It's time to rethink Green Bonds
People are angry.
Recent widespread protests over climate change and the rise of Greta Thunberg have highlighted the need for politicians to take action. Of course, transitioning the global economy to a sustainable model requires significant investment. But the current financing tools at the disposal of policymakers are ineffective.
Yes, I’m talking about green bonds.
Green bonds have been an incredibly successful addition to global capital markets since their introduction in 2007. We’ve seen tremendous growth in issuance, and they’ve done a great job in raising awareness amongst issuers, investors and dealers, bringing much needed visibility to the ESG investing movement.
However, green bonds, in their current form, will not stop climate change. The current model fall down on several fronts:
1/ The data doesn’t show any significant pricing advantage. When coupled with the reporting requirements, they can actually become more expensive than other forms of issuance.
2/ It’s difficult to prove that the projects being financed wouldn’t have been financed if the issuer didn’t issue a green bond.
3/ Political change can completely derail a project after the issuance, especially when it comes to sovereigns issuing green bonds. Case in point: in 2016-17 Mexico City issued $6bn in green bonds to fund construction of an airport (a transaction laced with irony), only for the project to be cancelled by the new government in 2018.
4/ If investors start to pick and choose which green projects to finance and which ones to pass on, the overall cost of funding could actually go up. International development banks enjoy top ratings and do a fantastic job of leveraging their credit quality to raise capital very cheaply and generically at rates below LIBOR, repurposing that capital for development projects around the world. Much like insurance, it’s the aggregation of risk that helps bring the overall financing cost down. If purpose-specific issuance proliferates, the benefits of aggregation are missed.
To be clear, we applaud the pioneers of the first generation of green bonds for creating the product and helping to give it visibility. But, we believe there is a major change that is needed to create the second generation.
The end of “Use of Proceeds”
Unless a project is legally ring-fenced and financed like a typical infrastructure project finance deal, the green bond market should move away from evaluating things at the ‘use of proceeds’ level, and should move towards the ‘issuer’ level.
Currently, an oil company could issue a green bond if it has a renewable energy project for which the proceeds can be used. But it would have access to that financing anyway and would complete the project regardless of the green bond market’s existence. It’s not even getting funding arbitrage for labelling that bond ‘green’. The only thing that’s happening is that the investors who commit to allocating a portion of their portfolio into ‘green’ investments can hit those targets, feel good and most importantly, look good.
In reality, green evaluations need to happen at the ‘issuer’ level, not the project level. Significant change will only happen if the relative cost of capital across different industries actually starts to diverge, and a solar energy company can access cheaper financing than an oil company. That doesn’t prevent oil, mining, or other ‘brown’ issuers from setting up wholly owned subsidiaries that have a greener asset mix than the parent. But it does ensure investors can fund the type of development they truly seek, rather than indulge in CSR.
To achieve this, controversially, I believe the SSA sector needs to stop issuing green bonds.
It’s commendable that SSAs issued green bonds initially, as they have helped create the segment and have helped bring a tremendous amount of visibility to the sector. We’ve written about this before and the impact should not be underestimated. However, as a concerned citizen, I rightfully ask why aren’t all SSA bonds ‘green’? Put another way, do any of my favourite SSAs fund ‘brown’ projects?
In 2010, World Bank stopped funding coal fired power plant construction and in 2017 it committed to stop funding upstream oil and gas exploration by 2019. As recently as this summer, EIB committed to end support for all fossil fuels by 2020. These transitions are incredibly important and need to be accelerated.
The world’s top 10 multinational development banks have a combined balance sheet of $1.6 trillion. While it’s important for the private sector investment community – both retail and institutional – to embrace ESG investment, their incentives will always force them prioritise financial risk and return first and other principles second. It’s a fact of life.
Official institutions are the only issuers that can adapt their investment principles in order to scalably deploy considerable financial firepower to the ESG cause. This includes not just increasing their investment in climate mitigation (as they are quick to talk about), but also in aggressively decarbonising their existing lending portfolios. The aforementioned issuer-level ‘green’ rating can then be applied to individual SSA issuers, allowing investors to see how far along that decarbonisation path that borrower has progressed.
Ultimately, the capital markets can play a crucial role in facilitating the move to a greener future. But that will only happen once it’s demonstrably more expensive for a ‘brown’ issuer to finance themselves vis-à-vis a ‘green’ issuer. This will, of course, take time. It will require a combination of evolving investor appetite, the mainstreaming of ESG criteria in investment processes, and regulatory change to ‘force’ certain powerful investors (government pensions etc) to invest only in green projects. It will also require other changes, unrelated to the capital markets, such as carbon tax and of course, further shifts to the public mood.
In order for green bonds to truly deliver on their promise and spearhead a new generation of sustainable finance, they need to evolve. In the short term, by moving the market away from a ‘use of proceeds’ model towards an ‘issuer level’ structure, green bonds can intensify the pressure issuers face in decarbonising their activities and accelerate positive change.