We explore one of the fastest growing segments of sustainable finance: Green bonds (...and note that not all green bonds are 'good' green bonds!)
The process of developing a green bond is likely not as regulated as many believe, but that doesn't mean issuers can get away with whatever they want.
Over half-a-trillion dollars worth of green bonds were issued in 2021, an increase of 75% compared to 2020. It may be time to explore these fixed-asset instruments in more depth!
Every week we see an increasing number of announcements related to ‘green’ or ‘sustainable’ financing. It's actually become a challenge to be able to keep up with all of the financing arrangements directed toward sustainable or environmentally-oriented ventures and developments--being those financing arrangements which take ESG or impact data into consideration.
Green finance encompasses a wide variety of approaches and arrangements, however green bonds are surely one of the most, if not the most, common arrangements we read about in popular media. Just consider PepsiCo’s issue of a staggering $1.25 billion green bond to fund sustainable agriculture and supply chain projects, or Maersk’s wildly over-subscribed green bond to build methanol-fueled container ships.
But what exactly are green bonds?
We’ve teed this up for a simple explanation…but it really isn't’ quite so clear.
The challenge is that the ‘green’ in green bonds does not answer to any particular regulatory or legislative domain. Bonds operate in a highly regulated financial space, however the ‘green’ component does not.
Broadly speaking, a bond is a financial instrument representing a loan between investors and an issuer, typically a corporation or a government, and typically underwritten by an investment bank or similar financial institution.
A company, for example, could issue a bond to help raise money to build a new factory or expand supply chain management initiatives. The bond would have a maturity date, upon which the principal of the loan is repaid, along with an interest, or ‘coupon’, schedule (typically an annual interest rate paid out in two 6-month installments). The bond underwriter, in turn, assists in bringing the issuance to market by preparing a prospectus and other legal documents, setting an initial price, driving early investor interest, and, if negotiated with the issuer, guaranteeing the issuance by a willingness to purchase any unsubscribed bonds.
Adding the ‘green’ component to the bond doesn’t change any of this. What it is supposed to do is stipulate to what end the revenues from the bond can be applied. If the bond is financing a project which has an environmental-benefit element then it can ostensibly be a green bond. If Maersk, building from the linked-article above, were to issue a bond to build new ships burning heavy bunker fuel, it would be a traditional bond, but should they issue a bond to build new ships burning lower-emissions methanol fuel, it could be a green bond.
Which end-goals count as being green and which do not is entirely up to market participants. Green bonds are self-labeled, meaning an issuer can call their bond green if they want…but this doesn’t mean investors need to accept them as green.
Today, most bond markets expect ‘good’ green bonds to direct 100% of revenues toward environmentally-beneficial projects…and they expect top-quality green bonds to also provide a second-party opinion, and possibly even certification, on the environmental merits of these projects. This doesn’t mean a company couldn’t issue a bond to finance building a new factory which had a tiny little solar panel to power the entry canopy lighting and wrap it all up as a green bond, but this is so far removed from what investors have demonstrated an appetite for that the issuer would likely have great difficulty finding a financial institution to underwrite it at any acceptable terms.
There is a logic to the development of good green bonds which becomes clear when we focus on the green bonds investors have demonstrated an outsized demand for. Here’s a high-level overview of how a good green bond is typically issued:
As you can see, the process itself is not regulated and most of it is entirely up to the issuer’s discretion. We outlined this process based on an analysis of good green bonds--meaning green bonds that investors have demonstrated a strong appetite for based on oversubscriptions and/or discounted interest rates. Issuers are at liberty to modify the process to best fit their situation and still have their bond be recognized as a green bond, just note that if your process deviates from the expected trajectory it is helpful to provide enhanced transparency and reporting.
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You may not have invested in a green bond yet, but certainly do not underestimate the growth of this market.
The Climate Bonds Initiative maintains a public database of green bonds. Limiting the analysis to only include good green bonds--bonds with 100% of net-revenues financing projects with environmental benefits--we can see that the market has really taken off. In 2021, green bond issuance surpassed $522 billion USD, an increase of nearly 75% over 2020.
