Green bonds: getting investors out of bed for the climate

JK Paper, one of India’s biggest paper manufacturers, is also keen to be environmentally efficient. Thanks to a $3m loan from the International Finance Corp, it has upgraded its machinery so as to save 10GWh of electricity and 1.5m cubic metres of water a year.

This is just one of the investments supported by the IFC’s $3.5bn green bond programme since its inception in 2010. If you were an investor who had bought some of those bonds, you would probably be feeling a pretty warm glow right now.

That thrill is, in a nutshell, the point of green bonds, which have leapt on to the agendas of all involved in the supranational, agency and local government bond markets.

“There was over $11bn of green bond issuance last year, multiples of what we’d seen in any previous year,” says Stuart McGregor, head of public sector debt capital markets at RBC Capital Markets in London. “We’ve found that tipping point where there is a more general acceptance of what a green bond is, and some of the investors have begun appreciating what this asset class can offer.”

The growth of green bonds would be very hard for a classical economist to explain. Investors and issuers insist they gain no financial benefit from them, compared with ordinary bonds. Indeed, green bonds are less efficient, because the issuer must set up mechanisms to ring-fence the proceeds and report on how the money is spent.

Green bonds are not meeting a need to increase investment in environmental solutions. Their issuers were already making such investments, and had plentiful access to funds for them from normal sources. 

But intelligent observers know there is much more to financial markets than hard numerical logic. Sentiment, marketing and brand are powerful in every sphere of economic life — they work in finance, too, though it is rarely admitted.

That green bonds’ purpose resides in the soft sphere of communications is acknowledged by Aldo Romani, deputy head of funding, euro, at the European Investment Bank in Luxembourg.

“We issued the first transaction with proceeds earmarked for disbursements in the fields of renewable energy and energy efficiency in 2007, when the EU took leadership in the policy debate on climate action,” Romani says. “The EU asked the EIB to intensify its action in this area and it became important to raise market awareness and mobilise investor support with a dedicated product.”

Raising market awareness – other issuers have called it “representing our commitment” – is not an operation that can be described in financial terms. But any marketing executive would know exactly what Romani meant.

One development bank after another has found it worthwhile to begin issuing green bonds. 

Communicating the organisation’s values is one motivation. But equally, SSA treasury officials are always hunting for new sources of demand. Marketing to investors with a green focus is a new way to do that. 

“Green bonds tap into a different set of SRI or socially minded investors, so in a way it’s a diversification play,” says Evelyn Hartwick, head of socially responsible bond programmes at the IFC in Washington.

The European Bank for Reconstruction and Development is proud of being the first supranational with an environmental and social mandate, dating back many years. “We already have a very strong sustainability focus — all our projects are assessed from an environmental and social perspective,” says Olga Dyakova, senior manager in the treasury funding department at the EBRD in London. “But since 2010, when we first began issuing green bonds, we have seen very specific demand for green bonds from investors with very restrictive mandates.”

For example, the EBRD might make a loan to improve the efficiency of a fossil fuel-based energy system. It would help the climate, but some investors would not want any exposure to fossil fuels. Others would object to financing energy efficiency at brewers or wine producers.

The EBRD has selected a suitable portfolio of loans, which backs its green bond issuance. This approach — a pool of green projects all meeting one set of criteria, linked to a pool of green bonds — is the same as what other development banks have done, though there are minor differences. 

Most green bonds from 2008 to 2012 were tailored to meet specific demand from investors with quite strong green requirements, often communicated through reverse enquiries. 

Many were sold to Japanese retail investors, for whom an ethical purpose is a selling point that helps a bond stand out among other investments. Other investors included Scandinavian state pension funds and specialist green asset managers. 

It remained a market largely of small deals. The World Bank’s first $3bn of green bond issuance up to 2012 came through 50 issues.

But since 2013, there has been a marked change in issuance styles. The deal that caught the market’s attention was the IFC’s $1bn green bond in March 2013. 

The IFC’s annual funding has trebled since 2008, so it can use some new investors. Having been issuing green bonds in Japan since 2010, the IFC saw a big potential for selling the product in the US.

The $1bn deal was by far the biggest green bond yet, and led to a wave of other benchmark issues in major currencies, very different from the previous niche transactions.

