Green bonds are a relatively new financial instrument to fund environmentally friendly projects. We attended a recent expert CFA seminar, Beyond the ESG Label: Green, Social and Sustainability Linked Bonds, for updates on market trends and the issuance headwinds in 2023.
We consider a number of market concerns and discuss the efforts of regulators, investors, and standard setters to address them. Ultimately, strong demand for trackable green bonds should lead to resumed growth in green-bond issuance.
The European Investment Bank (EIB) introduced green bonds in 2007 as a way to fund climate-related projects. The market grew rapidly for over 10 years. Green bonds are issued by countries, renewable energy companies, and companies transitioning their operations. Money is raised for projects to improve energy efficiency, add renewable energy, reduce pollution, instill sustainable resource practices, develop technology, or protect ecosystems.
The bonds are usually linked to the asset itself, but they are also backed by the issuer’s general credit so will often carry the parents’ credit rating. Green bonds often have various tax benefits associated with their issuance for buyer and/or seller.
From their introduction in 2007, global green bond issuance rose rapidly to $200 billion in 2016 and then to $1 trillion in 2021. The origins of the market were sovereign debt, so growth to about 40% of green debt issuance being corporate in 2021 was seen as a good trend of market acceptance of this security type. Additionally, several mutual funds and ETFs focused on green bonds allow retail investors to participate and add greater breadth to the market.
Heading into 2022, expectations of 40% growth ended up quite wrong as issuance contracted to about $600 billion with corporate totals just over $350 billion. Coming into 2023, expectations were that issuance might climb back to $1 trillion. So far, though, issuance levels are only similar to 2022 with issuance activity skewed geographically to Europe and emerging markets that want to show emissions progress.
Some media sources have reported “green” shoots in the market, if you will, so perhaps we are beginning to see a recovery. In any case, year-over-year comparisons in issuance should get easier as 2023 progresses, so there is still a chance that 2023 issuances will again reach $1 trillion.
Panelists spoke a lot about six key issues the green bond market faced in 2022—and indeed much of the market for ESG—that each contributed to slowing the market. Given investor demand for green initiatives, the issues highlighted below seem more like road bumps where the market slows temporarily rather than reaches the end the road. The issues are making both issuers and investors step back until concerns are addressed, a process akin to the market maturing rather than failing.
One issue that has arisen over the past couple years is tracking the actual use of proceeds by the issuers in as much as the funds were comingled with general corporate monies. Resolution seems underway with calls for greater post-issuance transparency into project progress.
A second issue mentioned at the seminar was the general lack of quality or even availability of reported metrics after issuance. Even if deemed “green,” how is green defined or measured through time? This issue has plagued the general ESG market as reported metrics around the world have been inconsistent or unavailable.
Investors have pulled back from the topic, and issuers have pulled back from the market until the rules are made clearer with standards and consistent metrics. And as with the ESG market, a lot of work is being done to identify metrics and provide a more consistent and focused set of KPIs to track.
While news headlines portray ESG and green bonds are losing favor, investor demand is still driving progress. Investors are giving more pre-issue feedback to syndicate desks on what each fund needs. Issuers are responding to the call for greater transparency and regular, follow-on reporting of investment progress.
Emissions were said to be easier to measure and report, so that focus topic may be an area of key agreement in the market. Conversely, measuring social progress, for example, may be more amorphous and difficult. One simple idea is for every company to report how much gasoline, diesel, jet fuel, natural gas, and coal they purchase each year. This data is no doubt available and would instantly scope out the vast bulk of the hydrocarbon emissions supply chain.
A third issue is that existing bonds have not always been provided adequate protection from non-compliance of bond terms. Green bonds often are certified by a third party such as the Climate Bond Standards Board as being truly green. Part of the problem has been inconsistent certification or assurance by third parties that proceeds were indeed being used for green projects.
If deemed that a project funded by the green bond was no longer green, there was often no penalty to the issuer for lack of compliance. Investors faced illiquidity if forced to sell because the bond in question was no longer graded green. Speakers even questioned whether a 25-basis-point interest rate step-up on some bonds was sufficient penalty for non-compliance.
Helping to resolve the market’s concerns about post-issue compliance will be greater transparency in reporting progress to achieve the goal of a green bond. The International Capital Market Association (ICMA) encourages post issuance periodic reporting as a best practice, though many might also say the market is pushing it as a standard practice.
