Awareness of the green bond and SRI market has increased “dramatically” among asset managers in the last three or four years, believes Hans Biemans, head of sustainability, markets at Rabobank. “In the past, you would ask them about the market and many would just laugh. They all have an opinion on it now.”
The increasing seriousness of investors towards the market has been driven by a better understanding of the economic cost of climate change, says Frédéric Samama, deputy global head of institutional and sovereign clients at Amundi in Paris. But policymakers are also catalysing growth in the market by stepping up the reporting requirements placed on investors.
In a speech given at Lloyds of London on September 29, 2015, Mark Carney, governor of the Bank of England, highlighted court cases where pension funds had allegedly failed in their fiduciary duties by not considering the economic costs of climate change related impacts. That sent a “very serious message” to the market, Samama says: “When the market was talking about climate change three or four years ago, it was much more complicated, and very much linked to messages from NGOs and policymakers. It wasn’t really about economics. A big shift has happened since then. Now what we talk about is the economics of SRI investing.”
Samama says the financial risks associated with climate change have been mispriced, driving an increased use of risk management approaches by investors.
Quantitative easing by central banks is also playing a role in boosting interest, by encouraging some investors to take greater notice of the SRI sector for the social and environmental returns on offer, says Biemans.
“In a low yield environment, if you can’t generate a good financial return you may be inclined to look for non-financial returns,” he says.
New laws could spur growth
The role of policymakers as market catalysts is fast becoming a central focus for the market.
On the national regulatory front, the adoption of Article 173 of France’s Energy Transition for Green Growth Law, which came into force on January 1, 2016, is expected to result in an explosion of demand for green investment opportunities.
Under the new framework, institutional investors must disclose how they factor environmental, social and governance (ESG) criteria and carbon related aspects into their investment policies. They must also disclose in their annual reports how their investment policies align with the national strategy for energy and ecological transition.
The first financial reports under the new framework, covering the period from January 1, 2016, must be published by July 30, 2017. Investors must report on a “comply or explain” basis. Those with a total balance sheet of less than €500m — or belonging to a company with a total balance sheet of less than €500m — are only required to report a general overview of how they incorporate ESG factors into their investment strategies. The law will “without doubt trigger more growth in the green bond market,” Biemans says, as investors strive to become best in class.
“This new law will necessarily have an impact on the way investors will select their investments, says Julien Bras, green bond portfolio manager and analyst at Allianz Global Investors in Paris. “Even if the constraint is only a reporting issue as of today it will probably encourage asset managers, for instance, to increase ESG integration in order to position themselves as best players. It will also naturally raise the issue of impact measurement for which as of today there is still an amount of work to be made because of discrepancies in reporting and data quality.”
Investors step up the pressure
Investors themselves have been encouraging of the steps taken by policymakers to help the market grow. On August 24 this year, 130 investors with a combined $13tr of assets under management wrote to the heads of state of the G20 nations, ahead of the G20 summit held in Hangzhou, China, on September 4-5, to urge them to ratify the Paris Climate Agreement and to expand global investment in green projects.
“The Paris Agreement on climate change provides a clear signal to investors that the transition to the low carbon, clean energy economy is inevitable and already underway,” the signatories wrote in the letter. “Governments have a responsibility to work with the private sector to ensure that this transition happens fast enough to catalyse the significant investment required to achieve the Paris Agreement’s goals.”
The letter was not wasted. On the eve of the summit, the US and China formally ratified the COP 21 agreement, boosting the chances it will become international law before the end of the year. At least 55 countries accounting for 55% of global emissions must ratify the treaty for this to happen. With China and US accounting for 38% of global carbon emissions alone, the announcement was a big step forward for the agreement.
Climate change and green finance was a central topic at the G20 summit in Hangzhou. In the communiqué issued at the end of the event, the G20 leaders said it was necessary to scale up green financing in order to support environmentally sustainable growth, and said that challenges facing the sector such as maturity mismatches, a lack of clarity in green definitions and information asymmetry could be overcome by collaborative approaches between the public and private sector.