In 2013, the World Bank, EBRD, Kommunalbanken, Korea Export-Import Bank, the Netherlands’ Financierings-Maatschappij voor Ontwikkelingslanden and the African Development Bank all issued benchmark euro or dollar bonds.

And in July the EIB’s Climate Awareness Bond programme returned, for the first time since 2007, to benchmark issuance in euros.

Normally when a new debt product grows and finds new investors, issuers are persuading buyers to become comfortable with a new risk or legal structure, at a rate measurable by the market’s growth and pricing.

With green bonds — from a legal and risk point of view identical to other bonds — there is no push against investors’ reluctance, only a loosening of the issuer’s restraint over a limited edition product.

How to do this is carefully discussed by SSA funding officials and their advisers.

Two objectives must be weighed up. For the communications, or public relations, purpose of issuing green bonds, issuing more of them is a good thing. But the funding diversification angle is not necessarily helped so clearly.

“Only 10% of our projects go into our very deep green portfolio that backs the green bonds,” says Isabelle Laurent, deputy treasurer and head of funding at the EBRD in London. “We still need to fund the other 90%, and we don’t want to cannibalise the investor base for it. If we issued a $1bn green bond, it would be very hard to tell the central banks who take a lot of our bonds that we didn’t want them in. Suddenly all the people who could fund 90% of our activity would be funding 10%.”

In other words, the investor diversification benefit of issuing green bonds may be strongest if they can be kept as much as possible just for the greenest investors.

“Green bonds do offer access to discrete pools of capital, but their scale is smaller than the pools of liquidity for a dollar or euro benchmark,” says Bill Northfield, head of SSA origination at Deutsche Bank in London. “If a supra wants to raise $1bn, they could rely on central banks to provide the bulk of demand in one go. But if a supra has a larger programme such as $10bn a year and can lock away $1bn to a discrete investor base like SRI clients, that’s great for the strategy.”

However, issuers have begun to decide that they can grow their green-minded investor bases with bigger deals, and end up with a larger overall pool of demand. 

“It’s true that at first, one of the results of issuing bigger deals is that it dilutes the pure SRI investor percentage in the deals,” says Olivier Vion, managing director of public sector debt capital markets at Société Générale in Paris. “But it also helps investors to feel more comfortable about the market. It’s one thing to say you have interest in a product, but the product needs to be investable. If it’s not investable because there is not enough size available you are running in circles.”

Some of the original deep green investors may be happy to buy more liquid deals. But demand has been swelled by a new swathe of paler green investors. 

“Last year, a number of investors started to voice a requirement for a product that would be climate-themed but launched in benchmark size and plain vanilla format,” says Romani at the EIB, “a call that we were quick to respond to.”

These buyers would not object on principle to buying ordinary SSA bonds, but the green aspect is an added attraction for them. They include mainstream asset managers that, having signed up perhaps to the UN Principles for Responsible Investment, are now trying to implement a consciousness of social responsibility — including to the environment — across their activities.

Most SSAs would score well anyway on most investors’ environmental, social and governance (ESG) scales. But a green bond can make the portfolio look that bit better. 

And the same asset managers are busily setting up dedicated bond funds with more stringent ESG criteria. For them, too, green is marketing gold.

“We are issuing liquid benchmarks, rightly priced and fully supported by a strong syndicate, being mindful of investors’ feedback,” says Hartwick at the IFC. She is keen to keep satisfying and growing SRI investors. But for successful liquid deals, non-SRI investors need to come in too – and start getting into green bonds.

“I am very encouraged to see the rapid growth of the SRI investor base, but also the interest from non-SRI investors – that’s what we need to support a fast transition into a green economy,” Hartwick says.

To control this process, the IFC keeps a close eye on how its bonds are allocated. “We have been very successful at managing expectations on allocations ahead of time,” Hartwick says. “We stay close to our investor base and have good ongoing communication. Central banks know that green bonds are primarily targeted to the SRI community.” 

The EIB has merged its Climate Awareness Bond programme with its Ecoop product — bonds of €500m minimum, aimed at co-operative and savings banks, especially in Germany. Through taps, it is building up one bond, its November 2019, issued in July 2013, into a big benchmark — now €2bn.

