Green Bonds 101: What are Green Bonds?
This is part 1 of a 6-part series on Green Bonds. This series was inspired by numerous conversations which prompted me to create an online compendium on Green Bonds. With the Kenya Bankers Association and other key market stakeholders creating a pipeline for the first green bond in Kenya, it is important to be informed on what green bonds are and their potential role in Kenya’s sustainable development.
Several months ago, the Governor of the Bank of England and Chairman of the Financial Stability Board Mark Carney was branded an alarmist for cautioning on the possibility of a ‘Climate Minsky Moment’, if the global financial sector did not raise its ante in transitioning to a low-carbon economy. He noted that there is general consensus that climate change does pose physical risks that would damage property and disrupt global trade but it is now that the financial sector is waking up to liability risks that arise from parties seeking compensation from those responsible for aggravating climate change as well as risks inherent in transitioning towards more low carbon resilient economy¹.
Yes, there have been a number of initiatives and deliberations in the financial sector about ‘green and inclusive growth’ but it is time for stakeholders to put money where their mouths are. In Africa alone, the cost of climate change adaptation has been estimated to range between US$ 20–30 billion annually over the next 10–20 years². Further, available numbers show that in 2013, annual global climate financial flows were approximately US$331 billion with only 4% being allocated to sub-Saharan Africa³
With Africa’s infrastructure needs estimated to be US$93 billion per year⁴, these numbers present a glass half-full, half-empty scenario for accessing alternative forms of financing. It is against this backdrop that there is need to incorporate climate-smart investments in national development strategies. Green financing is now being mainstreamed and is seen as a competitive form of raising form of raising capital as sustainable investments have doubled since 2012.
This series of articles is going to zone in on green bonds as one of the emerging innovations that are gaining traction.
Simply put, green bonds are fixed-income financial instruments that are used to fund low-carbon emitting projects, assets or business activities. By this definition, the endgame of this type of finance is to support projects that enhance climate change mitigation, adaptation and/or environmentally friendly projects. They have gained traction over the last decade mainly because they are perceived as a convenient and yet risk-managed means of investing in green infrastructure both in the public and private sectors.
If one was to go by textbook definitions, green bonds and climate bonds are differentiated by the fact that the proceeds from green bonds are supposed to be allocated to environmental projects like organic farms, park development, waste reduction and water use reduction. While the latter are for financing or re-financing climate change mitigation and adaptation projects. However, these lines seems to be blurred in the sustainability realm as both terms are used interchangeably due to the cyclical relationship between the weather elements and the environment.
Unlike vanilla bonds, the capital raised from the green bonds is ring-fenced to fund specific projects that have been labelled green. On the other hand, unlabelled climate-aligned bonds are those whose proceeds are used to finance low-carbon resilient industries and solutions but do not carry the green label yet. According to the non-profit Climate Bonds Initiative (CBI), the labelled green bond universe represents 17% of the climate-aligned bond universe which could be explained by the fact that many financiers are backing projects that they have not classified as green. Having the additional green label on a debt instrument acts a discovery tool for investors that reduces friction in the investment process⁵.
Mathews and Kidney (2012)⁶ noted the following as common features of green bonds:
- They are mostly tailored for institutional investors since they are good avenue for portfolio diversification by offering relatively stable and predictable returns as compared to other securities. This is important because green projects require high upfront costs to avoid re-financing risks as compared to high-carbon non-resilient non-climate aligned projects. This is even of more interest in emerging and developing markets where climate-smart investments are required but are deterred by high interest rates and cost of capital. Nonetheless, banks such as Rabobank, Netherlands and Nedbank South Africa have been able to cascade these instruments to individuals through green retail markets.
- Bonds are designed to be asset-backed so that they can channel the funds towards real investment projects that generate real assets on low-carbon industrial activities. Though these are expected to be income-generating, in case of failure, guarantees must be provided by the government that stands behind the issuing institution. This particular feature has led to the creation of the green sukuk, which are Shari’ah-compliant fixed-income securities as one of the key aspects of Islamic finance is the need to fund real assets.
- The tenor of a climate bond needs to be as long as practicably possible, to give the underlying project enough time to break-even and become as competitive as other conventional projects. For instance, the World Bank green bonds have a horizon of 5–10 years while UK government gilts are as long as 30 years.
