A rise in issuances, an increasingly diverse issuer base and the development of guiding principles have all contributed to the rise of green bonds. But, as they become more investor friendly, advocates of such products are keen to ensure that they remain environmentally friendly, too.
Capital market financing of climate change and environmental awareness projects has finally taken off. So-called ‘green bonds’ have celebrated a breakthrough in 2014, and expectations are high that an increasing number of issuers and investors will be attracted to the product in the coming years.
Green bonds have evolved from environment-themed retail bonds in Japan in the 1990s to the first international climate awareness bond issued by the European Investment Bank (EIB) in 2007, which pioneered the ring-fencing of bond proceeds to finance projects that contribute to renewable energy and energy efficiency.
Established mainly as a tool for sovereigns, supranationals and agencies (SSA), in the past 12 months green bonds have further expanded to commercial banks and corporate issuers, and ‘green bond principles’ have been established, as means of scrutinising the integrity of such products.
Taking action
After 2013’s record-breaking $11bn of issuance, which outpaced any previous year by more than three times, 2014 had already seen $32bn of green bonds by October 13, according to the Climate Bond Initiative, a non-governmental organisation (NGO).
The Climate Bond Initiative's CEO and co-founder, Sean Kidney, started the organisation in 2009, after his discussion paper and roadmap on climate change received widespread praise, but was followed by a dearth of actual action. “The idea behind the initiative was to find a way to channel capital quickly to achieve a rapid global transition to a low-carbon economy, so we formed an NGO and started harassing people,” he says. “Now investors are buying green bonds like hot cakes.”
Mr Kidney believes that by the end of 2014, green bond issuance will have surpassed $40bn, and that 2015 will see a surge to $100bn.
Green bonds received their first major boost in 2013, when the first benchmark-sized issues were sold, according to Philip Brown, head of Europe, the Middle East and Africa fixed-income socially responsible investment (SRI) origination at Citigroup.
“The success of the International Financial Corporation's [IFC's] two $1bn green bonds in February and November 2013 highlighted that there was substantial investor interest for large, liquid green bonds,” he says. Especially striking was the fact that the inaugural IFC transaction was sold on a day that was a public holiday in most of Asia – the geography that had, until then, represented the majority investor base in regular IFC bonds – adds Mr Brown.
Still, the deal was 80% oversubscribed and opened the door for US investors, who had previously played only a minor role in IFC dollar benchmark distribution, viewing supranationals as expensive. The Americas subscribed to about 70% of the transaction because of the environmental appeal.
In a second benchmark green bond issue in November 2013, the IFC allocated more than 50% to the Americas. “The US investor base represents the last frontier for SSA issuers, and in green bonds we have found a product that adds value and attracts the US real money investor community,” says Mr Brown.
Breakthrough deals
Benjamin Bailey manages the Praxis Intermediate Income fund in Goshen, the US, which is an SRI fund that also buys green bonds. “SSAs are big in trying to grow their investor base,” he says. “Many of these names we haven’t bought before, but now that they have issued green bonds we have.”
Almost 17% of Mr Bailey’s fund is allocated to what he calls “positive-impact bonds”. The fund, managed through Christian-based, member-owned financial services organisation Everence Financial, has had negative screens since its inception in 1994, and seeks to outperform the Barclays US aggregate benchmark.
“In about 2006 there was a bond for the International Finance Facility for immunisation, raising money to immunise children in different countries, and that was the first time it opened up our eyes to actively look for things that have a positive impact rather than screening out things that are negative,” says Mr Bailey.
His fund has since invested in early environmental project bonds, supporting the establishment of a specific solar or wind farm, which generally came with higher yields but also higher risk. “When the World Bank started up its US dollar-based green bonds, we thought that that is exactly what we want to do,” he says.
Going commercial
From the EIB, IFC or World Bank, things moved to commercial banks in late 2013. Bank of America Merrill Lynch was first to issue a green bond in November 2013. The $500m bond supported the financing of energy efficient and renewable projects, including the retrofitting of more than 140,000 street lights with light-emitting diode bulbs in Los Angeles.
In the same month, French utility Electricité de France (EDF) opened the green bond market for large non-financial corporates with its €1.4bn transaction with a 7.5-year maturity. It allocated about 60% of the deal to “investors integrating environmental, social and governance criteria in their investment decisions”, according to the firm.
