Green Bonds – are they colouring investors’ judgements?
Green Bonds (GBs) are an emerging area of debt markets that have been receiving an increasing amount of interest from both issuers and investors alike as they look for ways to improve their environmental or “green” credentials. The “green” tag tends to evoke a positive emotional response and has prompted predictions that this new asset class has huge growth potential across the globe to fund a wide array of projects. Marketing aside we would suggest that simply because a bond is labelled “green” it doesn’t circumvent the investment disciplines when assessing the risk and return. We view the “green” element as only one of many factors that ultimately drive the risk and return evaluation of a bond and hence drive the ultimate investment decision. When allocating capital as an investor ‘caveat emptor’ very much applies to GBs.
What are they?
Whilst the exact definition of a GB may vary, they are typically a bond where the proceeds will be applied towards new or existing green projects which are defined as activities that promote climate or other environmental sustainability purposes. Examples include renewable energy, sustainable waste management, clean transport and biodiversity conservation to name a few.
The market has continued to grow and diversify and total global issuance since 2007 has totalled USD$60bn1 of which USD$37bn was issued in 2014. The bulk of issuance had come from AAA rated supra-nationals although issuance from private corporations continued to rise and represented 43% of the 2014 issuance.
With the GB market still in the early stages of development there remains a lack of standard definitions about what makes a bond “green”. There is not a GB regulator or governing body although there is a set of GB principles issued by the ICMA2.These principles are voluntary guidance to participants for the issuance of GBs however they do not specify what exactly make a bond “green”. As such in some cases green reference in some bonds can be quite tenuous. We have seen an example where the proceeds can be used for “general corporate purposes” if no green projects are being undertaken. Also issuers with core businesses that are not green can issue a GB for a special project.
GBs can be compared to traditional bonds that do not have a stated specific green component but still have to comply with a myriad of existing environmental rules and regulations and other applicable laws.
Are Green Bonds lower risk?
GBs are subject to the same risk as traditional bonds as well as several other considerations. Like any bond they are subject to credit risk, term risk, liquidity risk and structural risk considerations. They are not ring-fenced from the overall risks of the issuer. Corporate or issuers GBs are not specifically government backed or guaranteed.
Importantly they are also subject to environmental risk or environmental default. A GB has an additional layer of standards it must continue to meet to retain the “green” tag. This is usually monitored annually and if the use of the proceeds of the bond in the opinion of the auditor or certifier3 no longer meets the green requirements (for which there is no agreed list) it will lose its green status. This is sometimes termed an environmental default as it has failed to meet its obligations.
In addition investors need to be attuned to the potential practise of “greenwashing”. This can occur in several ways but mainly where the GB proceeds are used to fund activities that are not sufficiently green, or it could be that issuers with core businesses that are not green issue a GB for a side project that is considered green and used to improve its green credential with customers and investors.
Furthermore a green project is not necessarily superior in terms of credit risk. For example green technologies that are untested or projects that are unable to achieve sufficient scale or cost efficiencies to be commercially viable carry real risks. We view GB as having the risks of a traditional bond plus the additional risk of environmental default.
One question that will be answered over time is whether investors value the green component of the GB. If they do then one may argue that the GB credit risk premium would be lower than a comparable corporate bond. As such a GB where the green component is valued could on one hand provide the investor with a lower return than a comparable traditional bond.
We would argue however that a GB in itself does not alter the fact that investors are subject to credit risk, term risk, liquidity risk and structural risk. These risks are not removed with a green tag and still need to be priced appropriately. In fact the additional risk of environmental default and greenwashing could suggest these added risks need an additional risk premium.
A change in the issuer’s business model or a change in rules or regulation or methodology of certifying green bond is a real risk that needs to be assessed and priced. The loss of green credentials could have a negative effect on the price of a bond and also likely to have an impact on liquidity as mandated green bond funds sell their investment and potential buyers may baulk at an issuer suffering reputational damage. In our view GBs do not provide valuation uplift.
For each corporate bond that we invest in we undertake a full fundamental credit assessment. This includes analysing use of the proceeds from the bond raising, the sustainability and variability of the cash flows that the project and the company generate and importantly the appropriate valuation required for the associated risks. The fact that it is used for “green” purposes in itself is not sufficient and “green” purposes are not risk free.
Successful investing requires investors to be appropriately rewarded for taking risk, broadly in this case for the credit, term, liquidity and structural associated risks. Green or not these key tenets of investing are what drive our process when we are lending out our clients capital. After all, our success is based on the issuer paying all of its coupons and capital at maturity. Green bonds still carry default risk.
On the broader issue of ESG our approach is to consider the ESG factors of the issuers and in particular how they impact the sustainability and variability of the companies cash flows; hence its ability to repay capital. For example a company with poor environmental standards and processes that do not meet the legal and regulatory requirements has a higher risk of loss of revenues from forced closure of operations and fines and associated costs.
GBs have been receiving an increasing amount of interest from both issuers and investors alike as they look for ways to improve their green credentials. We view the green element as only one of many factors. As with traditional bonds GBs are subject to credit risk, term risk, liquidity risk and structural risk considerations, and importantly they are also subject to environmental default risk. It could be argued that the additional risk of environmental default requires an additional risk premium to compensate for this and potential liquidity concerns.
We would suggest that simply because a bond is labelled “green” it doesn’t circumvent the investment disciplines when assessing the risk and return. Each investment needs to be subject to a fundamental credit assessment no matter what the proceeds are to be used for. It is only through such a process that the real extent of the risks can be assessed and priced. Calling something green does not make it risk free and should not colour investors’ objective judgement.
1Source: RBC Capital Markets
2The ICMA is the International Capital Markets Association which is a self-regulated trade association with a mission to promote resilient and well-functioning international debt capital markets.
3As there are no agreed set of standards or accredited third parties to certify the GBs the auditor or certifier are typically an independent consultants with expertise in this area that will provide an opinion usually based on the GB principles.
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