Understanding Green Bonds

Understanding Green Bonds

This fairly new asset class is growing rapidly.

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Reviewed by: Debbie Carlson
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Edited by: Debbie Carlson

[This article appears in our November/December 2021 issue of ETF Report.]

The green bond market could soon reach US$1 trillion in annual issuance volume globally by 2023, as governments, supranational entities and corporations make pledges to reduce carbon or have net-zero carbon emissions by 2050.

That’s still a tiny part of the $100 trillion total global debt, but considering the infrastructure upgrades that must be made to cut greenhouse gases—everything from improving the electrical grid to developing more efficient use of natural resources—the debt markets will play a key role in financing these projects.

“Green bonds are really well-suited to achieve those goals,” said William Sokol, product manager, ETFs, for VanEck, which issues the VanEck Green Bond ETF (GRNB).

But the market is still relatively new, having launched in 2007, when the World Bank and the European Investment Bank issued AAA investment-grade bonds from multilateral institutions, according to the Climate Bonds Initiative, a global nonprofit focused on using debt markets for climate solutions.

Green bonds fit in the larger environmental, social and governance framework, but advisors interested in adding them to client portfolios should understand their differences.

Funding Environmental Projects
Green financing has always existed in some respects, such as when municipalities would issue bonds for stormwater remediation, observes Trenton Allen, managing director and CEO at Sustainable Capital Advisors, which specializes in sustainable finance, including project finance.

What’s different now is, under the green-bond structure, investors can isolate and track the environmental component of the proceeds’ use, Allen explains, adding that by offering green bonds, issuers might be able to increase their investor base, and perhaps demand for their particular bonds, which may reduce their overall funding costs.

Although the issuer offers additional information about the bonds by explaining proceeds use, Sokol says investors still need to do their standard credit due diligence before buying these.

When green bonds come to market, the Climate Bonds Initiative reviews issuance using a taxonomy it developed based on the latest climate science and research from the Intergovernmental Panel on Climate Change, the International Energy Agency and other experts.

The taxonomy includes a broad list of assets and projects that will help reduce greenhouse gas emissions by 50% by 2030, and will achieve net-zero by 2050. Based on the list, it will designate whether a green bond meets its taxonomy, and its designation is considered the gold standard for third-party certification.

The group’s taxonomy includes eight categories for green bonds, including energy, water, buildings and waste.

Some green bonds get oversubscribed and have a “greenium”—a green premium, which means their yields are lower than a similar non-green bond. However, TD Securities notes premiums in recent green-bond sales have declined, so this may become less of an issue for income seekers.

How Green Bonds Fit With ESG
Ashley Schulten, head of responsible investing for global fixed income at BlackRock, which offers the iShares Global Green Bond ETF (BGRN), points out that green bonds share some similarities with other ESG-type offerings, but they aren’t interchangeable.

Green bonds focus specifically on the “E” part of ESG. Many sustainably minded investors often consider all three pillars of ESG, so they may avoid buying a green bond from a company that doesn’t consider the social or governance criteria.

ESG investments are subjective, Sokol notes, and an overall ESG score is based on several data points, while green bonds are solely about proceeds earmarked to a project: “You’re not necessarily looking at ESG scores, or even the broader activities of the issuer.”

Companies that are just starting to address climate change internally may offer green bonds as a way to fund that transition, Schulten remarks.

“I think those are the most interesting stories in the green space,” she said. “How can we use this funding tool to help companies go through this really rapid restructuring of the types of businesses they do, even if their parent company might not be the chosen child of today’s ESG portfolio?”

Jim Pratt-Heaney, founding partner of Coastal Bridge Advisors, stresses that advisors need to understand the distinction between green bonds and ESG if they’re considering green bonds for their sustainable investors.

“You have to look at the broader picture. For instance, if a project sounds really good, but [the issuer] is horrible to their people, I wouldn’t call that a green bond,” he noted.

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Avoiding Greenwashing
Sustainable investing’s popularity has led to some “greenwashing,” in which issuers sell green bonds that don’t align with carbon reduction. For example, a few years ago, Spanish energy company Repsol issued green bonds to make their oil refineries more energy efficient.

Mark Haefele, chief investment officer, global wealth management, at UBS, reassures investors that greenwashing isn’t widespread, and he expects it to become less of an issue as regulations and external reviews become more prevalent.

To identify greenwashing, UBS verifies whether the issuer is only refinancing existing activities or projects they must implement; is investing mostly in non-green business or aims to maintain existing polluting activities for as long as possible; doesn’t set any ambitious environmental targets on a corporate level; and how much transparency it offers.

BlackRock’s Schulten observes there aren’t huge incentives to greenwash bonds because of the transparency involved in stating bond proceeds. What investors may see are some debates about what can be included as green, such as blue hydrogen, which is made from methane.

“I think there is this agreement that we really need to stay away from fossil fuel upgrades in green bonds, or if they’re extending the life of some of these assets,” she explained. “[Those] have to be decommissioned if we’re actually to have any shot of getting to net zero.”

“Transition” bonds have started to become a small part of the green-bond market. These are bonds of companies that are legitimately transitioning from fossil fuels by aligning with Paris Agreement goals to reduce carbon emissions.

“There’s this whole spectrum now where you can be dark green or light green,” Sokol said. “Investors can take different views of what they want to invest in.”

VanEck’s green-bond ETF’s methodology doesn’t include transition bonds because, if the bond issuer’s offering doesn’t align with the Climate Bonds Initiative’s definition of green, the firm won’t include it.

“As the green finance market expands, I think there’ll be the ability to differentiate,” he noted. “I guess the question is whether investors want that lighter green transitionary [bond]. We’ll have to see.”

Expanding The Market
Sustainable Capital Advisors’ Allen expects this market to continue to grow, especially if issuers believe there’s a way to expand their investor base, and he adds that if growth continues, it needs to be met by ever-improving transparency into proceeds’ use and metrics that can quantify outcomes such as the amounts of carbon avoided or energy saved.

“As we start to get comfortable with the longer-term disclosure and performance of these particular assets, how are we going to deem impact and how will we evaluate targets?” he asked.

Schulten believes issuers have also become more comfortable with giving information and understanding what data investors want, which helps bring more credibility to the sector. With the green bond markets expected to reach US$1 trillion in annual issuance volume in a few years, she says she’d rather see a better market than a bigger market.

“I’m not keen on seeing growth just for growth,” Schulten noted. “If growth is there, because the actual projects are there, then great. But let’s not widen our standards just to incentivize larger AUM numbers.”

Debbie Carlson focuses on investing and the advisor space for U.S. News. She is an internationally published journalist with bylines in publications including Barron's, Chicago Tribune, The Guardian, Financial Advisor, ETF Report, MarketWatch, Reuters, The Wall Street Journal and others.