As a result of the developing groundswell of policy support for green investment, more and more investors are looking at the environmental impacts of their investment strategies, and not just at the financial returns, says Marie-Anne Allier, head of euro aggregate fixed income at Amundi in Paris.
“There are more and more companies that should be reporting the climate impact of what they are doing. For example, pension funds in the Netherlands, which now have to report their climate change impact when investing,” she says. “All these companies want to reduce the impact or at least disclose the lowest possible CO2 footprint, and that pushes everybody towards a direction where they are taking care in their investments and not just looking at returns.”
The second phase of SRI investing
To satisfy green reporting requirements, investors have now moved to a “second phase” of responsible investment, says Biemans at Rabobank.
After signing up to the UN Principles for Responsible Investment, which were unveiled in 2006, most big investors started to work in the equity market, he says. “Almost all of those investors have now moved to fixed income portfolios. The second phase is ‘impact’ investing,” he adds.
Through impact investments, investors are not targeting green bonds specifically, but fixed income products from companies and sectors that are considered inherently green or sustainable.
“They are actively looking for green or social impact in their portfolios through investment in infrastructure, clean energy, social housing, education, healthcare and other general categories. It’s not just green bonds but also social bonds,” he says. “People are looking at pure play sectors which they see as intrinsically sustainable, and count them as impact investments in their annual responsible investment reports.”
Amundi is one example of an investor incorporating this impact approach into its SRI strategy. The firm launched an open-ended fund for green bonds in late 2015, which caters for the demand it saw not only from large investors with green mandates, but from smaller institutional investors who prefer to invest in open ended funds.
Marie-Anne Allier says that at least 66% of the fund is geared towards green bond investment, but it can also invest in green companies that may not necessarily issue green bonds. The strategy helps the firm overcome a perceived lack of size and diversity in the labelled green bond market, she says.
“It invests in corporates that we believe are key to tackling climate change and who are the best in their industry, but who don’t issue green bonds,” she says. “We decided to do this because the green bond market was not big and diversified enough, and because by investing only in green bonds we would penalise some companies that are green in the sense of their business activities, but are too small to be able to issue labelled bonds.”
The firm also sees impact investing as a way of using its own expertise in sustainable investment, rather than relying on issuer’s green bond certifications.
“You have a portfolio which is much broader,” adds Allier’s colleague Frédéric Samama. “If you were to stick with just labelled green bonds, sometimes you have green washing, which means that you might be helping non‑green companies.
“Some companies are refusing to issue labelled green bonds because they themselves are already green, and they ask why they would issue a labelled green bond, and incur the extra costs for reporting and certification.”
Bras of Allianz Global Investors says that interest in impact investing has grown in importance in the context of the COP 21 Paris meeting, which has helped the market gain traction among investors. But he says that for equity investors, impact investing is less transparent than investing in certified green bonds, “given the fact that for an equity investor it is not possible to distinguish the projects for which the money is used like it is done within a green bond programme.”
Green bonds — striving to match demand
The drive for new impact investing approaches is partly driven by the demand for more traditional labelled green bonds outstripping supply.
“Investor demand is matching and sometimes exceeding a market that is growing at pace, and is widely geographically dispersed,” says Sean Kidney, chief executive officer at the Climate Bonds Initiative (CBI), an investor focused not-for-profit organisation that supports the development of the green and climate bond market.
“Demand for labelled green bonds is robust in every market — including in markets where people have been saying that demand would be weak, such as China and India,” he says. “Market sceptics have been proven wrong by regular, constant issuance of flat priced green bonds that continue to be well oversubscribed. We continue to see local investors that we engage with coming out and making public statements about how they want to see more green bonds.”
Issuers are creating new types of green bond to cater to investor demand. Obvion, the mortgage subsidiary of Rabobank, issued the world’s first green residential mortgage-backed security (RMBS) in June this year, Green Storm 2016, which was backed by prime Dutch energy efficient homes.
