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Keep transition and sustainable bonds separate

By Owen Sanderson
01 Oct 2019

Financing a dirty industry to clean up serves a different purpose to keeping a portfolio pure, and appeals to investors with different theories about the economy and the world. It's time for markets to start making the distinction.

Teekay Shuttle is out with a green bond as it finances a new fleet of oil tankers — a move sure to cause uproar in the burgeoning sustainable finance industry. This echoes earlier controversies at the frontiers of ethical finance, including green bonds for airports, and one for an oil company. Most recently, Brazilian beef producer Marfrig brought a “transition bond” to market, to fund the purchase of cow carcasses not grazed on cleared rainforest — again, forcing investors of a sustainable slant to consider their position.

Investors and arrangers alike tend to lump all bonds of an ethical orientation together, perhaps segmenting them according to the depth or credibility of environmental commitment. That’s broadly the approach of Cicero, which provided the second opinion for Teekay Shuttle’s new issue, judging it to be "light green".

That means an investment which “represents necessary and potentially significant short-term [greenhouse gas] emission reductions, but needs to be managed to avoid extension of equipment lifetime that can lock in fossil fuel elements.”

But rather than being simply one point on a scale, bonds which fund a dirty issuer like an oilfield firm to get clean represent a different theory of change entirely from bonds which set out to finance clean projects.

As end investors and savers increasingly choose to care about the environment in picking investments, they ought to systemically start to prefer green bond funds, and green ought to become a default, rather than an exception.

As more money flows into the sector, green companies will have a lower cost of capital, across debt and equity alike, than their brown competitors, incentivising more green projects and using the gentle nudge of price to push the whole economy greenwards. For an individual investor or fund manager in such a market, transition doesn’t matter — the important thing is to buy green assets, and let market pricing do the rest.

Bonds to help dirty issuers clean up rely on a different theory altogether, one in which it’s not about allocating capital at the level of a market, but through a firm’s management’s direct intention. It’s about managerial capitalism, an older, simpler theory of change — a company wants to do something, do you lend them the money to do it?

While the former, pure green theory may have attractions to economists and efficient markets academics, it’s a poor description of the real bond market. If you squint hard enough, there is indeed a green pricing advantage. Green bonds require smaller new issue premiums and achieve higher subscription levels, perhaps aided by being smaller, than their brown equivalents.

But the idea that an ethical portfolio ought to systemically yield lower returns than an unconstrained equivalent is bitterly resisted by investors, who are queueing up to launch new sustainability funds. While an environmentally friendly business may indeed do better over the long term (and a business with lousy governance is a red flag), funds without a sustainability mandate can also buy these investments — and any attractive unethical opportunities to boot.

Meanwhile, the managerial approach can deliver far greater carbon cuts. Spanish oil firm Repsol’s green bond framework, which mostly funds new tech in oil extraction, delivers carbon cuts around 30 times larger than those in ABN Amro’s green bonds, which mostly fund mortgages on energy efficient homes. ABN is not an outlier among European mortgage banks with green bond programmes — indeed, it is among the best of the bunch — but it is simply far easier to strip carbon emissions out of an activity like oil extraction and refining than it is to cut carbon by lending to energy efficient homes.

But the very act of allocating funds to an oil company may stick in the craw for some savers — and they ought to be free to choose. Different investors may care more about maximising carbon cuts, or about keeping their own hands as clean as possible. Those are not different grades of greenness, they are different approaches to investing and to changing the world. Time to split out the transition sector.

This has been amended to reflect errors in calculating Repsol's carbon cuts, and that ABN Amro's green bond is typical for a bank green bond with mortgage use of proceeds.

By Owen Sanderson
01 Oct 2019