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Investing in sustainable fixed income

August 2020
Marketing Material

Beyond green bonds

The European Union's rescue plan will give a huge boost to an already thriving market for green bonds and other instruments that promote sustainability. But investors need to be wary: green comes in many shades.

01

A thriving market

The market for green bonds has been booming. And it’s only likely to get bigger as ever more companies, governments and multinational organisations seek to raise funds to pursue environmentally-friendly projects and as investors see the attractiveness of these assets. For instance, more than 30 per cent of the European Union’s EUR750 billion rescue package is being set aside for green projects.1 

But as with any new types of investments, green bonds hide plenty of potential pitfalls – not least because many of them are not as green as they claim to be. 

Helping the world to turn green

Green bonds are typically issued to finance specific projects that contribute to a reduction of greenhouse gas emissions, such as renewable energy infrastructure, or that help countries or companies to adapt to climate change, for example by protecting coastal areas against sea level rises. They are issued with provisions governing how proceeds are to be allocated and they tend to carry the issuer’s credit rating.

As such, they are part of the universe of environmental, social and governance-focused (ESG) investing – investment strategies whose growing popularity has been matched by strong returns in recent years and particularly during the Covid pandemic.2 That’s just as well. Environmental- and climate-related investment is going to be vital in the years to come.

Unmitigated climate change could cost the global economy some 30 per cent of its potential GDP per capita by 2100.

Oxford University forecasters estimate that unmitigated climate change could cost the global economy some 30 per cent of its potential GDP per capita by 2100.3 It is estimated that, to limit global warming to 1.5 degrees centigrade from pre-industrial levels, some USD1.6 trillion to USD3.8 trillion needs to be invested annually through to 2050 in mitigation efforts.4

That might appear unrealistic but the money is there. For instance, in 2015, global subsidies to fossil fuels were worth USD5 trillion. That same year, total climate finance was just USD481 billion.

As ESG investing becomes more important so too will green bonds.

02

Blossoming bonds

Green bonds barely existed a decade ago. They were first issued by the European Investment Bank (EIB) in 2007 as a climate awareness initiative.  During 2019, some USD257 billion of green bonds were issued, a 50 per cent increase from the previous year, according to the Climate Bonds Initiative, which forecasts that another USD350 billion will come to market in 2020. (see Fig.1).

Fig. 1 - Green shoots
Total annual green bond issuance, USD bn
Total annual green bond issuance
Source: Climate Bonds Initiative. Data as at 30.06.2020, covering period 31.12.2011-31.12.2019
The US and Europe have until now dominated the market. Europe alone accounted for 45 per cent of global issuance in 2019. That is perhaps unsurprising given the region’s mature financial markets and the importance Europeans attach to improving their environments. But other countries have taken notice. Chinese companies, primarily banks, are already big issuers, accounting for some USD30 billion of supply in 2019 (see Fig.2).
Fig. 2  - Wealth of nations
Total historical green bond issuance (2012-2019) by country, USD bn
Historical green bond issuance by country
Source: Climate Bonds Initiative, UniCredit Research published 13.04.2020. Data covering period 31.12.2011-31.12.2019.

But as fast as the market has grown, it’s still only a tiny fraction of the USD100 trillion global bond pool.

Multilateral development banks (MDBs) have been key players from the start. That’s because MDBs are better equipped to meet issuance requirements. Issuing green bonds requires borrowers to set well-defined objectives and allow rigorous oversight of the environmental projects they are financing. Moreover, the scale of such endeavours has made it necessary to tap the international capital markets – easy for MDBs but more costly for other borrowers. The EIB and World Bank continue to be major issuers.

The Federal National Mortgage Association (Fannie Mae), the US government-sponsored mortgage agency, has been another major source of green bonds as part of its efforts to make the country’s housing sector more environmentally friendly. China’s Industrial Bank is also a frequent issuer, alongside other European sovereigns and institutions.

Sovereign borrowers, increasingly under pressure to meet green commitments, are likely to step up issuance. Shortly before the Covid-19 pandemic hit the UK, HSBC estimated that green bonds could finance around a quarter of UK government’s manifesto commitments for infrastructure spending.

And if the EU’s environmentally-focused EUR750 billion pandemic recovery plan is a marker, green bond markets could grow at an even more rapid pace in the post-Covid world.

But sovereign and sovereign-linked borrowers might end up playing second fiddle to the private sector which has now also discovered the benefits of green finance. In all, financial institutions and corporations accounted for some USD142 billion of green bond issuance during 2019, with corporate transactions alone increasing 90 per cent over the previous year. 

03

The greening of corporate credit

By the end of June 2020, the corporate green bond market was worth USD468 billion.5  In all, non-financial corporations accounted for nearly a quarter of all green bond supply during 2019, with the three biggest issuers all operating in the energy sector. Indeed, energy and buildings industries together account for the bulk of the corporate bond issues. Historically, some 17 per cent was directed towards transport and 13 per cent towards water (see Fig.3).
 
Fig. 3 - Green power
Green bond issuance by economic sector (2012-19), percentage of total
Green bond issuance by economic sector
Source: Climate Bonds Initiative, UniCredit Research published 13.04.2020. Data covering period 31.12.2011-31.12.2019. 

For firms, the benefits are that demand for these bonds tends to come from a wider range of investors than for conventional debt issues. And data suggest these investors tend to be more committed and hold the instruments for longer than they do traditional fixed income securities. Another attraction for issuers is these bonds’ longer maturities, which means refinancing can be less frequent. For example, green bonds (corporate and government) have an average duration of just under 8 years, compared to 7.2 years for global investment grade corporate debt, perhaps reflecting the fact that environmental projects have long time horizons.

