The green bond market has grown and evolved rapidly as investors have become more environmentally aware. Now the green bond market represents a valuable compliment to more traditional responsible investment equity funds and some would argue offers a more direct method of supporting responsible investment initiatives.
What is a Green Bond?
Green bonds are simply one of the latest types of themed bonds which trace their origins back to the railway bonds of the 19th century and more famously the Victory Bonds issued by the USA during World War II. In general theme bonds are designed to:
- allow institutional capital to invest in areas seen as politically important to their stakeholders that have the same credit risk and return profiles as standard bonds,
- provide a means for governments to direct funding to desired areas via preferential tax treatment, and
- provide a political signal to other stakeholders.
Importantly, financial products cannot be green per se – greenness is derived from the uses to which the funds are being put i.e. the underlying assets or activities. So, the definition of what constitutes a green bond ultimately occurs at the level of the underlying assets or activities. While the definition of a green project will vary from investor to investor, it is possible to set down some general criteria as to what constitutes a green project. Green bonds can be broadly defined as fixed income securities issued (by governments, multinational banks or corporations) to raise the necessary capital for a project which contributes to a low carbon, sustainable economy.
Types of Green Bonds Available
Investors need to consider that green bonds are just like a traditional bond and should be viewed accordingly. Like traditional bonds, there are four main types of issuance which may occur namely:
- asset backed (tied to a pool of green projects or refinancing of green projects)
- corporate bonds (issued by a “green” company or funding a “green” project)
- bonds issued by international development banks to fund green projects
- sovereign or municipal bonds
Up until relatively recently most issuance had occurred in the last two categories. This is unsurprising given the lack of a standardised definition of a green bond. In the absence of clear standards investors have relied on the credibility of issuers in the space, who have due diligence and monitoring processes built into their products. For this reason, the initial growth in the market had been driven by organisations like the World Bank which has (a) global credibility, (b) longstanding relationships with sovereign nations and (c) an ability to access special deals on projects and repayments which lowers default risk. However, as the market evolves and standardisation increases the use of asset-backed structures is expected to increase dramatically.
A more grass roots method to helping the planet
For many investors, the logical path for helping the environment is to invest in responsible investment equity funds. However, at this stage investors may face a tradeoff. Responsible investment funds apply various screening processes to invest in, or tilt towards, those companies which are deemed as being ’responsible‘ while rejecting, or tilting away from, those which are deemed as ’irresponsible‘. The application of a screening process means that investors face the prospect of investing in a restricted investment base. This has implications for equity portfolios which aim to achieve a level of diversification or are required to perform in line with a broader based market benchmark. Accordingly, there can often be a tradeoff between being socially responsible and achieving the desired level of diversification within an equity allocation.
Green bonds may assist to partially offset this limitation in several ways. Firstly, by using an investment type investors are already familiar with, i.e. a traditional fixed income structure, green bonds facilitate the seamless integration of environmental initiatives into portfolios. Secondly, green bonds, unlike most listed equites, can be used to more easily fund specific projects. Indeed, as part of the requirements to qualify as a green bond there needs to be a clearer identification of the funds raised with the particular projects and the associated environmental benefits. To illustrate the NAB green bond issued in early 2017 targeted growing demand for solar and wind projects in developed markets whereas the smaller green bond issue by FlexiGroup (in April 2016) specifically targeted the financing of rooftop solar panels. Therefore, a company which is undertaking specific actions to reduce their carbon footprint may be able to issue green bonds specifically to fund such actions even though they may be removed under common divestment equity screens due to the current ESG scoring assessment of their carbon emissions. The project specific characteristics of green bonds allows investors to not only allocate investment funds to specific projects but also to more proactively allocate funds to desired programs as responsible investment priorities evolve over time.