PRIMER: green bonds

Author: | Published: 3 Aug 2017
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What is a green bond?

There is no consensus on an official definition. According to Climate Bonds Initiative (CBI) chief executive Sean Kidney, what matters when considering if a bond is green is what it’s going to be used for (use of proceeds), not the issuer. Because of this, green bonds are generally thought about in terms of:

  • the specific process they need to go through (a fixed income debt instrument which needs to go through a vetting and certification process to get a green label); and
  • the kinds of projects they are used to finance (climate or environmental projects including renewable energy, sustainable water and waste management, and energy efficiency projects).  

And as the green market has developed, so has the classification of green assets. The ‘green’ label can also be extended to relevant use of proceeds revenue bonds, project bonds, covered bonds, securitised bonds as well as loans and promissory notes. There are also dedicated green funds.

How long have they been around for?

The European Investment Bank and the World Bank were the two first green bond issuers, in 2007 though there have been instances as far back as 1992 where fixed income securities were used to finance environmental infrastructure.

The market only really took off in 2013, when the International Finance Corporation (IFC) sold a $1 billion green bond.

green bond
Business and environmental interests don't need to be at odds

While all three previous examples were investment-grade multilaterals, the market has since opened up to green bond sales from issuers in a range of sectors and with varying credit ratings. There have only been a handful of high yield green bond issuances but these are expected to grow in the future as more corporates and local government agencies tap this market.

France and Poland were the first two sovereigns to issue green bonds, in 2016. The $7.5 billion 22-year French instrument has been earmarked as a template to be used by other central governments because of its landmark size and maturity.

“Asian and African sovereigns are expected to be part of the next wave of green bond issuing nations,” says Nicholas Pfaff, senior director, International Capital Market Association (ICMA), and secretary to the Green Bond Principles (GBPs).

According to Moody’s data, the value of issuances has risen from $807 million in 2007 to nearly $120 billion expected in 2017.

Are green bonds more expensive than normal bonds?

 Kidney defines green bonds as ‘standard bonds with green as a bonus feature’. There is no additional cost to issue a green bond (so-called flat pricing) and they rank pari passu to normal note issuances.

“Green bonds we used to see in renewable project finance transactions tended to be structured by way of private placement mezzanine debt schemes structurally subordinated (at a HoldCo level) to the senior bank debt (at the SPVs’ level) but are now evolving towards being pari passu with other debt instruments,” said Laurence Martinez-Bellet, partner at Watson Farley & Williams.

“This is in part because institutional investors are increasingly able to offer long-term funding of mixed brownfield and greenfield in large portfolios which can compete with long-term financing, such as bank debt,” she added.

More often than not, use of proceeds green bonds are backed by the issuer’s balance sheet, reducing cost and uncertainty.

"Green bonds we used to see tended to be structured by way of private placement mezzanine debt schemes structurally subordinated to the senior bank debt but are now evolving towards being pari passu with other debt instruments"

But there can be ancillary costs associated with a green bond issuance, notably those relating to the second opinion process (SOP), which vets the ‘greenness’ of the bond, and also possible internal organisational costs (employees of the issuer who report on and monitor the projects linked to the bond).

Sandro Pittalis, senior originator DCM corporates and senior legal counsel at NORD/LB, notes that there is a supply and demand mismatch in the market at the moment, which has an impact on spreads. This could mean that, for some corporates, issuing a green bond provides little or no pricing advantage compared to conventional debt.

“It’s a market that’s still young and small with the associated information asymmetries,” he said. “There’s some lack of regulation, guarantees and security but continued green bond issuance and market demand, and progress on standards have helped firm up the framework for this type of debt.”

What’s green and what’s not?

The market suffered for a long time from a lack of global standards to certify so-called green credentials. In some isolated instances, this has led to so-called greenwashing – where green bonds are used to finance projects which don’t necessarily have any notable environmental or sustainable impact. Kidney says green bonds need to be linked to assets and projects ambitious enough to meet Paris Climate Change Agreement requirements. An example of a green bond that wasn't ambitious enough was the Massachusetts State College Building Authority’s green issuance in 2015, where part of the proceeds were used to build a (green) car park.

This has led the industry to develop the practice of SOPs, where an issuer enlists a third-party organisation to certify the bond’s green credentials. This is not a mandatory process though many exchanges, such as The London Stock Exchange, will not list any green bonds unless issuers provide third-party certification that the instruments are considered green.

Does this mean that the market is self-regulated?

Not quite. While regulation in this sector seems to be reactive rather than proactive, some initiatives are currently addressing the lack of standardisation.

