How Green Is My Bond?
How popular are some green bonds? When the Dutch State Treasury Agency issued its first green bond in late May, a €5.98 billion, AAA-rated 20-year bond, it was 3.5 times oversubscribed in just 90 minutes. The yield was 0.50%.
This may be a unique situation. According to the Climate Bond Initiative (CBI), the nonprofit organization that helps set the standards that define green bonds, the Netherlands was the first EU nation to issue a Climate Bonds Standard-certified sovereign green bond.
The Dutch bond sale may represent a textbook example of what investors imagine when they hear the words “green bond,” but not all green bonds are that verdant. The Dutch bond represents the gold standard as it is supervised by a third party to ensure the proceeds are going to programs to address climate change, as defined by the Paris Agreement goals.
Others are lighter shades of green, those that follow the standards but skip the cost and supervisory part for certification. A third type are called “green” but are more a marketing gimmick meant to lessen the toxicity of fossil fuels rather than address climate change.
The proceeds of the Dutch bond not only covered typical projects such as renewable energy, it also included water infrastructure projects such as coastal flood defense and nature-based water infrastructure to lessen the impact of flooding. Water utilities have issued certified green bonds for infrastructure, but the Dutch bond is a first, says Sean Kidney, chief executive officer of the CBI, which is funded by several major philanthropies like The Rockefeller Foundation, Bloomberg Philanthropies, and European Climate Foundation. It also receives some governmental funding from Switzerland and the UK to support climate change mitigation projects through the global bond market.
“This is a bit of a breakthrough. It’s an interesting bond because you can say, that means New York City could issue a bond for the adaptation measures that its building as a result of Hurricane Sandy. This bond now opens up that side of the market,” Kidney says.
Wading into the green bond market means buyer beware. There are no global regulations covering the definition of green bonds, so any country or firm can come up with its own guidelines of how a project mitigates climate change. That means asset owners who want to add green bonds to satisfy growing client demand for environmental, social, and governance (ESG) investments need to do their homework so they don’t get “greenwashed,” meaning they’re buying something that doesn’t reduce carbon emissions. To paraphrase Kermit the Frog, it’s not always easy being green.
Greening Fixed Income
Asset owner demand for green bonds is growing. Norges Bank Investment Management’s CEO Yngve Slyngstad said in an April speech regarding the government pension fund that green bonds may account for a larger share of its environmental investing mandates. Marthe Skaar, a spokesperson for Norges Bank, said in an email that at the end of 2018, the pension had 13.4 billion kroner invested in green bonds, compared to 7.1 billion kroner year-end 2017.
Also in April, Japan’s Government Pension Investment Fund said it is expanding its World Bank Group partnership to invest in World Bank-issued green bonds.
Total green bonds issuance in 2018 was $168.5 billion, a fraction of the $100 trillion global bond market. Green bonds launched in 2007, but took off in 2014, when $37 billion was issued. Climate Bond Initiative estimates $250 billion will be issued in 2019, with a number of countries such as Germany, Denmark, Spain, and Chile expected to issue green debt, Kidney says. So far this year, $83 billion of certified climate bonds and Climate Bond Initiative-aligned green bonds were issued.
The gold standard of green bonds, which the Dutch issue embodies, is Climate Bond Standards-certified. A lot of green bonds meet all the criteria set by the CBI, but don’t have certification from the organization. Although Kidney didn’t go into why individual issuers forego certification, to be certified, issuers pay a small fee based on the bond’s size and be supervised. And then there are bonds that may have a goal of improving the environment, but only marginally—often because they claim to make fossil fuel usage less dirty, but not eliminate it.
Certified climate bonds meet the criteria set out by the organization to promote a low-carbon economy, such as renewable energy, public transit, and recycling. The CBI standards are sector-specific and were developed by scientists. These require the issuer to have the project certified by a CBI-approved third-party verifier, such as professional services companies EY and KPMG, or ESG research firm Sustainalytics, which vouch for the proceeds, and the issuer must file an annual report with the organization. The certification cost is one-tenth of a basis point on the size of the bond, or $10 on a $1 million bond.
Second are green bonds that follow CBI-aligned taxonomy, but are not certified. Third are green bonds not aligned with CBI definitions, only the “Green Bond Principles,” a voluntary best-practices guide created by several investment banks, now overseen by the International Capital Markets Association (ICMA), a trade group for capital market participants. These are guidelines for green projects, but let the issuer define the term green. These bonds are not included in CBI-issuance data.
The greenwashing occurs in this third category, issuers who follow the loose Green Bond Principles. One example was the 2017 green bond issued by Spanish oil company Repsol to improve the energy efficiency of its refineries. Chinese bonds also fall under this third category. The People’s Bank of China and Chinese regulatory guidance allow green bonds for “clean coal” plants, standards which don’t align with other countries’ frameworks to reduce greenhouse gases.
