A bright future for green bonds

With global warming, the world is facing one of its greatest challenges in history. At the UN climate summit in Paris, it was agreed to reduce global emissions of greenhouse gases in order to limit global warming to a maximum of 2 degrees Celsius. To achieve this, it is estimated that hundreds of EUR billions of additional investments are required annually.

In recent years, the majority of large companies and institutions within Europe have stated to pursue climate goals and increase sustainable investments. A green bond proves to be an ideal financial instrument for companies to fund these investments and to communicate their climate goals commitment towards their investors.

The green bond market is rapidly expanding with the increase in investors´ appetite for sustainable investments. The Climate Bonds Initiative (CBI) calculated that total global issuance of green bonds has reached USD 257 billion in 2019, marking a 51% increase from its 2018 levels. The European market in particular has boomed, representing more than half of the global total issuance in 2020. Green bonds prove to be an excellent tool for investment managers as well as retail investors to incorporate ‘impact investing’ and sustainability ambitions into their investment portfolios.

What is a Green Bond?
According to the International Capital Markets Association (ICMA), ”Green Bonds are any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible green projects and which are aligned with the four core components of the Green Bond Principles (GBP), namely, the use of proceeds, the process for project evaluation and selection, the management of proceeds, and reporting”.

The issuers’ commitment to pursue climate goals is often formalized in a Green Bond Framework. Within this framework, transparency and disclosure enable investors to better assess the green eligibility of the projects and make more informed investment decisions. This Green Bond Framework can be evaluated by a third-party in a Second Party Opinion (SPO), which may provide the issuing company with a sustainability rating.

Besides the fact that green bonds are labelled as a sustainable investment, green bonds have the same characteristics as a conventional (plain vanilla) bonds. As a financial instrument, they are structured the same way as conventional bonds as they are both backed by the issuing entity´s balance sheet. Therefore, a green bond label does not imply any additional benefits for bondholders in terms of seniority, so in the event of the issuer’s bankruptcy the green bondholder makes the same claim as a regular bondholder would. Investing in green bonds brings no additional transaction costs for bondholders.

Standardization: Green Bond Principles
Thus far, there has been no universal ‘official’ definition or standardized rule of the criteria/conditions a bond has to meet in order to be qualified as ‘green’. In 2020, the European Union has developed the “EU Taxonomy and EU Green Bond Standard (2020)” to increase efficiency and transparency and to create a long-term positive impact within the green bond market. This standard also defines relevant codes and taxonomies in order to standardize reviewing processes of ‘green’ and ‘impact’ financial instruments. With this milestone achievement, the EU is clearly taking a leading role in the Green Bond market, and this standard is expected to act as the blueprint for regulation in other regions.

As green bonds are self-labelled they naturally inherit the risk of ‘greenwashing’ (qualify a bond as ‘green’ when it is in fact not) while it also leaves room for different interpretations of what constitutes a green bond. The majority of issuers have used an independent, third-party review in the process of labelling green bonds. In this regard, the International Capital Markets Association (ICMA) has established voluntary process guidelines for issuing green bonds, namely the Green Bond Principles (GBP). The GBP have become widely accepted throughout the industry, aiding investors by providing and insuring availability of information on the environmental impact of their investment, as well as to assist underwriters.

The Green Bond Principles are organized around four components:

  1. Use of the proceeds: the use of proceeds should be utilized to finance ‘green’ projects within the issuer. These projects should contribute to beneficial environmental objectives. This guideline defines eligible categories under which projects are labelled as ‘green’.
  2. Project Evaluation and Selection Processes: issuers should clearly communicate their climate goals and sustainability of the projects to their investors. A high level of transparency into the issuer’s business objectives and policy is encouraged.
  3. Management of proceeds: the proceeds should be managed properly by the issuer in a formal internal process. This process should be linked and aligned to the financing or investment activity for green projects.
  4. Reporting: issuers are required to report on the allocation of proceeds to eligible green projects, which forms an important part of the issuers Green Bond framework. This is usually communicated through an annual report.

Challenges of Green Bonds
One of the challenges investors of green bond face is the presence of the so called ‘greenium’ or ‘green premium’. This ‘greenium’ is the yield differential between a green bond and a counterfactual conventional bond. Green bond investors driven by non-pecuniary motives are generally willing to pay this premium. The tendency of investment managers to incorporate green strategies in their mandates or funds contributes to the development of the green bond market, after which the ‘greenium’ is ultimately expected to erode over time.

Issuing small volume bonds (of any type) can be relatively costly for smaller companies such as SME’s. The decision for these companies to issue green bonds may however not solely be based on economic reasoning. Issuing green bonds may demand significant changes in organizational processes and policies to comply with GBP policy guidelines. Missing organizational knowledge, or unwillingness to change certain processes consequently form a hurdle for SME’s to issue green bonds.

With SME’s accounting for roughly 99% of all businesses in the EU, they are estimated to be jointly responsible for about 70% of the environmental impact. This poses a large threat to the climate on the one hand, though it signifies the huge potential that lies within the sector in fighting climate change on the other hand. By facilitating the accessibility of the green bond market for SME’s, investments in sustainable projects and companies will increase, which will accelerate the energy transition.

Green bond markets must keep on developing and innovating, to become accessible for any type of company. This future green bond market should go beyond issuance – of mainly repackages loan portfolios – within financial institutions and governments, towards a market where targeted, climate goal specific and measurable investment opportunities are available for any type of investor.

Exciting opportunities exist in facilitating green bond issuance for smaller companies, through ‘next-generation’ Multilateral Trading Facilities (MTFs). Through partnerships with these innovative investment platforms and expert advisors, companies can circumvent the exorbitant costs and complex rules associated with listings on conventional platforms. Although the Dutch green bond market is right up there with the leading European countries, it is taking steps towards this bright future for the green bond market.

This article is part of a two part series on the European Green Bond market. Part 1: What is a Green Bond? Why are green bonds so important, and what role can they play in the energy transition? Part 2: Green bond market size and trends. What opportunities do green bonds present to institutional as well as retail investors?

Max Terheggen & Olivier van den Eertwegh

Menu