“At this stage of market development, the participation of a broad set of investors is essential to bring liquidity to the green bond segment,” says Romani. Like IFC, the EIB wants to keep supplying the greenest investors, while getting the deals to benchmark size by drawing on paler green investors.

 “EIB and its lead managers entertain an ongoing dialogue with investors genuinely attracted by the climate component,” Romani says. “The idea is to maintain a balance between different constituencies of investors while green demand gradually builds up – a dialectic process that eventually benefits all.”

Investors that have come into the EIB’s euro CAB include Ikea and new responsible funds set up within bank treasuries.

The expansion of green bonds since 2013 has had several notable effects. “More issues are coming, and in bigger sizes, which suggests that there is an increase in interest from the investor side,” says Vion. “This theme is more and more popular, and it is popular because you’ve got more issuers looking at the market. Supply stimulates demand.”

It was perfectly possible to follow a climate-driven bond investing strategy before the existence of green bonds. Indeed, it is arguable that an investor really committed to the climate would not buy green bonds, since they do not generate new green investment or change organisations’ behaviour.

But green bonds have made green investing much more visible, and much easier. Hence the growth in demand for the product from asset managers like BlackRock and Deutsche Asset & Wealth Management, and from banks.

“As of today I think the number of green portfolios or green money does not cover the amount of green borrowing, so the order books are a mix between targeted SRI money and ordinary money,” says one agency funding official. “But we definitely see a growing trend for earmarked green money.”

So the issuers are diversifying their funding, not by accessing pools of green money that were previously barred to them, but by stimulating the creation of green funds, managing money for investors who previously might not have bothered to invest in a green way, or to buy supranational paper.

Giving a bond a green purpose creates a ‘get out of bed’ factor that can make US investors, for example, buy low-yielding IFC paper that they would not normally think worthwhile.

Some of the most enthusiastic buyers of dollar green bonds have not been commercial asset managers, bound by formal policies, but more freely managed pools of money. Among those in the IFC’s second $1bn deal in November were Ford Motor, Microsoft and the central banks of Brazil and Germany. Family offices, state treasuries and pension funds have also been involved.

The green bond marketing has awakened in these investors a preference for green investing that may have been latent or unexpressed, and made it active.

If investors are buying supranational and agency bonds that previously would not have, the diversification of funding effect is real. 

So far, the convention that green bonds should be priced at launch in line with an issuer’s ordinary bonds is being maintained, to please some investors that insist on this, so that they can claim they are not giving up an iota of financial return to pursue a green strategy. 

Borrowers and bankers are becoming more willing to admit that the market logic is for green bonds to trade tighter than ordinary bonds, since they offer the investor extra, non-monetary value. 

“I don’t think our green bond has been traded much — it’s owned by a lot of buy-and-hold investors,” says the agency funding official. “It has been marked marginally tighter than our regular curve — but only a basis point or two.”

But no one expects green bonds to be priced at new issue explicitly tighter than ordinary notes for some time to come.

However, the funding diversification effect of green bonds should logically be squeezing issuers’ spreads on their entire debt. “In a way, if US investors wouldn’t normally buy our global benchmarks because of the tight spreads, but they buy our green bonds, there is willingness to pay for climate change mitigation,” says Hartwick. “The environment has benefited because investors have bought bonds at tighter spreads than they normally would.”

The marketing benefit can also help an issuer’s ordinary bonds. “One of the good things that have happened,” says Laurent at the EBRD, “is that a number of green investors who because of our green bond issues have looked at us, have then said, ‘actually we could buy your ordinary bonds too’.”

Funding officials’ main job is to finance their organisations efficiently, and to that extent green bonds have been a great selling product. But the few basis points SSAs may save is not the big prize.

“We are mindful that development is a mandate of ours, so developing new financial instruments is also a priority,” says Hartwick. “It goes hand in hand — we are diversifying funding, while at the institutional level strategically developing a new asset class that can potentially mobilise capital and support the rapid transition into a low carbon future.”

The investors who have woken up to the possibilities of green investing may be inspired to go further, by buying the bonds of green companies and project vehicles that carry real risk. At the point where project bonds for green investments start to become easier to sell than they used to be, the green bond market will arguably begin to make a real contribution to the struggle against climate change.

