Supranational agencies introduced green bonds to the capital markets more than a decade ago as a source of funding for projects intended to deliver a positive environmental impact. Since then, green bonds have become more prevalent. Across sectors and regions, issuers of all types are using green bonds to finance projects related to environmental sustainability. The growing supply of green bonds is coinciding with surging demand for investments that incorporate environmental, social and governance (ESG) factors. Moreover, in addition to green bonds, investors now have access to an increasing number of conventional bonds that come from issuers with a demonstrated track record of leadership in sustainability. Some may consider these bonds to be just as “green” as green bonds.
As the green bond market grows and evolves, investors and issuers should consider some important questions. Primarily, there is still debate about what makes a bond “green.” There is no global consensus on the types of capital projects that fit within the scope of green bonds. In addition, a diverse set of providers with their own methodologies can certify and label these bonds. Importantly, green bonds generally do not include covenants that legally require the issuer to use the proceeds for specific green commitments. This heightens the need for investors to conduct their own due diligence. Investors focused on sustainability should evaluate issuers’ overall capital spending plans and sustainability track record.
Loomis Sayles partnered with Sustainable Market Strategies to evaluate the current green bond market. In addition to examining trends related to issuance and investment activity, we analyzed the financial characteristics of green bonds relative to conventional bonds. Our analysis confirmed a growing body of research that suggests declining yield premiums for green bonds. Today, green bonds’ characteristics are largely similar to those of conventional bonds.
A green bond is a fixed income instrument tied to projects that create an environmental benefit. Issuers use proceeds for a variety of activities aimed at contributing to climate change mitigation, adaptation or some other environmental benefit, such as conservation or pollution control. Examples include projects associated with renewable energy, public transportation, energy-efficient buildings and manufacturing processes, agricultural land management, waste management and water management.
Many green bonds are labeled as such—i.e., deemed to be “green” by the issuer—and third parties often certify the bonds’ adherence to a particular standard. But labels do not yet tell the whole story, as there is currently no universal standard for green bonds. Existing standards differ with respect to project criteria, green definitions and verification, and a diverse set of external reviewers can certify.
This should change, at least in Europe. The European Union (EU) is formalizing its green investment classification system—or taxonomy—which may alleviate some of the concerns about the lack of standardization in the green bond market. The goal of the EU’s taxonomy is to define what activities it considers “green” based on a corporation’s carbon emission levels. The assessment will include two climate-related factors: mitigation and adaptation activities. The EU Green Bond Standard will require that the assets in a green bond deal meet the EU’s formalized taxonomy criteria for a green bond.
Without precise criteria, some issuers may use green bonds to fund projects that aren’t universally recognized as supportive of environmentalism—often referred to as “greenwashing.” For instance, issuers may make modest efficiency improvements to carbon-intensive processes instead of investing in low-carbon alternatives. In other cases, an issuer may provide limited specifics beyond a vague claim that the organization will use the proceeds to promote sustainability.
However, it’s important to keep in mind that bonds without the green label may in fact be just as “green” as labeled bonds. For example, a rail project that boosts mass transit use may create an environmental benefit even if the issuer does not refer to it as a green bond or seek third-party certification. Furthermore, investing in unlabeled bonds issued by an organization that has become a leader in supporting sustainability can be an effective way for investors to make an impact, even without the green bond moniker.
ISSUANCE TRENDS
Green bonds are still a relatively new concept. In 2007, the European Investment Bank issued the first “climate awareness bond.” The World Bank and other development banks and supranational issuers soon followed. This bond issuance is now widespread across several types of debt: corporates (financial and non-financial), municipals, sovereigns, supranationals and asset-backed securities.
Labeled green bond issuance has grown rapidly, from less than $20 billion in 2013 to more than $200 billion in 2019. However, the green bond market is still relatively small. According to Moody’s Investors Service, green bonds represented just 2% of total bond issuance over the past two years and 4% in the final quarter of 2018. In Europe, however, the green bond proportion of overall bond volume is more than twice the global average. Issuance in Europe accounts for about half of all green bonds issued globally. Volumes, however, have also grown rapidly in Asia Pacific and North America since 2015.1
INVESTOR DEMAND
We expect that the green bond market will continue to grow significantly in the years ahead. More than 180 nations have ratified the Paris Agreement. The pact commits them to address carbon emissions within their countries in an effort to limit global warming to two degrees Celsius above pre-industrial levels. Economic development policies increasingly focus on sustainability, as reflected in the U.N. Sustainable Development Goals. Seeking these climate and development goals requires substantial investment—nearly $7 trillion a year through 2030, according to the Organisation for Economic Cooperation and Development.2
The complexity of structuring certain infrastructure projects with long lead times suggests that these investments will drive green bond issuance higher once they reach the financing stage. Offshore wind farms, for example, need to clear regulatory hurdles as well as potential opposition from nearby communities before the project owners begin raising capital.