Vikram Gandhi, senior lecturer at Harvard Business School, who developed and teaches a course on impact investing for the MBA program, says China’s green bond objective was to reduce emissions. “I think that it probably shouldn’t be called a green bond because it’s a bit misleading, but my understanding is they wanted to use them for the right kind of broader objective,” Gandhi says.
Patrick Drum, portfolio manager for Saturna Capital’s Sustainable Bond Fund (SEBFX) and an advisor for the United Nations’ Principles for Responsible Investment subcommittee on fixed income, says because green bonds are an entirely volunteer market, the buyer must use due diligence to clearly understand proceeds usage.
While he’s not knocking China because the country has a desperate need for energy, as an investor, Drum says it’s been hard to find good issuance because in 2016-2017, China commanded 40% of the green bond market. That may change, as Reuters reported China may be changing its standards to exclude fossil fuel projects.
Kristina Rüter, executive director, head of methodology at ISS-oekom, part of ISS ESG, says asset owners with ESG mandates need to understand what exactly is being financed by the use of proceeds of green bonds, e.g., whether these only focus on climate-change mitigation and don’t take into account other environmental aspects or the social and governance parts of ESG criteria. (ISS is the parent company of CIO). The overall ESG strategy, performance, and track record of the issuer is also an essential information when looking into the risks and impact of green bond investment opportunities.
Some ESG-minded investors may get squeamish, as some nuclear power plants and controversial large hydropower dams were financed by green bonds. Although the energy production may be non- or low-carbon emitting, there are risks with regard to nuclear waste and negative impacts on communities and ecosystems where dams are built, that need to be considered to obtain a holistic assessment of a green bond’s impact, Rüter says.
How to Evaluate Green Bonds
Cathy DiSalvo, associate portfolio manager in the fixed income unit of the California State Teachers Retirement System (CalSTRS), a $233.9 billion pension fund which owns $282 million in green bonds, says the pension fund reviews potential green bonds from credit and ESG analysis perspectives. She also recommends investors attend road shows and listen to the issuer’s explanations. “Even if you don’t have a question yourself, you get to hear what the other investors are asking, so that really helps,” DiSalvo says.
Saturna Capital’s Drum concurs that evaluating green bonds requires more work beyond credit analysis. He looks, in part, at the issuer’s transparency regarding proceed use, its external verifying partner and the ratings’ agencies specific green evaluation. He also cautions that investors may get a lower yield because the demand for green bonds is so high.
For investors, in-depth analysis can be difficult because sometimes the time between when an issuer announces a green bond sale and when it’s on auction might be only a matter of days to a week, Rüter says. Independent opinions can create transparency on risks and impacts of individual bond issuances and help investors with their decisions.
Even with all those precautions, sometimes green bonds go brown, due to political interference. In 2016-17, the Mexico City Airport Trust issued a US$6 billion green bond to finance construction for a LEED-certified green airport. It wasn’t Climate Bonds Certified, but was in line with looser Green Bond Principles that allow the issuer to define a green project. It also had a second opinion from Sustainalytics.
However, in a 2018 referendum, citizens voted down the initiative, causing the bonds to underperform. According to news reports, the trust offered to buy back a portion of the bonds but couldn’t afford to buy back all of them. The trust transferred the bonds to another project, and S&P withdrew its green evaluation report. NatWest Markets wrote in a blog report that the residual bonds are still technically labelled green as the money is slated for sustainability improvements and are likely to appear in various green bond indices.
CalSTRS owned some of the airport green bonds, which were held in the fund’s main credit portfolio. DiSalvo says when it happened, the credit team no longer considered them green bonds and looked at them strictly for the credit aspect. Eventually CalSTRS sold its holdings.
CalSTRS’s DiSalvo says it’s hard to say what lesson the investment team learned from the experience. “We can’t control all of those things. You really try to do your due diligence,” she says.
Despite a few bumps, DiSalvo, Saturna Capital’s Drum, and Harvard Business School’s Gandhi remain proponents of the industry. DiSalvo says although concerns about greenwashing are important, she says she wished people didn’t worry so much about it. “The green bond market is something that is positive,” she says.
Because it is a young market, investors may have to be a little forgiving, but still do their homework. Drum says he’ll buy green bonds from issuers who have the right framework because he’s willing to give them the benefit of the doubt. He makes sure to read the prospectuses to get a good sense of the issuer’s commitment.
To Ghandi, bonds that fall short of perfect in their use of proceeds are at least a start, and better than nothing. “Even if 5% of bonds in the portfolio are not pure, pure green bonds, if there is some kind of gray area, so be it. The fact is that even in those bonds, 95% of the proceeds are probably going to something that’s done right…. Don’t let the perfect be the enemy of the good,” he says.
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