Green is healthy. Also for bonds in the portfolio.
Green bonds allow investors to combine their financial interests with direct contributions to environmental and climate protection. The green bond market is a rapidly growing segment with high potential. Clarity is ensured through consensus on definitions and a longstanding track record. Ideal access is offered to investors through a combination of professional investment processes, traditional selection criteria, and sustainability aspects.
Climate change is manifesting itself ever more clearly. In 2016 the global temperature record was broken for the third consecutive year while 2017 was the hottest year on record without an El Niño event. In this context, most climate experts regard the frequency and intensification of hurricanes in the US not as random weather events but rather as the unambiguous consequence of climate change, as clearly evidenced by warmer ocean temperatures. Global warming has become one of the biggest challenges humanity is facing today and is likely to result in unprecedented, difficult-to-estimate damages and costs.
As a result, many investors feel the need to combine their financial interests – generating attractive capital market returns – with direct contributions to environmental and climate protection. Clearly defined and with a longstanding track record, green bonds are a good option.
What distinguishes green bonds?
The difference between green bonds and normal bonds consists in the intended use of proceeds by the issuer. Funds raised from conventional bonds may be utilized to finance any type of business project; by contrast, proceeds from green bonds must explicitly be dedicated to projects that have a positive impact on the environment and the climate. Proceeds from the sale of green bonds can be utilized to finance the construction of a solar power plant, for example, or the expansion of public transport.
Apart from this specific purpose, green bonds function like conventional bonds. The issuer is liable for green bonds exactly the same as for other bonds. Green bonds have no special default risk status. Consequently, yields on green bonds of the same currency and maturity are roughly on a par with yields on conventional bonds.
In addition, credit ratings of green bonds are generally at the same level as the issuer rating. The risks thus correspond to those of a conventional bond.
How are green bonds defined?
To be classified as a green bond, the following criteria based on the Green Bond Principles must be satisfied:
- The capital raised from the bond issue must be utilized to finance or refinance “green” projects (use of proceeds).
- Issuers must provide a detailed description of their project selection process along with a definition of the project’s purpose and scope (process for project evaluation and selection).
- Issue proceeds must be managed separately, and this must be verified by an independent auditor (management of proceeds).
- Issuers must provide a minimum level of transparency, must report at least annually on the progress of their projects, and must regularly provide reports on the use of proceeds (reporting).
The Green Bond Principles are voluntary guidelines set out by the International Capital Markets Association (ICMA). First introduced in 2014, the Green Bond Principles are reviewed and updated annually. Moreover, independent auditors are often engaged to check the use of proceeds. This represents a voluntary obligation on the part of issuers, but compliance enhances transparency. In accordance with these provisions, green bonds may be labelled as such only if the funds raised go to projects in any of the following ten categories: renewable energy, energy efficiency, sustainable waste management, sustainable agriculture, conservation of biodiversity, clean transportation, sustainable water management, adaptation to climate change, recycling management products, and green buildings.
How large is the green bond investment universe?
The green bond investment segment is still young but is growing rapidly. In May 2007, the European Investment Bank (EIB) issued the Climate Awareness Bond, the world’s first climate protection bond, which was successfully repaid in 2012. Since then, the market segment has seen very dynamic growth. The initial issuers were mainly supranational organizations, but for some years now they have largely been displaced by corporates, such as Iberdrola SA or Netherlands-based TenneT Holding BV, all of which issue green bonds. More than 390 issuers currently have outstanding green bonds, with a global market volume of approximately USD 350 bn (data as of end-June 2018.)
Over the short and medium term, issuance activity in the green bond market looks set to remain very strong. After Poland issued the first sovereign green bond in December 2016, France followed suit with a EUR 7 bn issue in January 2017, which was later topped up repeatedly to total over EUR 14.7 bn. As a result of the Paris Climate Accord (Paris CoP 21), it is anticipated that in the near future other countries will follow the example of Poland, France and now also Belgium. More generally, the investment segment is likely to expand rapidly over the next few years given the enormous need for investment in measures to address climate change, and green bonds have established themselves as a reliable source of financing. The Luxembourg Stock Exchange, a key trading venue, in 2016 set up a separate segment for green bonds.
In terms of performance, green bonds no longer lag the overall market – to the contrary. Since the introduction in December 2013 of the main benchmark, the Bloomberg Barclays MSCI Global Green Bond Index, green bonds have outperformed the Bloomberg Barclays Global Aggregate Index by a total 2.37%.
How are individual green bonds selected?
Successful green bond strategies combine traditional selection criteria with sustainability aspects. Companies engaging in controversial business activities are excluded from the investment universe. These activities involve the usual suspects such as arms manufacturers and so-called “sin sectors” (alcohol, tobacco, gambling and pornography). The remaining investment universe is reviewed at the issuer level using various ESG criteria to identify the most sustainable companies. Last but not least, individual green bonds and/or the quality of the underlying green bond projects should be reviewed. This is to prevent “weak” environmental projects – the sole purpose of which is to give issuers a green veneer (greenwashing) – from being supported.
Green bonds represent an excellent opportunity for private investors and institutional investors alike to combine their financial interests with direct contributions to environmental and climate protection. This growing investment segment allows investors to invest in green bonds in increasingly greater scope.