“The traction we generated with investors from the first IFC transaction in 2013 was the catalyst for our conversations with EDF,” says Navindu Katugampola, head of green bond origination at Morgan Stanley. “The EDF transaction was a watershed moment for the corporate market. It really galvanised the market for 2014, by illustrating a roadmap that corporates could follow for green bond issuance, building on what we have done in the development bank space and translating it into a corporate model.”
The proceeds of EDF’s bond were exclusively dedicated to financing future renewable energy projects led by wholly owned subsidiary EDF Energies Nouvelles.
Innovation curve
But innovation did not stop here. Anglo-Dutch consumer goods company Unilever showed that a firm does not need to be in the renewable energy sector, or finance it, to be able to issue a green bond.
“Unilever showed issuers outside the renewable energy sector that green bonds could be relevant to them,” says Mr Katugampola. “They can help companies in almost any industry sector to consider how they run their businesses and how to further improve on the environmental sustainability of their operations.”
Unilever issued a £250m ($403.8m) four-year bond with a clearly defined criteria on greenhouse gas emissions, water use and waste disposal for the investment projects supported with the bond proceeds.
The market has also seen green bond asset-backed securities, such as the one supporting automaker Toyota’s hybrid cars, or the first ever solar securitisation for US energy services provider SolarCity, which was backed by a portfolio of solar panels, as well as the related contractual customer payments and performance-based incentive programme payments. There have also been the first green bonds by speculative grade-rated issuers.
Of the $32bn of green bonds issued by mid-October 2014, some $8.5bn were recorded in September and October, including the first green bond out of Japan for the Development Bank of Japan; the largest tax-exempt green bond to date for the US state of Massachusetts, which was partly sold to retail investors; and the largest dollar-denominated green bond – $1.5bn – issued by German development bank Kreditanstalt für Wiederaufbau (KfW).
Achieving credibility
One of the keys to the recent success of green bonds has been the emergence of the green bond principles, which provide issuers with guidance on launching a credible green bond. First published in October 2013 and updated in January 2014, the principles quickly gained traction, starting off with 13 signatories from the banking sector, as of October 9, 2014, the principles have some 66 members, comprising banks, issuers and investors.
“It’s a collaborative process between the different parts of the bond issuance process, which is supported by an independent secretariat,” says Abyd Karmali, managing director of climate finance at Bank of America Merrill Lynch, one of the founding institutions of the principles. The principles are now headed by an executive committee of six investors, six issuers and six underwriters, and supported by the International Capital Markets Association.
Zurich Insurance Group is one of the signatories and an executive committee member. The Swiss firm famously shifted $1bn of investment capabilities out of US Treasuries and into green bond opportunities in November 2013, before further increasing its allocation to the sector to $2bn in 2014.
“The green bond mandate we gave to [advisor] BlackRock in November was reflecting the opportunities in the market then,” says Cecilia Reyes, chief investment officer at Zurich. “Since then, we have seen the market grow from the dollar-dominated SSA market to corporate issuers and other currencies. It gives us more choice, so we were able to expand our commitment.” Ms Reyes adds that Zurich is keen to see more green bond issues out of Asia and Latin America in local currencies.
She also sees great value in being part of the green bond principles executive committee, and in developing the principles further. “As one of the biggest investors, it is really in our best interest to safeguard the integrity of the market,” she says. “We will play an active role in making sure that it doesn’t become a free-for-all. We want to set clear standards for the issuance of green bonds in terms of how you safeguard the use of proceeds, including transparency on environmental impact.”
Value proposition
Green bonds are pari passu with ordinary bonds and largely distinguish themselves by the ring-fenced use of proceeds, so the question arises, why should investors buy them?
“The first thing investors ask me is: is there a price benefit?” says Mr Kidney. “The answer is: no. If you are a portfolio manager and you don’t care about climate change, then don’t bother. But if you are a pension fund with international statements about climate change, of which [funds managing an aggregate] $32,000bn now have, or if you think the climate agenda could be pertinent to your investments going forward, you should think about it.”
Priced at largely the same level as ordinary bonds, green bonds bring the advantage of raising funds for an environmentally friendly project. “Switching into a green bond from an issuer I already hold is an easy option for me,” says Ulf Erlandsson, senior portfolio manager at AP4, a Swedish national pension fund. “We haven’t set up a specific green bond fund but my [green bond] portfolio has become large and we are a frequent investor.”
Mr Erlandsson, who manages the credit and SSA portfolios at AP4, says that he only buys the bonds he expects to appreciate in value – green or not. “Some issuers attempt to price green bonds through the secondary curve,” he says. “I don’t buy them.”