Investors of all kinds have committed to supporting the transition to a more sustainable economy. This investor base ranges from millennials and high-net-worth individuals to large asset managers and owners. Asset managers and owners representing nearly $90 trillion of assets have signed on to the U.N. Principles for Responsible Investment (PRI).3 Fixed income accounts for approximately 40% of these assets, including green bonds.4 The growing demand for green bonds even extends to central banks. The Bank for International Settlements (BIS) recently launched an open-end fund allowing central banks to invest a portion of their reserves in green bonds.5
REPORTING STANDARDS AND CERTIFICATION
Standardization will become increasingly important as the green bond market grows. Currently, there is no global consensus on how to classify projects qualifying for green bond financing. The non-profit Climate Bonds Initiative issued the Climate Bond Standard back in 2010. Other organizations, including the International Capital Market Association and the International Standards Organization, are at various stages of developing their own standards. Financial data providers might add to investor confusion as they develop their own methodologies to track the green bond market. The implementation of the EU’s taxonomy system will help to set standards in Europe. Other regions may follow the EU or adopt their own taxonomy system.
Because all standards are currently voluntary, investors often seek assurance through third-party certification. In Europe, over 98% of green bonds receive some external review.6 This typically involves a pre-issuance report on the alignment of the intended use of proceeds with the chosen green bond standard, as well as an assessment of the issuer’s integrity and capability to select projects consistent with that standard. Post-issuance, reports may verify the allocation of bond proceeds and assess the environmental impact of completed projects. Several different types of organizations conduct third-party certifications, including accounting firms, credit rating agencies and specialty ESG service providers.
ABILITY TO DIRECT INVESTMENTS FOR ENVIRONMENTAL IMPACT
For investors, a big benefit of green bonds is the enhanced ability to direct capital to activities that can generate positive environmental impact and help finance the transition to a more sustainable economy. This is particularly true for project financing where the issuer legally cannot use funds for general purposes. If a municipality issues a green bond backed by the revenue from a light-rail transit system, for example, the investor is assured that the proceeds will not be used elsewhere.
GREATER INVESTOR OVERSIGHT FOR CERTIFIED GREEN BONDS
Conventional bond issues typically do not include specific reporting on the use of proceeds. If the bond is backed by the issuer’s credit, rather than a specific asset or project, the issuer generally may use the proceeds for any legal purpose. However, investors in certified green bonds receive additional assurances that their capital is invested in accordance with a green bond standard and allocated to projects as intended. The reporting may also measure the environmental impact specific to their investment.
TECHNICAL BOND MARKET FACTORS ARE LIKELY A TAILWIND
Demand is growing quickly for sustainability-focused investments. Green bonds are one way to fulfill this objective. At the same time, large-scale projects aimed at transitioning to a low-carbon economy take time to reach the financing stage. As a result, green bonds and other sustainability-focused bonds may be in relatively short supply, providing technical support for prices in the short term.
CARBON RISK IS NOT YET PRICED INTO FIXED INCOME MARKETS
We see little evidence of fixed income markets assigning a higher default risk to those issuers most threatened by the transition to a less-carbon-intensive economy. For instance, EU-issuer credit default swaps have not responded to changes in the price of EU carbon emission allowances, even after a recent threefold increase in the carbon price. As carbon risk may increasingly become a material factor in future credit risk assessments, the bonds of issuers with lower carbon risk might benefit—at least on a relative performance basis.
Higher-carbon issuers with a robust transition strategy might also benefit. However, if this market shift does occur, we expect the issuer’s actual sustainability track record and carbon exposure to carry more weight than any bond label.
FUNGIBILITY OF PROCEEDS MAKES IMPACT ATTRIBUTION DIFFICULT
In a worst-case scenario, the funds raised from a green bond issuance could become interchangeable with the issuer’s other funds. As a result, the issuer could use capital originally intended for sustainability projects for non-green projects—and vice versa. This fungibility makes it difficult to trace capital to a specific project once it ends up in the hands of an issuer.
