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In defence of Denmark's green idea

Danmarks Nationalbank from media gallery 229x150
By Jon Hay
10 Dec 2019

Denmark’s debt officials have a highly original plan to issue green bonds in which the green element can be stripped off and traded separately. It’s going to put many a green nose out of joint. That’s no bad thing: the market needs to re-examine its claims to efficacy and virtue.

The plan by Denmark’s national debt management office for a new way to issue green bonds is bound to be controversial. It involves giving the investor the right to separate the green commitment from the bond part and trade them separately.

The purpose is to allow Denmark, which issues very little debt, and is therefore particularly anxious to keep what bonds it has as liquid as possible, to issue its first green bonds without having to create a new, small, off the run security that is priced less tightly because of its illiquidity.

To solve that puzzle, the clever people at Denmark’s DMO have thought of making a green issue of, say, Dkr5bn (€670m) as part of a much larger bond stock, say, a Dkr80bn 10 year. Green and non-green versions of the same bond would exist at once.

To make the green and non-green notes fully fungible, and hence maximise liquidity, the green element would have to be detachable, with its own legal identity and ISIN code, with a maturity, size and denomination, but no cashflows.

Puzzling the market

Baffled? You’re not alone. Some of the most prominent green bond bankers and investors said in May, when the idea first saw the light of the day, that it sucked.

The plan makes logical sense. There is no fundamental reason why it cannot work, although a serious hurdle could be that it may be tricky for investors to find a way in their systems to book this strange, new, cashless instrument.

The concept came out in May, when Germany’s DMO borrowed the idea and considered it as one option for its first green Bunds. But it seemed likely then that neither country would actually go through with it, because it was bound to make green bond investors uncomfortable, in two ways.

First, it would logically mean that someone could own the green part, representing the bond’s green use of proceeds, without ever having owned a single Danish government bond.

This is not the kind of thing green bond enthusiasts like. As one banker put it, the point of green bonds was that “you know where it’s coming from and what it’s made of”, like organic or Fairtrade coffee. Transferring this label to another bond made no sense, he argued.

Pricing the unpriceable

Second, making the green part separately tradable would mean giving it a price. This is a big no-no in the green bond world.

Even though, at least since 2014, it has been clear to anyone watching the market that green bonds tended to be issued at tighter spreads than equivalent ordinary bonds, for years no one would admit this.

Issuers, investment banks and investors maintained a conspiracy of silence, for fear of undermining the market by implying that investors were paying over the odds to make green investments.

Somewhat illogically, everyone feared that if it became known that investors liked this product very much, investors would be put off.

In the last couple of years, however, the mask has been discarded. Bankers and issuers now state openly that green bonds trade more tightly. Governments such as that of France have calculated the saving officially. It is plain to see in the secondary market curves of, for example, the European Investment Bank.

Many investors, however, are still reluctant to concede that green bonds are more tightly priced, or that they themselves ever buy them at tighter spreads.

As Thorsten Meyer Larsen, head of Denmark’s DMO, put it last week: “The issuers say it’s cheaper funding to issue green than comparable bonds, but the investors say they are not paying a dime more than for a regular bond. They can’t be true at the same time. The lack of transparency makes it easier for both parties to get away with it.”

The law of demand

The underlying logic has been evident all along. Green bonds are exactly like normal bonds in credit terms, but they offer the investor something extra: the feeling that it is putting its money to work in a green way.

In return for this, nothing is asked of the investor, in terms of extra risk. Very occasionally, such bonds are smaller and less liquid than ordinary bonds, but this is rare, and most bonds of any kind are not very liquid anyway.

Of course such bonds are going to be more demanded by investors than the boring ordinary kind. And in open markets, such as a bond bookbuild, supply and demand determine price.

There is simply no need to try and justify the green premium or “greenium” in theoretical terms, as if it was caused by, for example, some calculation on investors’ part that such bonds were likely to be less volatile. The basic and dominant reality is: investors want them because they want to do green investing.

But the fact that market participants can now talk about this in an adult way does not mean  investors are ready to lay a precise sum of real cash on the table and say “Please sell me the right to call my investment green.”

What would it be worth? A syndicate banker could tell you what investors have paid for that right on countless green bond issues. But there are plenty of things people pay for in private that they would not buy in the open air.

