Green Bonds: the Green Force Awakens

Last month’s article was about the challenge that climate change represents for future generations and the cooperation between nations, companies, and individuals to overcome this threat. One sweet spot that has gained relevance in recent months due to the massive monetary stimulus applied by central banks around the world is the green bond market. With interest rates at historical lows, the cost of bond financing right now is lower than equity financing. Moreover, segregated ownership and lower monitoring costs can make fixed income securities lower-cost alternatives to bank loans. Thus, this coming 2020s decade might represent the “golden years” for green bond issuance in low-carbon sectors.

Green bonds can be defined as any bond instrument where the proceeds will be exclusively used to finance or refinance, in part or full, new or existing green projects such as renewable energy, energy efficiency, clean transportation, and other green activities. Further, many bonds are certified by the Climate Bond Initiative (CBI), which assures their alignment with the Paris Agreement objectives and ensures their proceeds are allocated to sustainable investments. 

The green bond market technically took off in 2007, when the European Investment Bank (EIB) issued its Climate Awareness Bond. Most of the market growth has come in the past few years, with corporate issuers becoming more active than other agents. After 13 years, more than 1,700 green bonds have been issued by almost 500 institutions in more than 30 different currencies worldwide. In 2019, the green bond market achieved a new global record of issuance (US$ 258 Bn.), which represented an increase of more than 50% compared to the green bond issuance of 2018. More than 80% of the green bond proceeds were allocated to finance renewable energy projects, green buildings, and clean transportation projects in 2019.

Academic research has found that green bond markets and corporate and treasury bond markets are dependent. In contrast, the stock market and energy commodity price swings have negligible effects on green bond prices. The diversification benefits they provide to stock investors and their relative insulation from stock price fluctuations also allude to the functions that the green bonds have to help in expanding financial markets.

It is widely observed that green bonds are sold at a premium (lower yields) when compared to equivalent conventional bonds. As a result, issuers can finance green projects at lower costs. This advantage is due to the ability for green bonds to bring the benefits of flexible payment schedules, credit enhancement techniques, alignment with long-term project schedules, leverage options, and other cost-reducing benefits of debt securities.

However, this green bond premium varies across markets, currencies, and issuer types. Thus, at issuance (primary market), green bonds trade at lower yields (20-30 bps) than their conventional counterparts, on average. This effect is even stronger for green bonds denominated in US dollars than in euros. (Kapraun & Scheins, 2019).

One would expect the positive benefits for green bond issuers in the primary market to translate mechanically into lower returns for investors in the secondary market. But the empirical evidence suggests green bonds perform in-line with their non-green peers in the secondary market (see graph below)

Further, reputation aspects seem to be considered by investors when assessing the pricing for green bonds. For example, in the secondary market, only green bonds issued by governments or supranational institutions trade at 2 bps less than their conventional counterparts. In contrast, corporate green bonds trade at 43 bps higher yield than traditional bonds. This divergence observed in the secondary market is the result of investors’ concern about how to assess the green credibility of certain issuers accurately.

In such a rapidly growing market, one challenge for investors and issuers has been a consistent classification framework. The European Union is perhaps the most advanced region in this regard. Last Thursday, the European Parliament gave its final approval to the EU sustainable finance “taxonomy”, which establishes a classification system for sustainable activities. This taxonomy will restrict which investments can be classified as green and will force providers of financial products to disclose which investments meet the criteria, starting from 2022.

As investors’ demand for green assets continues to grow and reshape financial markets, standards and taxonomies will continue to improve. In other words, demand will keep creating and developing its own supply.

Gino Beteta