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Mirko Gerhold, Head of DCM Bonds Solutions, explains the evolution and benefits of the green bond sector.
A look at the rise of the green bond market
First of all, what would you argue are the key benefits of green bonds for issuers and investors?
Many investors now have an environmental, social and governance (ESG) strategy or run dedicated portfolios that are subject to certain socially responsible investment (SRI) criteria. A green bond allows them to invest directly into something that is seen to be environmentally beneficial and where the goals of the investment are transparent and accountable.
Issuers, meanwhile, can benefit from the additional investor demand that green bonds attract. A green bond also allows issuers to diversify their investor base and visibly allows them demonstrate their commitment to sustainability.
Additionally, a green bond offers issuers a valuable internal learning process. They have to look at the project being financed and their own ESG performance. They are encouraged to report on what impact the financing has had. That, in turn, allows them to benchmark their ESG performance against others. The upshot is that issuing a green bond encourages organisations to scrutinise their own environmental efficiency and impact. If that ultimately results in a company using less power or water and saving money, that has to be a good thing.
2016 is expected to be another record year for green bond issuance. Looking at the next two to three years, what are going to be the important trends to watch?
Diversification across sectors and regions will continue. I think we are going to see lots more issuance activity out of Asia, but also in Europe and the US more issuers will tap the green bond market. At the same time I expect that many investors will continue to increase their focus on sustainability and set up additional portfolios for investments in the green bond market.
Alongside growing issuance volume, there are some significant qualitative developments taking place that will help establish green bonds as an asset class. For example, we’re seeing the development of impact reporting, further enhancement to the Green Bond Principles and market indices are being established. Once you've reached a certain stage it's quite likely growth will accelerate as these different initiatives all begin to work in the same direction.
So how did this come about? What are the origins of the green bond market and how has it progressed?
The first transaction to be defined as a green bond was the Climate Awareness Bond issued by the European Investment Bank in 2007 to fund projects contributing to climate action. EIB was the pioneer in this market and is still the biggest issuer in the green bond market today.
For the next five years, the market was limited to supranational, sovereign and agency (SSA) issuers. Then in 2012 we saw the first issue coming out of the corporate sector and in 2013 banks also joined the green bond market. At the same time, SSA issuers began to issue much larger transactions. Since then, we’ve seen rapid growth across multiple sectors, currencies and regions, and 2016 is on course to achieve issuance volume of over €60bn (US$66bn). This July also saw the largest multi-tranche green bond transaction to date — a US$3bn multi-currency transaction from the Bank of China. It’s still a very young market but one that’s clearly starting to attract substantial volumes.
What defines a green bond?
There are no hard and fast rules to which issuers need to adhere. However, participants have come together to create common frameworks. So for example, the Green Bond Principles (GBP) were introduced in 2014 to provide voluntary guidelines for the development and issuance of green bonds.
Under the GBP, a green bond is defined as any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance in part or in full new and/or existing eligible green projects. The issue has to be aligned with the four core components of the GBP, which address use of proceeds, the project evaluation and selection process, management of proceeds and reporting.
The GBP are supported by over 100 members, including issuers, investors and underwriters. At Commerzbank, we conducted an investor survey, which indicated that two-thirds of investors regard compliance with the GBP as a minimum requirement for investing into a green or sustainable bond issue. So while there is no legal definition for a green bond, a widely-accepted framework is emerging.
What activities is the sector helping to finance?
The scope of projects that can be supported is extremely wide. The Green Bond Principles mention nine different examples for eligible categories spanning renewable energy, energy efficiency, pollution prevention, sustainable management of living natural resources, biodiversity conservation, clean transportation, sustainable water management, climate change adaption and eco-efficient products and technologies.
In addition to green bonds, we are also seeing issuance of social bonds where the projects being financed or refinanced are of a social nature such as a portfolio of loans for social housing. As part of the 2016 update of the Green Bond Principles, a note has been released recommending that this whole framework of the Green Bond Principles can also be used for social bonds.