- Since green bonds are still a fairly new area of project financing, these debt instruments are modelled fairly closely to the conventionalbonds and often relative to relative to reference bond rates indicating flat-pricing (pari passu). Additional ‘frills’ such as varying interest payments are minimised so that they can appeal to wide class of institutional investors. Nonetheless, evidence is emerging that it has been seen in some markets that green bonds are receiving better prices than conventional bonds, a “greenium” (premium for being a green financial instrument). A CBI study analysed bonds issues in the green bond primary market in Euro and US Dollar denominations but worth USD 200mn within the last quarter of 2016. 15 out of the 19 bonds issued (due to data availability issues)that had been issued pari passu were priced at a premium. They explain this anomaly with the fact that there’s unmet demand for green debt as shown by the tight prices and over-subscription.
The lack of clear definitions around green financing and what exactly constitutes “green-ness” leads to the danger of green washing, where bond proceeds are allocated to projects with little or uncertain environmental elements which in turn erodes investor confidence and impedes efforts towards low-carbon economy.
Green bond issuers are currently drawing on experiences of past issuance which should have assisted them to develop their own green definition and process to suit their own business profile. This challenge can be further mitigated through the use of tools such as Green Bond Principles (GBP) as aforementioned, external reviews by independent consultants and Climate Bonds Standards which creates a sense of uniformity in the industry.
Having recognised the need for standards to boost the green bond market, in 2014 a group of leading global financiers established the voluntary Green Bond Principles (GBP)⁷ with its secretariat at the International Capital Markets Association (ICMA) to create a clearer understanding and transparency of what constitutes a green bond to reduce market frictions while enhancing integrity. Under the GBP, projects that can be supported by green bonds include renewable energy, energy efficiency, pollution prevention and control, sustainable management of living natural resources,terrestrial and aquatic biodiversity conservation, clean transportation, climate change adaptation and eco-efficient products, production technologies and processes.
The voluntary GBP enables issuers, investors and underwrites to differentiate from standard bonds by assessing them through four key components. First, the use of proceeds which is the central to the bond. The principles emphasise that the bond proceeds should be appropriately described in detail while taking into account definitions of green and green projects may also vary depending on the sector and geography. Second, the process of project evaluation and selection should outline how the project met the green criteria, the related eligibility criteria and the environmental sustainability objectives. Third, the management of the proceeds should be clearly stated, whether they are credited to a sub-account or moved to a sub-portfolio. The bond issuer should also inform investors of the balance of the unallocated proceeds and their temporary placements. Lastly, the issuer should have updated and readily available information on the use of proceeds and inform the investors when there are new developments⁸.
Similarly, the Climate Bond Standards Board issues the Climate Bonds Standard oversees the development and certification for the labelled green bond market.
At the moment, the external reviews are normally conducted by third party reviewers which enables bond issuers to confirm their green bond alignments through consultant reviews, verification, certification and ratings. These reviews go along way in enhancing their issuers’ credibility and increases investor confidence.
NEXT: Green Bonds 102: A Brief History of Green Bonds
REFERENCES
- Carney, M. (2016) Resolving the Climate Paradox. Speech. Arthur Burns Memorial Lecture, Berlin. 22 September. Available here.
- Duru, U. and Nyong A. (2016). Why Africa Needs Green Bonds. Africa Economic Brief 7 (2). Tunis: African Development Bank. Available here
- Ibid.
- Foster, V. and Briceno-Garmendia C. (2010) Africa’s Infrastructure : A Time for Transformation. Washington: World Bank. Available here
- CBI (2016) State of the Market Report: 2016. London: Climate Bonds Initiative. Available here.
- Mathews J. A. and Kidney S. (2012) Financing Climate-Friendly Energy Development through Bonds. Development Southern Africa 29(2) pp 337–349 (Pay-walled)
- ICMA (2016) The Green Bonds Principles : Voluntary Process Guidelines for Issuing Green Bonds. Paris: International Capital Markets Association. Available here
- Ibid.
FURTHER READING
Disclaimer: All views expressed here do not necessarily reflect the opinions of my employers or clients, past or present.
Last Updated: May 5,2017