A fourth issue is when a green bond that has been certified on issuance is no longer “rated” or certified by third parties, perhaps because of lack of information. Resolution of this issue requires greater commitments from the certifying assurance firms to track a bond through its life cycle. Greater transparency and trackable metrics should make this easier to accomplish.
Issuer confusion is a fifth issue. As with ESG investing in general, there’s been a plethora of standards from a plethora of rating agencies, exchanges, index providers, buy-side groups, intergovernmental (e.g., EU) dictates, and international standard bearers. Pending EU and SEC guidelines, and allegations of greenwashing—the practice of presenting investments as environmentally friendly when they are not—have each led issuers to pull back from the market until greater certainty returns. The market needs to realize, too, that an issuer does not face the same post-issue rules and requirements for regular bonds compared to green bonds.
Resolution here will come with greater consistency between standards. But what to report? Though many groups and subgroups are meeting to unify the rules, it’s a period of uncertainty and, once standards are set, a period of waiting to develop metric reporting systems.
Information is getting better year over year, though a central repository of good information was said to be lacking. Europe was again noted as the leader in this regard, and companies trading with the EU will need to comply. Hence Europe in many ways is pulling the world along.
The EU’s Commissions’ International Platform on Sustainable Finance and its Common Ground Taxonomy Project should help narrow the gap between different standards. In the United States, the SEC’s disclosure rules—already proposed but awaiting finalization later this year—also have some on the sidelines until full clarity is in hand. Questions about the economy’s trajectory are a coincidental uncertainty that should also be resolved in coming quarters.
A sixth issue is that several analysts have stated that green bond issuance has not translated into cheaper financing for issuers nor pricing differentials. Perhaps this is due to similar underlying credit metrics to the parent issuer.
One possible resolution is policy support for private green bond issuance through the government-underwritten green bonds. For example, the EU Commission’s plans to fund a massive €250 billion of NextGenerationEU green bonds should, in part, drive capital flows into these kinds of assets. And the U.S. Inflation Reduction Act (IRA) should also support new green bond issuances once funds are released and paired with other fund raising.
In addition to the market’s call for greater information on green projects, the higher cost of money, (i.e., high interest rates) has coincidentally put issuers somewhat on their back feet. As we have heard in other contexts, panelists stated the recent interest rate levels were less of the issue than the volatility in rates. As a result, resolution of that headwind—and perhaps for investing activity in general—will be greater stability or even a convincing slight moderation in rates in the quarters ahead.
Many of the green bond market’s headwinds are either shared by all markets (i.e., from interest rates) or should be resolved with greater transparency, more consistent global regulatory guidelines, regular reporting of consistent metrics, regulatory funding support, and stronger certification programs. There remains great societal and investor interest in all things “green,” so there remains strong underpinnings for the green bond market. Activity has retreated toward higher quality companies and sovereigns, which are deeply involved with developing future standards and are able to afford reporting requirements that many smaller companies can’t. All in, it seems like a market undergoing growing pains rather than a slow death.
FactSet partner LGX Datahub offers granular data in the sustainable bonds market. Created by the Luxembourg Stock Exchange in 2016, LGX has a leading market share of listed green, social, sustainability, and sustainability-linked bonds worldwide.
Jacqulin Kuk of FactSet contributed to this Insight article.
Green bonds, climate bonds, and sustainable bonds are terms often used interchangeably. But as the market is maturing, specific definitions are developing. Sustainable bonds is the overarching category and can include green and social bonds. Green bonds are issued to finance new or existing projects or activities aiming for a positive environmental impact. Social bonds finance projects or activities that aim to achieve positive social outcomes such as reduced poverty and support for migrant workers, unemployed individuals, and people with disabilities.
Climate bonds are a subset of green bonds more focused on carbon emissions or adaptation.
Blue bonds are also a subset of green bonds focused on water related ecosystems, including oceans and fisheries, coral reefs, and reduced acidification.
While sustainable bonds help finance green and social projects, sustainability-linked bonds may be used to finance anything. However, the latter carries covenants linking coupon payments to the issuer’s progress in achieving sustainability commitments.
Types of Green Bonds
Source: Climate Bond Initiative
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