This is true even for green bonds backed by specific assets rather than the issuer’s credit. Consider an electric utility that issues a green bond backed by a renewable energy source. If the utility uses the profits from that project to fund the construction of a coal-fired plant, is the original investment still green? These concerns suggest that investors need to evaluate environmental benefits at the issuer level. This involves factoring in the complete capital budget picture and sources of funding, rather than simply relying on a green bond label to provide assurance that the capital is truly making a positive impact.
That said, the increasing focus on standardization, certification and auditing may strengthen investors’ confidence in the ultimate use of certified green bond proceeds. As this oversight improves, labeling becomes a more powerful and reliable signal to investors. As noted above, fungibility is likely less of an issue for project-based green bonds issued by municipalities.
NO CURRENT FINANCIAL INCENTIVES OR PENALTIES FOR ISSUERS OR INVESTORS
Our research found that, across most market sectors, there currently is no statistically significant difference in terms of pricing and performance between green bonds and conventional bonds with the same credit risk. The fundamentals of an issuer do not change based on the structure of the debt. Green bonds do tend to have lower liquidity in the secondary market relative to conventional bonds. Although green bond issues have grown in size over the past several years, they still tend to be smaller than conventional issues, contributing to lower liquidity. In addition, buy-and-hold investors are more likely to own green bonds, which can lead to a scarcity of a particular issue’s bonds in the marketplace. Despite these liquidity limitations, our research indicated that green bonds are currently trading in line with their conventional counterparts.
STANDARDS ARE STILL DEVELOPING; FUTURE REGULATION POSSIBLE
Uncertainty and lack of consistency around reporting standards and taxonomy are meaningful issues in today’s green bond market. Even if two bond issues adhere to the same standard, there may be differences in the quality of reporting offered by various third-party providers. Though the EU taxonomy should drive longer-term improvement in methodology and measurement challenges, ESG data comparability currently remains a concern.
Additional confusion may result from terminology “creep.” Bonds with similar labels, including climate awareness bonds, sustainability bonds, sustainability-linked bonds and social bonds, have joined green bonds in the market. These other bonds may support projects with environmental benefits similar to green bonds, or they may target different impacts such as social justice.
CERTIFIED BONDS HAVE ADDITIONAL ISSUER COSTS
Third-party certification of bonds entails additional pre- and post-issuance costs for issuers. If industry standards are slow to develop, certification could become increasingly important in the market. Reporting costs could increase to the point that they become a disincentive for issuers.
When the green bond market was in its infancy, performance of these early bonds suggested that investors were willing to pay a premium for labeled bonds. Recent studies by the International Monetary Fund (IMF)7 and the BIS8 suggest that this premium has largely disappeared. Green bond and conventional bond pricing is largely aligned today.
A team of Loomis Sayles analysts worked with Sustainable Market Strategies to further explore the performance and financial characteristics of green bonds. We compared a sample of conventional bonds in existing portfolios with similar issues designated as green bonds by Bloomberg across different sectors. Although the difficulty of matching bonds limited the sample size, results of the analysis were consistent with IMF and BIS conclusions about the general nature of the green bond market. In particular, market yields of green bonds were similar to matching conventional bonds in many categories. We also found that secondary market liquidity appeared to be more limited for green bonds.
The market for green bonds is growing and evolving. An increasing number of governments, businesses and investors are seeking to shift toward a more sustainable global economy. This suggests that green bond financing will capture more attention as a source of funding for this transition. However, the lack of a global green bond standard reflects, in part, the spectrum of opinion on the best transition path.
Green bonds offer investors a mix of potential benefits and limitations. Green bonds provide investors an enhanced ability to direct their money toward investments with environmental benefits. In many cases, a third party verifies the impact. Strong demand for green investments may provide a near-term tailwind for green bond owners. Green bonds also have the potential to outperform over the long term if carbon risk begins to affect credit quality. However, fungibility-related concerns and a lack of consensus around reporting standards suggest that investors need to focus on green bond issuers rather than the label of specific bonds.
Investors considering allocating capital to green bonds need to develop their own due-diligence framework. This framework should include criteria consistent with the investor’s environmental and financial objectives. It should also detail a method of monitoring and evaluating financial performance and environmental impact. Due diligence should focus on the issuer, in addition to the specific bond issue, and include a review of the issuer’s sustainability track record and its commitment to greater sustainability in the future.