The US leads in green bond issuance, followed by the EU and UK, and China. A full 75 percent of green bond issuance in 2021 originated from developed economies, with 21 percent from emerging economies and a remaining 4 percent from supranational organizations, such as The World Bank. Most interesting to us is that green bonds seem to favor scale. Across total issuance in 2021, 37 percent of green bonds exceeded $1bn, followed by 32 percent at the $500m to $1bn range, 22 percent at the $100m to $500m range, and only 9 percent under $100m.
Green bond issuance in 2021 also demonstrated a clear preference among KPIs with 81 percent addressing issues improving sustainability in Energy, Buildings, and Transportation, and the remaining 19 percent spread across Water, Waste, Land Use, Industry, and Information & Communication Technology (ICT).
With the issuance of good green bonds surpassing half-a-trillion USD in 2021, and with global representation, it is hard not to imagine that this market is now building from a strong foundation.
The ‘green bond’ label seems to be the term which has captured the media’s attention but there are nonetheless a few important distinctions that sometimes get lost in translation.
The 'green' in green bonds does not refer to all things sustainability. In fact, there is another category of bonds known as sustainability bonds which covers a wide range of sustainability issues. Below is a quick breakdown of different types of bonds being issued in this space:
As you can see, both green bonds and social bonds can be types of sustainable bonds, but a green bond is not a social bond. Likewise, climate bonds and blue bonds can be types of green bonds, but not all green bonds can be climate bonds or blue bonds.
As it stands, the market seems to be gravitating toward green bonds in general, with a growing sub-sector of climate bonds, while social bonds, once demonstrating great momentum in the early 2010s appear to be stagnating.
The big question about green bonds, other than “what are they?”, is whether issuers can gain a premium from offering a green bond instead of a traditional bond. To put it bluntly, can issuers offer a lower interest rate to investors if they package their bond as a green bond? As you can see above, there is relatively more work to packaging a green bond compared to a traditional bond, but it would all seem so trivial if it results in lower interest rates owed to investors.
Research on the existence of a ‘greenium’ is mixed (Affirmative Investment Management, a well-established fixed-income asset manager, published a blog last year which links to many interesting studies in this space.
The short answer is that some green bonds do provide for discounted interest rates, to the benefit of the issuers, while others do not. There are far too many variables at play to determine the presence of an overarching premium: consider that two green bonds that could be packaged exactly the same still differ by the characteristics of the companies issuing the bonds. But there is strong evidence that good green bonds are more likely to provide an advantage to issuers than are simply green bonds. While not impossible, a self-labeled green bond absent KPIs, SPTs, and an independent SPO is not likely going to sufficiently capture the interests of investors to reduce the coupon rate to be paid.
Putting in the effort to package a bond as a good green bond is likely to be worth it, but anything less than this effort is likely not.
A Quick Overview of Recent News
Sustainable finance is not slowing down. As explored in this Financial Times article, some green bond issuers are finding it increasingly challenging to derive a greenium as more companies than ever before are jumping into this fixed-income market to meet ever increasing investor demand, but the opportunity for a premium does still exist.. This places a greater incentive on issuers to make sure they package good green bonds.
The broader grouping of green, social, sustainable, and sustainability-linked bonds is expected to exceed $1 trillion USD in issuance this year. This projection has been revised down from $1.35 trillion USD facing the growing risk of a global recession, but it is important to note that analysts are not revising projections downward for this group as much as they are for traditional bonds and fixed-asset vehicles. Seems there may be some resiliency in sustainability.
In yet another Financial Times article, the authors declare that the CSO is now an indispensable part of the executive team and this is changing the types of skills needed to lead this position. Increasing nervousness around environmental and social risks is leading more companies to integrate the CSO role directly into business management strategy, thereby placing an emphasis not only on knowledge of sustainability but also, and perhaps more so, on strategy, revenue modeling, legal compliance, and supply chain management. With this growing focus, it is possible more companies will split the role leaving the CSO with the more business management-oriented activities while redirecting issues of ESG reporting leadership and deep climate/sustainability knowledge to newly created senior non-executive positions.
In the end, green bonds are critically important components of sustainable finance and are likely going to become even more popular in the coming years. We do a lot of work in this space, particularly helping companies package good green bonds (steps #1 through #5, above, but we don’t serve as an SPO as that would be a conflict of interest). If you would like to continue this discussion, please connect with us on Twitter and LinkedIn, or from our website.