Germany goes its own way

In the last month, Germany has decided not to use strippable green labels, instead opting for another innovation to address the illiquidity problem: twin bonds. In this model, Germany will issue the green bonds with an identical maturity and coupon to a conventional Bund, and will promise investors always to accept the green notes and exchange them for ordinary ones, if the investor should want to surrender them.

This is meant to neutralise any perception of illiquidity. There are technical questions to be answered about this method and it would still make the greenium fairly explicit, but investors would not have to swallow the pill of holding and pricing the greenium separately.

Pressing on

Last week, Denmark’s DMO surprised many by ignoring the reservations of green bond experts and going ahead and publishing the stripping idea on its website.

This does not make it an official government plan. The DMO has developed the technique itself, to find a way that Denmark could issue green bonds without a price penalty. The actual order from politicians to issue green bonds has not come yet. When it does, the government may tell the DMO to issue them a different way.

However, it looks like a serious proposal, suggesting that there is a good chance Denmark could actually put this experiment into practice next year.

Lending this further credibility is the fact that Denmark has discussed it with a range of its investors, domestic and foreign. Some asked questions about it — and they may have had further critical thoughts in private — but the DMO says it was able to bring sceptics about the separate trading round by pointing out that: “Transparency is usually a good thing.”

It is a hard point to argue against.

Cool reception

Green bond aficionados may be unconvinced. Over the last 12 years, they have built up the whole market around the central idea that green bonds enable the investor to finance specific green projects, and that the issuer will report back on what it has done with the investor’s money.

Some of them may feel Denmark is letting the side down. Perfectly capable of issuing a normal green bond, it is instead confusing things and overcomplicating them because it begrudges giving anything away to investors without screwing every last penny out of them.

Ulf Erlandsson, a prominent green bond investor and commentator, wrote online on Tuesday: “Stripping the green from green bonds? This Danish construct effectively tries to strip away credibility from the green bond market… someone who is sceptical of the green bond market is looking to take advantage of what they believe is an irrational and daft segment of the market.”

Are the critics right? And — a separate question — is Denmark’s plan doomed to fail?

Technical challenges

Taking the second question first: not necessarily. It is quite possible that Denmark’s bond investors are not the leading lights of the green bond market. They may be Danish government bond investors first — and very happy to eat their familiar fare with a green garnish for a change. Green bonds are not just for the illuminati who go to green bond conferences.

Theoretically, there is no reason why an investor contemplating buying an issue of Danish strippable green bonds should reject it. Even if the investor places no value on the green component, it should be able to buy the bond as a normal Danish govvie.

Denmark’s DMO would be largely satisfied with that: its aim is to be able to issue green bonds, if its political masters order this, without paying more than for ordinary bonds.

In practice, the strippable green labels introduce a new element that investors are unfamiliar with and may not know how to handle. The nuisance factor alone may put some investors off — so the scheme could backfire on Denmark with slightly wider pricing.

Liquidity issues

How the instrument would behave in the secondary market is also difficult to predict. At new issue, the bond is identical to an ordinary green bond, though more complex administratively. In the secondary market, the seller would have to find buyers for both elements. That is inherently more complicated than selling a single note, and in a very finely calibrated, tightly priced market such as Danish govvies, it could make these notes less liquid.

The investor of course can sell just the bond part, and wait to sell the green certificate later. But that delay would mean it had not recovered the full value of its original investment: and what is the certificate worth without the bond?

Many investors could simply associate the certificate with a different Danish government bond — it would seem wise for the Danish DMO to relax its view and bless this transferability.

But ultimately the value of the green commitment is in the eye of the beholder. If market participants look askance at it, when divorced from its original bond complement, it becomes less valuable.

It is also worth observing that the liquidity of a Danish government bond plus green certificate combination may actually be inferior to that of a conventional government green bond, because of this need to sell the two elements — and that not all investors may be set up to accept such paper.

These are all reasons why the scheme’s results could prove disappointing to Denmark: it may not deliver the unimpeachable liquidity and perfect pricing it desires.

Keep it simple

Many in the green bond market would say — and this is GlobalCapital’s pragmatic advice, too — just pluck up courage and issue an ordinary green bond, suck up the odd basis point of pricing disadvantage if it occurs and write that off as a contribution to building the green bond market (which is one of the main reasons government issuers always give for introducing green bonds).

