In the green and social bond markets of Europe and North America, participants have reached a new level of confidence — about how the market should operate, and what its future is.
Many of the debates that have disconcerted participants — such as how SRI bonds should be priced, what criteria should be applied to judge them, and whether they should be subsidised — are now beginning to be tackled more proactively.
Another notable change is that, in Europe, officialdom is beginning to take note of the market and think about it as a subject — or instrument — of policy.
The European Commission established in December 2016 a High Level Expert Group (HLEG) to advise it on sustainable finance. Its interim report in July was Europe’s first attempt to make a comprehensive draft of policies needed to green the financial system, as all countries have promised to do in the Paris Agreement.
On the HLEG’s agenda are issues such as creating a European green bond standard — defining what the “green” in green bond means.
That would please many in the green bond market, which has so far ducked this question. Stephanie Sfakianos, head of sustainable capital markets at BNP Paribas in London, says the “single biggest comment from investors is concern over a lack of standardisation”.
“They don’t have infinite resources to research each asset,” she says. “They want to understand the project and have useful metrics. Standardisation would help other investors into the market by making it easier for them.”
Olaf Brugman, head of sustainable markets at Rabobank in Utrecht, says there is a growing realisation within the market, and its structures such as the Green Bond Principles organisation, of the need for clearer and stronger guidance. “The relative freedom that the standards offered a couple of years ago is now being refined by the market itself,” he says.
Oil company Repsol’s issue of a green bond in May, financing reductions to greenhouse gas emissions in its operations, forced many to think more rigorously about these issues. Some applaud the deal, others are uncomfortable with it — but still, most are unsure where the line should be drawn.
And no level of standardisation will entirely settle the debate on such a multi-faceted topic as what is green. As Brugman points out, there has recently been more emphasis on climate change and carbon emissions — partly because there is some agreement on how to measure them. “Other environmental issues and opportunities for investment, such as biodiversity or pollution reduction, sometimes have to struggle for the right attention,” he says.
Ultimately, investors will have to develop their own criteria and make up their own minds whether or not they consider a particular asset worthy of their capital.
“We’re a particularly long way away from a workable standardisation for emerging markets projects, because profiles can be so radically different,” says Sfakianos. “They must really be assessed on a case by case basis.”
Standards can be a double-edged sword, too. While investors are likely to be reassured by them, issuers may be put off coming to the market by the effort of complying, if the bar is set too high.
Hans Biemans, head of sustainable capital markets at ING in Amsterdam, believes those attempting to standardise the market should have a clear idea of their role.
“It’s important that we have harmonised taxonomies, but I think the most appropriate approach is to use the existing sustainability standards already in use in each sector,” says Biemans. “It doesn’t make sense for financiers to come up with new standards for what constitutes sustainability in each sector. We must embrace their own initiatives and link them to rules for finance.”
Bodies such as the International Organisation for Standardization (ISO) or sector-specific groups such as the International Maritime Organisation have spent 30 years developing criteria for many aspects of greenness. Financial bodies attempting to establish their own sustainability criteria might just add unnecessary work.
Issuers find benefits
However, if a miracle occurred and the standards question was solved overnight, it would not necessarily lead to a huge expansion in green financing. All agree that the green bond market is constrained more by lack of deals than by any reluctance on investors’ part.
For Joop Hessels, head of green bonds at ABN Amro, the deterrent for borrowers is not a lack of standards. “Standards help but, honestly, when I talk to potential issuers, they don’t say: ‘I can’t issue because the standards aren’t clear’,” he argues. “They say: ‘We don’t have the right projects’ or ‘we can’t measure them in our systems’.”
Attracting issuers is a difficult business. The role of a treasury team is to finance an organisation in a stable, cost-efficient way. While many finance officials are also delighted to get their organisation into headlines as a green issuer, or to reach new investors with green-labelled bonds, others are reluctant to do something that they don’t see as bringing a financial advantage.