Quantifying the impact of green-bond funded projects has become a big focus, hasn’t it?
Absolutely. Impact reporting — evaluating the environmental or social impact of projects financed by green bonds — is an important topic for both issuers and investors. But the questions remain as to what reporting standards and requirements to impose.
For example, a major and frequent green bond issuer may have the resources to develop an extensive reporting framework. But what about a smaller corporate issuer issuing a one-off green bond? You can’t impose the same impact reporting demands on two such different issuers.
The Green Bond Principles are therefore looking to build a framework that encourages issuers to provide impact reporting, but only where this is feasible, i.e. it is not so strict that it deters smaller issuers from coming to the market. Hopefully that will deliver a solution that’s acceptable to everyone, while allowing meaningful assessment of whether green bonds are meeting their funding goals.
Green bond specifics
Looking at the structure of green bonds, they tend to be very similar to normal bonds in terms of duration, coupon payment or ratings. Is that likely to stay the case?
Yes, that's the case for what is called a green ‘use-of-proceeds’ bond. To explain, the Green Bond Principles define four different types of green bond structure including project bonds or securitised bonds where the credit quality of the bond is directly attached to the cashflows of an underlying project.
But use-of-proceeds bonds — the type of green bond responsible for the rapid recent growth in the sector — are just normal debentures, so all the requirements that apply to a normal bond issue also apply to a green bond. The only difference is that the issuer states that it is going to use the proceeds of the bond issue to finance or to refinance specific green projects.
This means that pricing is also similar?
Yes. That is because the rating of a green use-of-proceeds bond is the same as the rating of a non-green bond of the respective issuer. In addition, a green bond is placed with normal fixed income investors and not all of them have a special environmental, social and governance (ESG) focus. As a consequence you don’t yet see green bonds being priced tighter than standard bonds. However, in some cases issuers were able to pay a lower new issue concession at time of issuance and some repeat issuers have established a green curve below their normal secondary curve. It will be interesting to see if further pricing differences will emerge and if the greater demand for green issuance leads to lower spreads.
Is the additional work involved issuing in a green bond — getting a second opinion, reporting on the use of proceeds, impact reporting and so on — sufficiently balanced by the fact that being able to call something a green bond increases interest in the market?
It depends. There is some extra work involved in issuance of a green bond. For example, as you mention, it’s become the market standard that an independent agency with experience in the ESG sector provides a second party opinion. But from a cost point of view it’s not expensive. For example, depending on the nature of the project and the agency you talk to, securing a second-party opinion may cost €20,000-€50,000, which isn’t much compared to the other external costs that a bond issuer normally incurs.
But certainly, there is extra work in terms of setting up internal processes and reporting over the lifetime of a green bond. I think it’s a strategic decision whether an issuer wants to make that commitment. Some issuers say, ‘Well, there are only limited benefits because there is no real cost advantage in issuing a green bond yet’. But many other issuers see a green bond as a powerful tool that fits very well into their sustainability strategy, which helps to improve the environmental awareness and performance of the company and allows diversifying the investor base.
You’ve forecast that green bond issuance is likely to exceed €60bn (US$66bn) this year. How do you see this market developing in the future?
First of all, it always takes time to grow a new market. And growth rates of the green bond market have been tremendous across sectors, regions and currencies.
In addition, there are different ways to support the market further. You could create monetary incentives for green bonds to make them cheaper; for example in China, they are working on tax benefits for green bonds.
Alternatively, governments can introduce additional regulation which may help grow the green bond market. For example in France, institutional investors are now required to disclose their position in relation to environmental risk and carbon exposure. This could be an additional catalyst to the market.
But it is not only about size and growth. We also need to look at what the bond proceeds are actually being used for. To help meet climate change targets, for example it may be beneficial to create additional incentives to channel the proceeds of green bonds towards the projects that will most help to achieve these targets.
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