whether projects are financed ex-ante or ex-post issuance of the green bond. A text book example of how a green bond fails the ‘additionality’ test would be the Federal Republic of Germany’s green bond that saw 100% of issuance proceeds allocated to projects approved prior to the launch of their green bond.
Some sovereigns (New Zealand and the UK) allow up to 50% of proceeds to be allocated to expenditures prior to issuance, with the remainder of proceeds to be allocated to expenditures up to two years in the future, but even with future projects, it is moot whether they create any material additionality.
This is particularly true of sovereigns who, unlike private sector borrowers, are better able to issue longer-dated debt and unlikely to benefit from any ‘greenium’, as was the case with Germany’s issue as they utilised a ‘twin bond’ concept (identical coupons and maturities).
On the issues of transparency and measurability, the lack of a set of standardised global impact reporting metrics makes assessment and comparisons challenging for investors.
What does the future hold for green bonds?
A study on green bonds in Sweden’s capital markets indicated that green bonds had little direct impact on shifting capital from unstainable to sustainable investments, while the research carried out by the Federal Reserve indicated that: “Sustainability-linked bonds, rather than specific green projects (like green bonds), may be more effective for connecting sustainability minded investors with firms making credible, systemic green investments.”
The Financial Times Lex column opened this year with a provocative headline: “Green bonds: the disappearing greenium is a welcome development … Longer term, the bonds will cease to exist as a separate asset class.”
As the FT opinion piece highlights, green bonds have played an important part since their 2008 debut in raising awareness and accelerating capital utilisation towards addressing environmental problems and challenges, but perhaps they’ve had their time in the sun and will be overtaken in popularity by instruments such as sustainability-linked bonds, which have better incentives, additionality, and measurability characteristics.
NZ’s green bonds ‘halos’ or ‘horns’ for environmental credentials?
In November 2021, Climate Change Minister James Shaw set out some pretty big expectations for New Zealand’s green bonds, with the statement that New Zealand would reduce its “net greenhouse emissions by 50% by 2030 ... capital needs to be directed towards activity that will accelerate the transition to a low carbon economy. Green bonds will be a crucial part of that.”
Climate Change Minister James Shaw.
Unlike New Zealand’s Infrastructure bond in 2007, which probably received a one-line journal entry into the Government’s financial statements, last year’s green bond will require more reporting than that – a lot more. The two-year forward allocation of proceeds, set out in the Green bond framework, means the clock is ticking.
Projects financed by the 2024 green bond will require significant resourcing to ensure robust governance in the evaluation, selection, and reporting of impact metrics to guarantee the (timely) delivery of environmentally positive outcomes. Delivery shortfalls risk turning those halos into horns for New Zealand’s environmental credentials.
Given these headwinds and the potential for progressive change in the GSS market, the 4.25% May 2034 green bond may turn out to be a fossil in New Zealand’s capital market landscape.
John Young is a director of St Clair Group. He has three decades of experience in global financial markets, with a particular interest in capital market issues and developments.
John Young
Sat, 21 Jan 2023