In fact, more and more issuers now report that they can issue green bonds at tighter pricing than conventional bonds. One public sector issuer puts the gap at about 2bp. It might be wider for issuers with fatter baseline spreads, such as companies.
Issuers, according to Margret Hess, a debt capital markets originator at DZ Bank in Frankfurt, do not come to the market expecting cheaper funding. But often, thanks to the strong demand for green bonds and limited supply, deals can be priced a basis point or two tighter than a conventional bond.
“The SRI aspect brings new investors into our deals and generally means we have hugely oversubscribed books, leading to a price tightening,” says Tom Meuwissen, head of funding at Nederlandse Waterschapsbank in the Hague. “Because of the format, size is limited, so we have more price tension because we can’t increase the deal. That allows us to tighten pricing. Generally, nobody drops out of the book. It’s always a very high quality book and there’s more demand than supply in the market. As a result, we price with a tight new issue premium, if any.”
However, this price advantage is so far insufficient to motivate borrowers to issue green bonds rather than conventional ones. It depends on market conditions and is therefore unreliable.
Ralph Ockert, head of sustainability at DZ Bank in Frankfurt, suggests: “If we had some sort of mini-quantitative easing in green bonds — big asset managers buying everything to fill their quotas — then that would compress credit spreads and at the end of the day lower costs for the issuers.”
Any cost saving also has to be set against the costs of a second opinion, and reporting on how the green or social bond proceeds are used — something investors are demanding more and more detail on.
If the prospect of slightly cheaper funding is not a strong enough pull for issuers, one tangible attraction is — attracting new investors. Sfakianos calls this a “compelling story” for issuers. Financial theory suggests that, other things being equal, if more investors buy your debt, your overall cost of funding should come down.
Time for subsidy?
If green-labelled finance is to become a lever for actual environmental progress, it needs to start providing a financial incentive for issuers to engage in green projects.
One way would be through subsidies — tax breaks or lower regulatory capital requirements.
“Issuers and investors can’t bring about tax incentives; that requires political endorsement,” says Ockert.
That is one reason why the European Commission’s involvement could have far-reaching implications.
If something is to receive subsidies, it must be legally defined. Those involved with the HLEG believe two of its many ideas that stand the best chance of becoming firm recommendations to the EC are the creation of a European green bond standard and establishing a classification system for sustainable assets.
If these became officially enshrined — even if the actual classification work was left to the market — the first step towards making subsidies possible would have been taken. In practice, governments would probably want to make sure the definition of green was aligned with their priorities, so would take a close interest in the taxonomy.
DMOs not yet won over
Many green bond specialists feel that at this stage, the market needs more government involvement to develop further. This might take the form of more sovereign green bond issuance, which bankers would love to see. France’s green OAT issue at the beginning of 2017 was widely cheered. As Sfakianos points out: “It’s easier to encourage issuers to access the market if you’ve done it yourself.”
However, many state treasuries are unconvinced. If governments decide to do green projects, they feel, they can fund them with normal debt — carving out specific bonds is unnecessary. Even Agence France Trésor advised its government not to issue a green bond, but was converted to the idea when ministers insisted.
The sceptics have a point. A great deal of government activities could be labelled green or social projects, but doing so would not increase the amount of money spent on them. “Even if we rename, say, all railway financing as green, would that get us closer to the two degree scenario?” asks Hessels. “I don’t think so. We need to be doing more than relabelling existing projects.”
In fact, doing so would arguably swallow up more of the dedicated SRI investor capital, which should be adventurously scouring markets for new opportunities.
This does not mean sovereigns are powerless. Many important infrastructure projects and environmentally friendly start-ups, particularly in emerging markets, are credits that the average green or social investor is unlikely to look at.
Sfakianos and Hessels both call on sovereigns to take on a share of risk with investors — rather as the International Finance Corp is doing with its Green Cornerstone Bond Fund (see ‘Green finance breakthroughs’ chapter), attracting the sort of capital needed to create a sustainable world.