Back to May 2019

Multi-trillion-dollar prospects

By Paul Mackintosh  
  • Asia
  • Global
  • USA

Rise of responsible investing helps drive demand for green bonds

Green bonds are a relative novelty in the fixed income universe. However, they are already sufficiently visible for Maarten Biermans, head of sustainable capital markets at Rabobank, who recently warned of their potential implication in “greenwashing” exercises.

Like many other new asset types, green bonds are part of a growing selection of impact- and environmentally-focused investment products. As sustainability-linked investments become more mainstream and more richly financed, this is perhaps the right time for asset owners and managers to get to grips with the characteristics of green bonds, and understand more about exactly what is on the table, and what the benefits are of investing in them.

This could be especially true for Asian investors. “There has never been a better time to invest in climate solutions,” Philippe le Houerou, who was then executive vice president of the International Finance Corp (IFC), the World Bank’s private sector arm, wrote in 2016 in the foreword of a report on Climate Investment Opportunities in Emerging Markets. According to Mr. Houerou, who is now chief executive officer of the IFC, the 2015 Paris Accord on climate change “will help to open up nearly US$23 trillion in opportunities for climate-smart investments in certain emerging markets between now and 2030”.

That kind of volume is worth looking at, especially when the investment opportunities may be right on an institutional investor’s doorstep. However, this still requires understanding of what’s at issue, and how to proceed.

Structure and definitions

Green bonds are debt instruments issued to fund projects or entities with a clear environmental or climate focus, and are often also known as climate bonds. The rules dictating the structure of such bonds include the International Capital Markets Association’s (ICMA) Green Bond Principles, which are voluntary but nonetheless widely accepted as applicable standards. They focus primarily on use of proceeds, process for project evaluation and selection, management of proceeds, and reporting.

In each of these core areas, the principles dictate that the green bond should be transparently and verifiably linked to underlying environmental or climate priorities. Bonds that cover the wider field of social as well as environmental impacts are defined as sustainability bonds, and are covered separately by the ICMA’s sustainability bond guidelines.

Alban de Faÿ, head of fixed income SRI and green bond strategies at Amundi, notes that green bonds are “self-labelled” but that it is now standard market practice for issuers to follow the ICMA principles. He considers the framework for the principles as being adequate to foster transparency and disclosure, and give the developing green bond market sufficient standards of integrity as it evolves.

Amid scepticism over greenwashing and marketing labels, it is certainly hard to imagine a green bond getting too far without visible adherence to the ICMA principles or similar guidelines.

Felipe Gordillo, senior environmental, social and corporate governance (ESG) analyst at BNP Paribas Asset Management, emphasises the use of proceeds as the fundamental defining characteristic of a green bond. Classifications and measurements of what constitutes green may differ, but the principle is clear: proceeds raised must be actually expended on green issues and benefits – frequently around greenhouse gas emissions reduction or avoidance, according to Mr. Gordillo.

Issuers and market size

The green bond market is still very much nascent, but how nascent, and who are the major issuers? Hans Biemans, head of sustainable markets at ING, says that according to his company’s research, 40% of green bond issuance is by financial institutions, 34% by governments and sovereigns, supranationals and agencies, and 17% by utilities.

The biggest share of redemptions of green bonds in the near future is also from the financial sector, with 55%-60% due over the next two years.

As for buyers of green bonds, Mr. Gordillo cites a survey by Credit Agricole Corporate and Investment Bank, a top underwriter of green bonds, which found that green bond funds already held 16% of the total issuance of these debt at the end of 2016. This figure is likely to increase with time. According to Mr. de Faÿ, working from admittedly limited information, some two-thirds of bonds issued by European agencies are held by socially responsible investing, or SRI, investors, and 10% by Asian investors.

The ICMA principles were only first formulated in 2014, an indication of the relative youth of the asset class. All the same, the Climate Bonds Initiative (CBI), another non-profit focused on the field, says total estimated issuance for 2018 was at least $167.3 billion – a figure likely to increase as more data becomes available.

The CBI forecasts green bond issuance in 2019 to top out at some $250 billion, with $45.4 billion already sold in the first three months of the year. Given that it pegs the size of the total global bond market at some $100 trillion, there obviously is still plenty of room for growth, but the trajectory of development definitely seems to be on the right path.

Based on Amundi’s data, Mr. de Faÿ says the total outstanding volume of labelled green bonds as at March 2019 was $490 billion. The market size has “multiplied by almost 12 over the past five years”, he adds. He expects the trend to continue, thanks to a more favourable regulatory environment and investors’ “deepening concern” over environmental issues.

The ING research indicates there were some $105 billion of newly issued and self-labelled green bonds in 2018, slightly down from $118 billion in 2017. All the same, Mr. Biemans sees strong support from financial institutions and policy initiatives driving the kind of growth expected by the CBI. One such initiative is the European Union Green Bond Standard, which is focused on enhancing the integrity and transparency of green bond markets.

Mr. de Faÿ notes that the green bond market “has long been dominated by development banks and agencies”, which naturally could be expected to maintain high standards of integrity and transparency. He says the corporate green bond market has been given impetus by initiatives such as the ICMA principles, which provided the standards for new issuers.