But recommending that Denmark might have an easier time and more market success with a more market-friendly instrument does not mean GlobalCapital agrees with the critics who argue Denmark is somehow betraying or falsifying what green bonds are for.

On the contrary, Denmark’s idea poses an intellectual challenge to the green bond market, to which it has few answers.

Speaking up

First, the greenium. It is certainly uncomfortable for green bond investors to talk about the greenium, still less to put a hard price on it in kroner. But the reality is it exists.

Transparency is not always good. Some things in finance are better off left unspoken — for example, the financial benefit captured by a company that makes all its lending banks vie for its capital markets business. If loans and bond business were fully separated and priced to be independently profitable for the banks, companies would pay more for funding, and probably get a poorer service. The hope of banks that this year they are going to get more of the client’s wallet keeps them competing keenly, on both pricing and quality of service. This hope has an intangible financial value.

So there may be little benefit to the world in trying to make the greenium transparent. But you cannot blame Denmark for speaking in public about one of the market’s little secrets, and calling the bluff of those who would prefer to hide the value of the greenium.

No different from normal

Second: stripping the green promise from the bond. It would certainly seem at first glance bizarre and wrong for an investor who has never lent Denmark any money to buy one of its green certificates in the secondary market. What could that investor then say about whether it had made green investments?

Yet logically, this is no different from or worse than what happens routinely with green bonds. When they are sold in the secondary market, the new holder has not lent the issuer any money. By buying out the original investor, of course the secondary buyer supports the liquid bond market system that enables the issuer to raise money in the first place. But that is no different with Denmark’s proposal. It is simply that the ultimate holders of the bond and the green pledge may turn out to be different.

Again, green bond supporters may object that investors should not claim to have made green investments when their money has not gone to that green investment.

But if the Danish scheme is open to any such criticism, it could only be as a result of investors’ actions. At the point of issue, when the bond would leave the Danish treasury and enter investors’ hands, it would be identical to a normal green bond, just documented differently.

Moving the green certificates to unsuitable hands, or making unjustified claims, would be entirely the responsibility of investors.

The Danish DMO would have no power to prevent such behaviour — issuers never have power over who owns their bonds or what the investors say about them.

In fact, the Danish DMO plans to deter such claims by stating that it, at least, would only regard the investment as green if the certificate were held alongside Danish government bonds of the same maturity.

It would make sense for the DMO to relax this requirement to any Danish government bond, and this is likely to happen.

Use of proceeds link is not secure

At a more fundamental level, however, the complaint by green investors “how can you claim to have made a green investment if your money has not gone to that investment?” rings hollow.

The whole green bond market is built on a similar fiction.

I suspect my teenage son of smoking. He asks me for £5. I say: “I don’t know, I’m worried you’ll spend it on cigarettes.” He says: “No, I need it for lunch.”

“Alright then, here you are — as long as you promise to spend it on lunch. Show me the receipt afterwards.”

Sure enough, he shows me the receipt. But then he leaves a packet of cigarettes on the sofa.

“Where did you get those? I thought you promised not to use that money for cigarettes?”

“Oh, I used your money for lunch. I bought the cigarettes with another fiver I had.”

My son has not lied. But had he not been able to get the money from me, he would have had to use his own £5 for lunch. It would have been more unattractive for him to buy cigarettes.

Was it really “my” money, in any meaningful sense, that paid for lunch? Or have I facilitated his unhealthy habit?

By lending a company or government money, you make it easier for that issuer to finance all its activities, even if it promises to use “your” money only for good purposes. You reduce the extent to which, when financing its dodgy business lines, it has to rely on its limited pool of unfussy investors.

The premise of green bonds — that the investor's money goes only to the good activities on which reports are written — cannot really be sustained.

Only by looking at the organisation’s whole activity can you be sure that you are not financing something reprehensible — and hence bearing the credit and reputational risk of that.

Equally, it is only by analysing a whole organisation that the investor can tell if the organisation has advanced or increased its green activities — which is the first prerequisite of additionality.

And without additionality, how can green bonds have the positive impact their investors love to claim?

Green bond fans regularly argue that the market’s great virtue is starting conversations and drawing attention to issues in new ways. So it does.

So don’t knock Denmark for drawing attention to several issues that are fundamental to the green bond market and its claim to be useful. These deserve closer scrutiny.

By Jon Hay
10 Dec 2019