Demand for the €500m deal was so strong that Obvion was able to limit participation only to investors deemed sufficiently green under a set of its own criteria. Of the €1.2bn of orders received for the bonds, Obvion restricted allocations only to dedicated green bond investors, which accounted for €900m of the order book. The criteria that Obvion used included investors’ SRI strategy, their green funds and mandates, as well as their membership initiatives such as the UN Principles for Responsible Investment, Carbon Disclosure Project, Green Bond Principles and Institutional Investors Group on Climate Change.
“Obvion used a classification tool for investors that was bespoke for the market. I think it is a trend that you will see more often,” says Rabobank’s Biemans. “It’s becoming more important in the market to be clearer about investor diversification, and seeing how advanced a sustainable investor really is.”
Market analysts suggested when the bond was launched that securitization could play an important role in the green bond market, since investors participating in deals have greater certainty of the assets that the deal is financing, rather than unsecured bonds — the mortgages backing the bond are secured on energy efficient homes that have already been built. Indeed, the bond drew a number of new investors to the traditionally small securitization investor base.
But a big obstacle to the growth of the green RMBS market is the quality and consistency of house energy efficiency labelling, and the ability of banks to identify qualifying assets.
“We need more green RMBS like Green Storm. There is large demand for this asset,” says Maarten Jan Hoefnagel, a portfolio manager for several asset-backed security (ABS) funds at Aegon Asset Management in the Hague, in a company report on the deal in August this year. Aegon invested €60m in the deal, €17m on its own account and €43m for third party clients.
“The problem is a lack of supply,” says Hoefnagel. “The market is limited by the number of energy efficient homes.”
The Netherlands could become a leader in green mortgage financing in this respect. Since January 2015, the Dutch government has sent an initial energy performance certificate to five million households. In theory, this could make it easier for banks to identify mortgages that would qualify for a bond backed by energy efficient households.
Wanted: industrial and utility issuers
Bank issuers financing real estate assets are expected to form a growing portion of the issuer base in the coming years. But investors are hoping for more issuance from corporate and industrial issuers.
Bras of Allianz says he hopes more industrial issuers will look to the green bond market to finance adaptation projects, such as those looking to develop more sustainable business models, increasing the energy efficiency of production lines and industrial installations, and switching to bio-sourced raw materials. More issuance is also expected from utility companies, such as waste treatment facilities and water companies.
“There is no doubt that every single company has ways to improve its environmental impact and reduce its carbon footprint,” he says. “It is also a way, from a business perspective, to reduce natural resources and energy dependency and also to optimise costs.”
Growth in the private placement market for green bonds could help corporates issue more frequently, says Biemans.
“For corporate issuers the private placement market helps because not all have enough assets to launch a benchmark sized bond, so it’s easier to launch a private deal,” he says.
Geographically, investors are positioning themselves for a wave of green bond issuance from China, following the G20 summit in September where environmentally sustainable development was a key topic of discussion.
China: incoming
“China is the country on the planet that has the biggest potential impact on climate change, says Samama of Amundi. “They are pushing for risk transparency and they want to revitalise their capital market.
“More and more investors are considering Chinese investments — not just in green bonds — because of the GDP growth in the country. Many investors have made statements to say they want to rebalance their portfolios towards Chinese bonds, to match the importance of GDP growth in the country.”
He adds that the country has to improve credit risk analysis before international investors will fully embrace its capital markets.
The increasing number of bulge bracket asset managers now developing dedicated green bond portfolios, and taking a broader view of the sector including social and impact investing, means the maturing SRI market has overcome the initial scepticism it faced from some investor, says Crispijn Kooijmans, head of public sector origination at Rabobank in Amsterdam.
“The market is still young but at the same time, it’s mature enough that everyone agrees it is here to stay. That’s not the discussion any more.”