Greenium: Are green bonds worth the premium?
By Atharva Palve
Amidst the turmoil the COVID-19 pandemic has created, a silver lining has emerged in the form of changing attitudes towards climate change, with governments and corporations scrambling to clean up their acts in line with increasingly topical environmental, social and governance (ESG) criteria.
With a UN report describing climate change as a “threat multiplier”, rising importance is being placed on creating channels of funding intended to accelerate the transition towards a low-carbon future (UN 2019).
This fundamental shift in awareness and concern has led to a surge in the issuance of green bonds, a relatively new type of debt instrument that has been gaining traction in recent years, helping to encourage sustainability influenced investment.
The green label these bonds carry has meant investors are willing to pay a premium, dubbed the “greenium”, however, no theoretical reason lies behind green bonds being traded at a premium compared to non-green bonds, with green bonds just as likely to be repaid as non-green bonds. Yet green bonds continue to command a premium, providing issuers with a cost advantage over non-green counterparts.
What is the greenium?
The existence of a greenium has been debated since the creation of green bonds and encompasses the idea that issuers are able to borrow at a cheaper cost, by issuing debt at a higher price compared to non-green bonds (also referred to as “vanilla debt”). This funding is then directed towards environmental initiatives and implies that those who have invested in green bonds (the lenders) would need to accept a lower yield for an otherwise identical bond (AIM 2021). (Lower yield denotes that the interest payments investors receive as a fraction of the bond’s price, is lower for green bonds compared to non-green bonds.)
The greenium is therefore the difference in yield between green bonds and non-green bonds of similar maturity and can be depicted using a yield curve, which is a curve illustrating how the yield of a debt instrument varies with the time remaining to maturity.
If a bond is issued at a higher price, as is the case with green bonds, then the bond will price inside its yield curve, which benefits the issuer because it costs less to fund that bond relative to the non-green bonds it has issued.
The graph above demonstrates exactly that; a pair of green bonds issued by Volkswagen in 2020, to finance two sustainability projects, priced inside Volkswagen’s non-green (vanilla) yield curve. This indicates a difference in yield of up to 2 basis points (a unit of measure in finance used to describe the % change in the value of a bond) between green and non-green bonds.
Denmark, a newcomer to the green bond scene in Europe, has issued twin bonds in January of this year, similar to the twin bonds issued by Germany in 2020. This ties a 10-year green bond with a non-green bond of the same maturity allowing investors to switch between the two as a means of hedging against risk. This issuance also allows for the comparison of near-identical bonds, providing greater clarity on the existence of the greenium (Bloomberg 2022).
Why is the greenium present?
We have established previously that there is no theoretical reason for there being a difference in the pricing of a green bond and a non-green bond, so if the risk of default is similar for both types of bonds, then the greenium must arise because of demand outpacing supply.
Green bond issuance increased by 50% in 2021 compared to 2020, with a total issuance standing at $645.5bn in 2021 (CBI 2021). However, this rise in supply has been met with even greater demand as investors have become increasingly sensitive towards the types of initiatives they are investing in, with green bonds proving to be increasingly popular.
For Volkswagen’s issuance of its pair of bonds, the 8-year bond was more than 4 times oversubscribed, whilst the 12-year bond was 5 times oversubscribed (CBI 2020). (Oversubscribed means the demand for a new issue of a bond is larger than the number of shares available). It is therefore evident that despite commanding a premium and providing lower yields, investors are still willing to invest in green bonds. This seems to be driven by the increased incorporation of ESG criteria when making investment decisions, as it allows for higher returns in the long run because sustainability reduces existential risk, the ultimate risk of default (ING 2021).
Will the greenium remain?
The existence of the greenium, therefore, arises due to demand outstripping supply, and the evidence to support this has become stronger as green bond issuance continues to rise in 2022 as polluting industries step up their climate efforts.
Until very recently it had been difficult to pinpoint the reason for the existence of the greenium, predominantly due to green bond issuance being very much in its infancy. This made it challenging to compare green and non-green bonds issued by the same issuer that also shared similar characteristics, such as maturity, coupon, issue date, currency, or sector.
However, as the supply of green bonds has risen, more definitive calculations can be made regarding the existence and size of the greenium, allowing us to quantify the yield disparity between green and non-green bonds across regions. For example, a recent calculation by IMG suggests European corporate bonds have a greenium of up to 3 basis points, whilst US corporate bonds hold a higher greenium of up to 8 basis points (IMG 2021).
This difference could be down to less green bond issuance in the US compared to Europe, causing the US bonds to command a higher premium. Other markets depict similar results and continue to demand a higher greenium than the European bond market.
So, whilst Europe has seen a fall in the greenium, evident from the graph below, other markets will need much greater levels of green bond issuance to experience similar falls in the premium on green bonds.
On the whole, the convergence of green bonds with non-green bonds is unlikely to occur in any market in the near future as this would require much higher levels of supply, above the levels of demand we see at the moment.
The future of the greenium
The premium we see on green bonds has no theoretical reason for its existence, but it seems to have its advantages. Firstly, it encourages companies to issue green debt, not just to reap the benefits of lower borrowing costs, but also as a means of signalling their plans of transitioning towards low carbon operations.
Companies, in turn, reveal more information about their sustainability initiatives, providing investors with more accurate depictions of a business’s ESG credentials.
The greenium, therefore, also boosts investment into green bonds, helping to fund sustainable initiatives, whilst remaining less volatile than non-green bonds, reducing risk for investors.
An alternative to green bonds is sustainability linked bonds, which rather than funding specific projects, punish issuers by increasing interest payments when they fail to meet specific environmental targets. This may overtake green bonds as the tool required to transition towards a low carbon economy because unlike a green bond, it sets specific targets that issuers are obliged to follow (Financial Times 2021).
Overall, the greenium we see on green bonds is set to converge sometime in the future, but until then, the greenium is here to stay, benefiting issuers through lower borrowing costs, as well as investors through less volatility and greater long-term returns. Whether or not sustainability-linked bonds overtake green bonds in popularity could alter this course towards convergence, however, the likelihood of this occurring is not yet known.
References:
AIM (2021) Greenium — fact or fiction?
https://affirmativeim.com/greenium-fact-or-fiction/
AMFG (2021) Q2 2021 ESG Finance Report, p23
https://www.eifr.eu/document/file/download/2143/afme-sustainable-finance-report-q2-2021-v2-pdf
Bloomberg (2022) Denmark to Discover Its ‘Greenium’ With First Green Bond Sale
CBI (2020) Green Bond Pricing: In the Primary Market
CBI (2021) 2021 Green Forecast Updated to Half a Trillion — Latest H1 Figures Signal New Surge in Global Green, Social & Sustainability Investment
Financial Times (2021) Squeeze on ‘greenium’ as ESG bond investors demand more value
https://www.ft.com/content/ecbed322-1709-4ed6-9f7f-d974f6e181da
ING (2021) The corporate premium in green finance https://think.ing.com/bundles/greenium-sustainable-finance-bonds-sovereign-ssa-premium-costs/
UN (2019) Climate change recognized as ‘threat multiplier’, UN Security Council debates its impact on peace https://www.un.org/peacebuilding/fr/news/climate-change-recognized-%E2%80%98threat-multiplier%E2%80%99-un-security-council-debates-its-impact-peace