In that context, a service was performed by Solactive, the German index provider that began in March to publish the first green bond index. The listing does one important thing: alongside the SSA and blue chip corporate green bonds, it includes a handful of project bonds such as the Topaz Solar Farms deal by MidAmerican Energy. Investors who use it will be directed to look at such deals, as well as the EIB and World Bank’s paper.

There are still SSAs that have not issued green bonds — the standout example being KfW. The German development bank’s refusal to be rushed into a trend is admirable. KfW is as committed to sustainable development as any of its peers, indeed it has been ranked the world’s most sustainable bank. Bloomberg ranked it the biggest investor in environmental projects, with $147bn committed since 2007.

KfW has also long been alert to SRI. “When meeting with investors we are always adequately prepared,” says Horst Seissinger, head of capital markets at KfW in Frankfurt. “If you are doing investor relations and talking to investors you have to be in a position to explain the economics about KfW and Germany, the balance sheet risk policy, our activities, but also about sustainability.”

Like other SSA issuers, KfW finds sustainability has risen up the agenda of mainstream fund managers considering its normal bonds, though it would be wrong to imply that it had become a core consideration for all but the SRI specialists.

“We are in the middle of a very intensive discussion about how to react to the newest developments — increased demand for green bonds,” says Seissinger. “Our general approach so far has been very holistic: we put the emphasis on overall sustainability, and try to be very good with respect to our ESG ratings. Our holistic approach to sustainability will continue to be the focus, nevertheless we see strong interest in capital markets.”

KfW is still deciding whether green bonds could play a part in its approach to sustainability. But bankers agree that issuance in general will grow, though it is not clear how fast. “We don’t see an explosion of issuance,” says Northfield, “but rather a process over time to absorb the liquidity, and create the reporting, monitoring and segregating of funds.”

One of the big growth areas may be regional and local government. The Province of Ontario plans to issue a green bond, more or less the first in Canadian dollars, to finance investments in rail transport in and around Toronto.

“The transit projects will be built regardless,” says Paul Belanger, managing director of SSA debt capital markets at RBC Capital Markets in Toronto. 

“But by doing a green bond, Ontario is doing a few things. They are giving investors an option they don’t already have in Canadian dollars, developing the market in Canada, and hopefully it brings in some incremental investors from the green space who may not otherwise have bought an Ontario domestic bond.”

Some bankers still hanker for the green bond market to be standardised. “There are so many shades of green, some sort of standardisation would be helpful,” says Belanger.

One leading issuer would like more clarity on the investors. “It’s more on the investment industry side that action must be taken,” an executive says. “It is one of the major challenges we see that there is no proper classification of what an SRI investor is.”

But it is unlikely — indeed undesirable — that there should ever be one approach to green investing, or one system of classifying green investments. 

To take just one of many possible examples, nuclear power can reduce greenhouse gas emissions, but entails risk of catastrophic poisoning of the environment. Different societies at different times will take views on how to weigh its risks and advantages. Investors need to apply their own values and judgment and contribute to society’s decision-making process — not slavishly follow the advice of external experts or a unitary rating agency.

One issue in the back of some market participants’ minds when they think of standardisation or an agreed green bond badge is winning favoured treatment from regulators or tax authorities.

“At some point there is going to be a certification,” says McGregor at RBC. “Investors are not going to want to pay up for green bonds, so for this market to get a lot better, there should be some sort of incentive. That’s where the real lobbying is going on at the central government level. Does the asset class take a step forward with some sort of tax incentives?”

Whether subsidies are necessary is debatable. The rapid growth of green bonds has shown that there is great appetite to finance green investments, if they can be served up in a palatable way. Trying to tinker with the cost of capital for green projects as a whole is a blunt way of trying to make specific initiatives viable, and could lead to misallocation of resources.

Perhaps the most exciting recent development is the IFC’s introduction in March of a US retail distribution programme, using the online platform of Incapital, which connects with 800 broker-dealers. 

This initiative is taking the product back to its roots — the EIB’s first Climate Awareness Bond was retail-targeted, as were all the Japanese deals of the following years.

“At the end of the day it’s retail demand that’s going to drive the market,” says McGregor. “Institutional funds are going to have demand because there is demand from the end user.”

If the most valuable purpose of green bonds is to spread the environmental message, getting it to the population at large is the biggest prize of all.

Thank you, Mrs Watanabe. Hello, Main Street USA.