The ICMA’s GBPs and the CBI are two major examples of international programmes which were launched to assess and provide green label eligibility. Both mandate that the use of funds and revenue generated from the project revenue must be carried out in sectors or industries deemed green. The GBPs go further by stating that a green bond needs to be part of an overall environmental sustainability initiative on the part of the issuer.

There are other initiatives including the Asean Green Bond Standards, Moody’s Green Bond Assessments and the Center for International Climate and Environmental Research Oslo (Cicero). In the EU, the High-Level Expert Group on Sustainable Finance, backed by the EU Commission, is expected to publish a report in December 2017 on proposals to create an EU green bond standard and a classification system for sustainable assets. It’s believed this EU programme could provide a global standard template for green bond issuances.

 What about China?

The first issuance out of China was in 2015 when wind energy firm Goldwind sold a $300 million instrument. The Chinese market has since taken off in a spectacular fashion and local issuers sold nearly $40 billion of green debt in 2016. It’s easy to see why: the nation has ambitious green infrastructure plans and targets to fulfil in a very short space of time, with debt capital expected to play a crucial financing role. 

China is also the only regulated green bond market in the world. Its Green Bond Finance Committee has set out a strict definition of processes and eligibility of projects which is mostly consistent with the GBPs, at least on the process side. Other countries are also developing different types of green bond guidelines - these are already in place in Brazil, India, Japan and Morocco.

“But this has led to what some call a bifurcated market for green bonds,” said Christopher Kaminker, head of research, climate & sustainable financial solutions at Swedish bank SEB. “One issue that the market needs to focus on is avoiding fragmentation, which will keep transaction costs low, and maintain credibility and integrity.”

Where is the market at?

While green bonds have been around for 10 years, issuances only started taking off in 2013 after the IFC’s landmark issuance.

"There is a supply and demand in the market mismatch at the moment, which has an impact on spreads"

One key explanation for the increasing volume of green bonds is many states’ commitment to 2015 Paris climate agreement. It’s widely believed countries are keen to showcase green initiatives to show their support for this United Nations-backed initiative. Signatories have agreed to actively combat global warming notably by ‘pursuing efforts to limit the temperature increase to 1.5 °C above pre-industrial levels’. Major signatories include the EU, China, India and the US (the latter three accounting for 42% of global greenhouse gas emissions) though the US notified fellow states of its intention of pulling out of the initiative earlier this year.

And of course China is driving green issuances because it needs to plug the funding gap for its 12th five-year plan.

There’s also a clear indication that investors are largely in favour of environmental, social and governance initiatives at corporate level. Green bonds are part of this wider strategy.

“Issuing a green bond sends a signal to the market,” said Pfaff. “There are also clear advantages when it to comes to diversifying the pool of investors and exploring different – sometimes very long-term – maturities.”

What next?

There are two main challenges facing the green bond market. The first is ensuring that there is a large enough pipeline of bankable projects that can be financed through green bond issuance. As Kaminker notes, demand for green bonds continues to outstrip supply.

"Good underlying framework conditions for green infrastructure investment are needed, such as ambitious and stable policies, adequate carbon pricing, fossil fuel subsidy reform etc," he said.

“One of the challenges we are seeing is that there are not enough bonds to offer investors – both in local and benchmark currencies,” agreed Kidney. 

But there are positive signs for the market. Chinese activity is stabilising but also now diversifying beyond financials. While SSA issuance remains an important highly rated foundation to the market globally (including the entrance of sovereigns), and while financials (banks and real estate for instance) are also present this year, the market is only beginning to feature large-scale issuances from the sought after non-financial corporate sector - Apple recently launched in the market. 

Another issue is harmonising the market on a global-scale, to streamline the green bond issuing, certification and accountability/reporting process – which is currently recommended but not mandatory in many countries.

“What I’ve seen so far is that the issuer will adhere to all the rules to get the green label but this will not necessarily be fully documented in the green bond financing documentation,” said Martinez-Bellet. “There will be two paragraphs on the fact that it’s a green bond but no set up of any detailed binding framework.”

The US, for instance, has a wide-range of tax incentives available to stimulate green bond investment but has not proven to be a key growth driver like China or France. Organisations there have sold around $30 billion of green debt, in large part driven by municipal bond issuances. US dollar-denominated green bonds account for over one-third of the total, on par with euro-denominated instruments.

One obstacle that could stand in the way of green growth is the proliferation of green asset classes, which could stand in the way of harmonisation attempts. 

See also

Green loans are catching on 

Islamic finance explores green market

PRIMER: the Hong Kong-China Bond connect