How big a problem transparency and integrity is in this end of the market is debatable, but the CBI has already singled out and criticised some corporate green bond issues, and the ratings agencies that certified them, for being insufficiently green.

Environmental performance

As the CBI’s action suggests, the measurement of the environmental impact of a green bond, and the mechanisms whereby it achieves environmental impact, can be a fraught topic. Mr. Biemans cites Harvard Business Review research that suggests companies issuing green bonds do indeed improve environmental performance after issuance. The study found that the environmental score for green bond-issuing companies improved 6.1 percentage points on the Thomson Reuters’ ASSET4 scale, or a reduction of 17 tonnes of carbon dioxide per $1 million of assets, with green innovation also up 2.1%.

Mr. Gordillo outlines how green bond issuers are expected to show their offering’s credentials under the ICMA principles. A year after issuance, they are expected to demonstrate allocation of proceeds, and critically, the estimated and actual environmental benefits from the bond financing. These benefits can include a reduction in net emissions compared to a scenario without the initial bond issuance, or greater volumes of carbon dioxide absorbed, or waste water recycled.

On the pure performance side, Mr. Gordillo says there is “no clear pattern of pricing behaviour” for green bonds to date. Some outperform their non-green equivalent, and some perform comparably. The positive interpretation is that there is definitely no strong trend towards underperformance by green bonds.

Mr. Biemans points to further broad benefits from green bond issuance. These include a “2.4% increase in long-term value” for green bond issuers, as well as benefits in operating performance measured by return on assets, increasing by around 0.6% over the long term.

In pure performance terms, Mr. de Faÿ emphasises the Amundi house view that green bonds “are pari passu to other bonds of the same issuer with the same seniority”.

Position in a portfolio

For potential investors in green bonds, the performance question still leaves open the reasons to choose them in the first place. Investors may have compelling non-financial reasons for committing to green bonds, but where can they fit in a portfolio?

According to Mr. de Faÿ, green bonds can fit in a diversified portfolio even for investors who are agnostic towards the debt. In such cases, he recommends a spread-neutral replacement approach, since most “have a similar risk/return profile as compared to regular or conventional bonds issued by the same issuers”. This will lead ultimately to a broader range of issuers and issues coming into the market, which has diversification benefits in itself, as well as a more transparent fixed income universe.

Mr. Biemans identifies three classes of green bond investors. There are the mainstream or conventional “anchor” investors who are mainly looking at green bonds from the point of view of scarcity value. Then there are the SRI investors, who are already using responsible investing principles to filter their allocations. This group typically includes signatories of the United Nations-supported Principles for Responsible Investment, the ICMA principles, or are members of the Institutional Investors Group on Climate Change.

The third type of investors are those Mr. Biemans dubs “green bond heralds”. These are investors who have pro-actively instituted a green bond strategy, in many cases setting up their own green bond fund or dedicated pocket. He sees them as springing up especially in France, the Netherlands, and the Nordic countries.

Mr. Gordillo, meanwhile, sees most of the appetite for green bonds coming from institutional asset owners, especially those “pursuing a portfolio decarbonisation goal”. Others, including retail investors and private banks, are still far less committed to the notion of green debt.

Still, Mr. Biemans sees some growth in the retail green bond market, especially after the bellwether issuance of the first retail green bond in 2014 by the IFC. However, he says the retail market is still relatively small.

According to Mr. de Faÿ, some investors are willing to get behind the idea of financing eco-friendly projects. Green bonds increase the transparency of such funding, while mitigating risks that the investor will get caught up in a greenwashing exercise.

But he warns that even though standards such as the ICMA principles are increasingly familiar to issuers and investors, asset managers and asset owners involved in this market should still be ready to follow the CBI’s example, do their own due diligence, and be ready if necessary to “challenge issuers about the greenness of their issue”. This may require deep analysis of the issuer’s environmental and energy strategy, and probably complete exclusion of some sectors, such as coal, oil and gas.

Whatever their green credentials, green bonds in principle behave like any other bond in pricing terms in the primary or secondary market, Mr. Gordillo says. As such, there should be no problem including them in a bond portfolio like any other bond.

The positive case for investing in them, he says, is that they come to the investor already comprising specific environmental benefits, enabling asset managers “to set up dedicated green bond funds for clients, investing only in green bonds, and able to report on the positive environmental impact the investment is making, in addition to the financial benefits a mainstream bond fund would capture”.

This ought to take care of both the investor’s environmental and financial targets, provided that standards like the ICMA principles are properly followed.

Mr. de Faÿ points out that some investors may want to go beyond simply tracking the destination of their funding, and evaluate the environmental impact of their green bond investment themselves. He notes that more and more issuers are encouraged to provide impact indicators in their annual report. These allow actual measurement of the impact of a project, such as energy savings, avoidance of greenhouse gas emissions, and renewable energy generation. However, he cautions that “ESG expertise is needed to analyse the reports provided by the issuers and their environmental strategies”. This requires a truly hands-on, knowledge-driven approach by investors who seek to track the environmental impact of their money.