Green Bonds: The Growing Market for Environment‑Focused Investment​

​​Investor interest in green bonds is rising, but thorough risk management is crucial.


Investor interest in “green bonds” is rising, with new issues meeting steady demand. Broadly defined as debt instruments in which the proceeds are applied exclusively toward new and existing environmental projects, green bonds offer investors an opportunity to engage in long-term sustainability initiatives – which may become increasingly critical to the health and growth of the global economy. Green bonds may help investors target portfolio objectives even as they help issuers target sustainability (and business) goals.

However, green bonds pose several investment risks as well. The very definition of a green bond – or the related climate-themed bonds, which include green bonds but are not labeled as such – is a point of controversy; until standards are established, the process of investment research and due diligence remains extremely challenging. Also, though the market is expanding, it is still relatively small ($35.8 billion in labeled green bonds outstanding according to the Climate Bonds Initiative Group and HSBC) and new (the World Bank issued the first labeled green bonds in 2007/2008), with the associated information asymmetries along with general illiquidity. This means thorough risk management is crucial.

Green is growing
The market for labeled green bonds has been growing steadily, with issuance reaching $11 billion in 2013 (see Figure 1). Exemplifying this growth recently is the largest ever green bond issue – $3.4 billion by GDF Suez, the French power company. This bond issue almost doubled the previous record of $1.9 billion set by another French power company, EDF. Issuance of labeled green bonds exceeded $18 billion halfway through 2014 and is likely to reach $40 billion by the end of the year, according to the Climate Bonds Initiative group.


The larger universe of climate-themed bonds encompasses around $502 billion, with 2014 issuance already reaching $60 billion, according to HSBC research (see Figure 2). Many of these bonds are not labeled as “green,” largely because of the lack of standardization in the market, but other reasons may include political or stakeholder sensitivities and concerns over restrictions associated with using the label. Green bonds come from a range of issuers and industries, with transport the dominant sector.


The green bond market also is developing a broader base. Most issuance is in U.S. dollars, but we also see issuance in euros, Brazilian reals and other currencies. Thus far, supranational and agency issuers like the European Investment Bank and the African Development Bank are the market’s dominant players, but non-supranational issuers are also incorporating “green tranches” into their general debt issuance. An example is a floating-rate green bond issued by the Vornado Realty Trust, an owner/operator of office and retail properties on the U.S. East Coast. More recently, there have been a number of U.S. state issues of green bonds, such as the DC Water and Sewer Authority $300 million issue of 100-year bonds at a 4.88% yield to maturity.

A growing green bond market consisting of established agency/supranational issuers has helped clear a path for corporations to tap the market for environmental projects as well. The green bond market reached a milestone in November 2013 when the Swedish real estate company Vasakronan issued the first corporate green bond. Since then, other corporate issuers in several industries, including Unibail-Rodamco (real estate), Unilever (consumer goods), SCA (forestry and paper) and Skanska (construction) have made their entry into green bonds. Low-carbon initiatives in the transport sector are a major source of new issuance: Auto manufacturer Tesla issued a $600 million convertible green bond in May 2013, and Toyota issued an asset-backed security in March 2014 to finance hybrid vehicle loans. In less than a year, corporate green bond issuance has reached over $10 billion and makes up 30% of total green bonds issued to date, according to HSBC and SEB research. While green corporate bonds constitute less than 1% of the total global corporate bond market, they represent a growing segment.

Role in a portfolio
Investors may include green bonds in a portfolio in accordance with specific environmental and social responsibility guidelines or other longer-term objectives. Green bonds may become trophy assets, underwritten by favorable regulation as governments and agencies seek to promote environment-focused investments.

From a portfolio perspective, green bond yields tend to be relatively low, and their returns tend to resemble those of Treasury securities (according to HSBC and SEB research). The reason is that a green bond’s cash flow is reinvested in green projects that usually have government sponsorship, or in some cases, green bonds may provide some tax exemptions, such as municipal bonds in the U.S. Therefore, valuation of green bond securities generally has not been in line with that of securities of the same entity that were not issued for environmental reasons. Historically, markets have demanded generally low risk premia for green bonds. Moreover, some green bonds can be linked to the performance of an index, like the FTSE4Good Environmental Leaders Europe 40 Index, rather than paying a fixed coupon. In that regard, green bonds could serve a defensive function in portfolios. Given their smaller issue sizes (often $200 million to $500 million), green bonds are likely to be held by “hold-to-maturity” types of investors or others over the longer term, and less by liquidity-focused investors.

Challenges defining ‘green’ and related risks
Environmental research is likely to influence the broader economic landscape, and thus the issuance of green bonds, on a potentially large scale: The World Economic Forum estimates $700 billion per year needs to be invested in cleaner energy, transportation and forestry, and the International Energy Agency recommended in its World Energy Outlook 2013 a sustained $1 trillion annual investment in the low carbon economy.

Certainly, the investment community is responding to the movement to sustainable development and practices. The United Nations’ 2006 publication of its “Principles for Responsible Investment” (PRI) was a key development, prompting a growing base of investors to implement environmental, social and governance targets. As of August 2014, the UN PRI Initiative lists 1,087 investors (asset owners and investment managers, including PIMCO) as signatories for the principles; together they represent approximately $45 trillion in assets under management. The UN principles have also encouraged about 30 stock exchanges globally to enhance environmental, social and governance disclosures among the listed companies.

However, unified standards for green investing are still in the early stages – and the confusion raises certain risks for both issuers and investors. Specific to fixed income, a group of 25 leading financial institutions (with administrative support from ICMA, the International Capital Market Association) has begun to develop standards. Their Green Bond Principles recognize several broad categories of potential eligible green projects, including renewable energy, sustainable waste management and land use, biodiversity conservation and clean transportation and water.

However, the set of Green Bond Principles remains a voluntary framework. It doesn’t opine on eligibility criteria for green projects and has no method of enforcement. There is unlikely to be universal agreement on the principles that should govern green bonds, not least because there is scope for differences over whether certain projects – such as retrofitting pollution-reduction technology at coal-fired power plants – can be considered green. Also, not every project may meet broad criteria beyond environmental protection, including contribution to local development and the well-being of local communities, fair and ethical relationships with suppliers and subcontractors, human resources management and good corporate governance.

Issuers are likely to view these factors with caution when weighing the potential benefits of “going green” to reach a wider pool of investors against the additional costs, particularly if the environmental returns on projects are to be monitored over the life of the bonds.

Investors, for their part, should evaluate carefully the risks of investing in green bonds, including limited liquidity, potential for mispricings (which could be risks or opportunities), complexities of research and due diligence given the absence of broadly accepted standards for green projects and investments, and the generally low risk premia.

The market for green or climate-focused investments is likely to continue to grow as climate change raises the urgency for renewable energy and low carbon industries. The principles that underpin green investments like these speak to long-term sustainability of the global economy and environment, but as with any investment, careful risk management is critical.

The Author

Luke Spajic

Head of Asia EM Portfolio Management

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