For an issuer, green bonds can help with the diversification of the investor base. They also come with the ‘halo’ effect, but reputational benefits only apply if the integrity of the green issue is being kept.
“When a frequent issuer issues a green bond, I know that they will come back to the bond market,” says Mr Erlandsson. “Green bonds give me a good position. If you fool me with this one, I am not going to like you as an issuer. As a dedicated fund you don’t have the same amount of leverage over the issuer.”
A matter of principle
Measures to safeguard that a bond finances ‘green’ projects and contributes positively to the environment are costly for the issuer but are essential to investors.
“The recent intensive growth in the market is positive because it raised awareness,” says Petra Wehlert, head of new issues, capital markets, at KfW. “The next target is to set higher standards for green bonds, which will be crucial for the further positive development. KfW has already set a standard with the new structure of its green bonds by including a second party opinion and impact measurement – [making] the effect of investments in terms of greenhouse gas reduction… transparent.”
For this reason, a number of research firms and accountancies have started specialising in green bonds. EDF’s bond came with an independent valuation of project eligibility by French research provider Vigeo, and it publishes annual verifications of the eligibility through Deloitte. Unilever has worked with environmental consultancy DNV to create its bond.
Research firm and investment ratings agency Sustainalytics, which was founded to monitor and report on environmental, social and governance factors for companies, has seen the appetite for responsible investment strategies increase over the past six years. Due to the flurry in green bonds, Sustainalytics created a dedicated green bond team in 2014.
“The team has worked with a number of issuers to develop green bond frameworks that are in alignment with the green bond principles and that are aligned with best practice in terms of management and use of proceeds, including impact,” says Simon MacMahon, global director of advisory services at Sustainalytics. “Investors want assurance from a second party that a green bond is green at the time of issuance. In addition, investors are increasingly concerned that the securities remain green in subsequent years, and we have built this into the process with an annual review.”
When green turns grey
Meanwhile, there also are concerns of issuers selling a green bond to ‘green-wash’ themselves from other environmentally unfriendly activities that they may be involved in. The green bond principles do not address the question how green a green bond issuer is, so it remains with the underwriters and investors to judge.
“When I get issuers presenting to me on their green bond project I ask them: what is the brownest activity you have,” says Mr Erlandsson. “That is my cheeky rule of thumb.”
Another issue is the question of refinancing. The green bond principles allow green bonds to be issued to finance not only new projects with environmental benefits but also existing ones. “Bondholders accept the inclusion of existing projects because of the preference for large and liquid bonds,” says Mr Brown. “But the environmental lobby is asking: what are you doing in terms of generating new investment that would have otherwise not been financed?”
And does that mean that a green bond can be refinanced with a new green bond without any additional investment in the underlying project? The controversy is clearly visible. “There is only one time as an investor that you hand over money to a green project and that is when you buy the bond in the primary market,” says Mr Erlandsson. “If you buy the bond in secondary, nothing good was done. You actually contribute much more if you turn over your portfolio twice a year and reinvest in something new.”
Moreover, while investing and holding a green bond until maturity is characteristic of SRI funds, and while issuers favour these so-called ‘sticky’ investors, these funds are ultimately not contributing much to the green bond market.
According to the World Energy Investment Outlook published by the International Energy Agency in June 2014, much more investment is still needed. To avoid what the agency calls “catastrophic” global warming, some $53,000bn of investment in energy efficiency and supply is needed by 2035. Even with this sort of investment, the agency says that we will be unable to avert a two degree Celsius rise in the temperature.
A positive effect
Green bonds are expected to continue their expansion with issuance from a wider range of corporates in Europe and especially in the US, as well as further green city and municipalities bonds. Green securitisations with green underlying loans are also a potential growth area as well as different currencies.
And, the idea behind green bonds has, especially in the past six months, also been transferred to social issues. The Inter-American Development Bank, for example, sold a $500m bond to support education, youth and employment in Latin America, utilising the green bond principles.
Dutch public sector agency BNG sold a €500m bond in early October that comes with a holistic approach to sustainability, by using the proceeds to finance municipalities based on the sustainability performance of the borrowing entity rather than on the nature of the projects to be funded.
“Everyone is talking about green bonds but there are also a number of sustainable bonds applying the green bond principles that are more focused on social issues,” says Mr MacMahon. “There is great potential for the green bond market to have a positive impact in regards to social issues, too.”