And recently, issuance has been broadening along the credit spectrum. Although corporate green bonds are mostly rated investment grade, high yield issuers such as recycling and waste management company Paprec, wind turbine manufacturer Nordex and glass manufacturer O-I Packaging Group have also made forays into the market. And more could find themselves there. The fallout from the Covid pandemic could see some of the 44 per cent of these green bonds that are rated BBB – a smaller proportion than the wider corporate debt markets – become fallen angels by dropping into high yield territory.

04

Caveat investor

Corporate green bonds have certainly performed well relative to other credit (see Fig.4). But the muddiness of much of the universe for green finance means investors risk confusing bonds that exist out of a company’s genuine desire to push forward a green programme with those that are little more than greenwashing. That’s to say, companies issuing debt as green bonds, but then using the money raised for other purposes, such as financing pet projects. 

There’s no clear demarcation between where the one ends and the other starts. Partly, this is because green bonds aren’t necessarily ring-fenced project financing, but rather tend to sit on the issuing company’s balance sheet and thus are part of the total mix of assets – which is why green bonds are generally assigned the company’s credit rating. While ratings agencies are increasingly taking ESG factors into account, it’s unlikely their ratings methodologies will change substantially in the near future. At the same time, green bonds are assigned the carbon footprint of the issuer rather than that of the project for which the funds are being raised.

Fig. 4  - Sustainable advantage
Performance of green bonds (GREN: ICE BoA Merrill Lynch Green Bond Index) vs euro corporate bonds (ER00: ICE BoA Euro Corp IG Index), total local currency return, rebased to 31.12.2010=100.
Green bonds performance chart
Source: Bloomberg, ICE BoA Merrill Lynch Indices, Pictet Asset Management. Data covering period 31.12.2009-27.07.2020. Past performance is not a guarantee or a reliable indicator of future performance.

For instance, Spanish energy company Repsol issued a EUR500 million bond in May 2017 with the claim that it would save 1.2m tonnes of carbon dioxide per year. But it was excluded from the main green bond indices after critics including the Climate Bonds Initiative, a non-profit institution, argued that it failed to change the company’s business model, and merely offered incremental progress.6

Or take Teekay Shuttle Tankers, owner of one of the world’s largest fleets of oil tankers which set out to raise at least USD150 million to build four new fuel-efficient ships with a green bond. It fell short, in part because investors questioned how green even a fuel-efficient oil tanker could possibly be.7 

Another complication is how some issuers are extending the concept of green bonds to other environmental objectives. For instance ‘blue’ bonds that are related to investment in water infrastructure, or ‘social’ bonds that promise wider societal impact have seen renewed interest following the global coronavirus epidemic.

Sometimes it makes sense to look past the green label and to invest in ordinary securities issued by a truly green company. Some firms with a strong environmental pedigree have shied away from issuing green bonds because of the still small size of the market and its specialised nature, or because they calculate they are not being compensated for the additional compliance costs associated with green bonds.

So, for instance, only three car companies have so far issued a green bond and Tesla, a leader in the field of electric vehicles, isn’t one of them. And that’s notwithstanding the sector’s wider push into green transport, particularly electrification.

And while green bonds are certainly attractive for sovereign issuers – spreads on their green bonds are generally tighter than for conventional debt, according to analysis by Barclays – the benefits for investors are less clear. As a class of instrument, sovereign green bonds haven’t shown themselves to outperform conventional bonds or to be less volatile, including during times of market stress, the study argued. Any advantages of the green market are generally down to compositional effects.8 Which reinforces the need for investors to take a studied approach to these investments.

05

Setting standards

But for all the grey areas in green bonds, matters are improving. Some of that improvement comes from best practice, some comes from industry bodies, and some from regulators.

Through their industry body, the International Capital Market Association, investment banks and other capital market participants have established Green Bond Principles, a voluntary set of guidelines promoting transparency, disclosure and reporting standards for green bonds, but not, however, what sorts of investments might qualify. 

A voluntary industry code determines what qualifies as a green bond – the Climate Bonds Initiative has defined the range of eligible activities. These, in turn, are verified by a third party approved by the Climate Bonds Standard and Certification Scheme. The greenness of the bond can be verified further by independent external agencies such as Sustainalytics. And data provider Refinitiv recently launched the first ever league tables for sustainable finance, rankings that will help unearth the best of the field.

The EU's recovery fund could trigger a step-change in the availability of low-risk green bonds.

Finally, government agencies have been getting involved. The EU has led the way by passing Green Taxonomy legislation, establishing the world’s first official “green list” which classifies environmentally sustainable economic activities and which is key to laying the ground for the EU to become climate neutral by 2050. This legislation is also fundamental to the establishment of a green bond standard for the EU, which is already at the planning stage. This could throw up a challenge to the industry – by one estimate less than a fifth of the MSCI Green Bond Index would meet the requirement of the EU green bond standards.9

Meanwhile, the EU’s recently agreed EUR750 billion recovery fund could trigger a step-change in the availability of low-risk green bonds, according to industry analysis.10 As much as a third of the fund could be green spending.

But quantifying what are often qualitative aspects of operations is a challenge and the field is still new. Agencies that rate companies on ESG criteria can provide wildly differing assessments, depending on the weights they give to various factors, such as industry, operating region and management intentions.

Given all the complexities involved, investors need to take a careful, analytical approach. Some green bonds are greener than others. Some ordinary corporate bonds issued by green companies will be greener than green bonds. And sometimes, ordinary debt finance raised by companies in dirty industries will be put towards environmentally worthy investments – especially when the firm is looking to fundamentally change the nature of its operations. Balancing environmental credentials with social factors also demands taking a broad view of the market. No single green bond should be assessed in isolation of the issuing company’s overall strategy towards a greener more sustainable business model.