Green bonds have matured, the asset class has outgrown the infancy phase and it's here to stay. Apple Inc. issued several green bonds this and last year, fuelling corporate involvement in the asset class. But what are green bonds, what are the benefits and what are the pitfalls?
What is a green bond?
The generally accepted definition of a green bond is: "A bond whose investments are used to fund environment-friendly projects". The bonds often have a tax-exempt element, but there are taxable green bonds as well. Green bonds are also referred to as "climate bonds" – bonds whose investments are linked to projects battling climate change – but we have also seen references to "social (responsible) bonds", "sustainable bonds" and "ESG bonds." Another acronym that pops up in the green bonds space is PACE (Property Assessed Clean Energy), financing or securitisation. You can read up on PACE in these two articles: " Property Assessed Clean Energy (PACE) securitisation market on the rise" and " It's coming at a rapid PACE".
No longer green as grass
Green bonds have been around now for a good 10 years. The first green bond – the Climate Awareness Bond – was issued in 2007 by the European Investment Bank (EIB) to finance renewable energy and energy efficiency projects. This was listed on the Luxembourg Stock Exchange (LSE). In 2016, the LuxSE launched the Luxembourg Green Exchange (LGX), creating a dedicated platform for green securities. Six years after the first green bond issuance, in 2013, the first corporate green bond was issued. Now, in 2017, the green bonds market is around US$200bn in outstanding bonds, coming from just under US$1bn in 2007 and US$11bn in 2013.
Based on the outstanding green bonds year to date, one cannot deny the asset class is here to stay. Furthermore, corporates are willingly jumping on the bandwagon, fuelling the growth. One of those companies is the renowned iPhone manufacturer Apple Inc. At the beginning of last year, Apple Inc. issued a large green bond, worth US$12bn. In June of this year they issued another green bond, worth US$1bn, to fund environmentally focussed initiatives. The latest Apple green bond will run for 10 years, has a coupon of 3% and yields 82 base point spread (bps) over comparable US treasuries.
Projects need to have sufficient green ambition
We have seen the definition of what a green bond is, however the definition does leave (a lot of) room for interpretation. So one might ask, when is a project financed by a green bond, green enough? To answer this question we could look to the Green Bonds Principles and the Climate Bonds Standards, the two main frameworks for green bond governance. However, these principles and standards are voluntary; issuers do not have to comply with them. Furthermore, they are not as clean-cut as you might think. Therefore answering the question is proofing to be difficult and loose interpretation does occur. Hence the issue around 'greenwashing', the phenomenon where unsuitable projects are financed by green bonds. For now the green of a project can only be interpreted by how the issuer markets the project pre-issuance and its impact measured post-issuance by means of impact reporting, preferably by an independent third party, something that does not happen for all green bond projects.
Green bond benefits for issuers and investors
The two key parties involved in any bond are the issuer and the investor. For green bonds, this is no difference, but in addition, the environment benefits as well and subsequently, we all do.
Issuers benefit from issuing green bonds in numerous ways and below are the main benefits.
- Finance green initiatives. Obviously the biggest benefit is attracting capital to finance green projects.
- The possibility to tap into a different, new, investor base. Green bonds attract green investors. This is especially interesting for issuers who themselves are not necessarily considered green.
- Green appeal. Let's not beat around the (green) bush; issuing green bonds does wonders for how potential employees and partners perceive your company.
- Pricing advantages. It's argued that green bonds, due to their popularity and additional costs for reporting and compliance, warrant a premium price that issuers could benefit from. I say 'argued' since in practice, we have seen very little of this yet.
On the other side of the bond spectrum, investors can benefit, for mostly the same reasons, from green bonds as well:
- Diversification. Investing in green bonds means diversifying your investment portfolio, opening it up to a new, different risk and return profile
- Tax benefits. When investing in a tax-exempt green bond, investors do not have to pay taxes on the interest from the bonds they hold
- Fulfil your mandate. Investing in green bonds helps you fulfil your ESG (green) mandate.
- Green appeal. Again, going green as an investor improves how you are perceived by the outside world.
The benefits described above for both parties will fuel the need for green bonds.
The future of green bonds
The green bonds market has matured; however, there is still much to be developed and changed for green bonds to really take off.
For one, unified and clear regulation is needed. The industry needs a set of rules to follow when it comes to determining how green a green bond, or actually, the project financed by the bond, really is. Green bond issuers and investors need an enforceable and well defined set of rules around green project evaluation to measure the impact on the environment. This will require harmonisation of existing guidelines and regulations within and between regions, for example between Europe and China.
China is the biggest green bond issuer in the world. There are clear rules and regulations, and the government is pushing this with clear, top down, regulations. In Europe, there is no standard set of regulations. The European Commission is looking into how the green finance market in Europe should be regulated but the outcome is still up in the air. Obviously, the rules should focus on transparency but leaving issuer flexibility and giving incentives to issue green bonds. Furthermore, a unified set of rules will hopefully contribute to the comparability between green bonds as well.
Alongside this, with the first point (unified and clear regulation), I would welcome green bond tiering. In simple terms, a triple A rating for the bonds with the biggest environmental impact and further tiering for bonds that have a lower impact. This will give investors more clarity on comparability.
Thirdly, we need scaling. To further develop the market, corporates should get more involved as green bonds issuers. Apple is a great example but we need more companies to really step up to ultimately diversify the investment options.
To further fuel the market we need new products around green bonds and exchange-traded funds (ETFs) could be a very nice option for this. It would open the market to a much wider audience, and spark further innovation and maturing of the asset class.
And last but not least, a bigger difference in pricing is needed between green and 'normal' bonds. The price discrepancy could be a big benefit for issuers and it would ignite their interest in issuing more green bonds. This could be accomplished by lowering the risk rates, meaning lower capital charges and giving an incentive to open the market beyond institutional investors.
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