Green Bonds Series: Part 1 - Why are Green Bonds the hottest thing in debt capital markets right now?

2018 is shaping up to be another big year for the development of green finance markets, in this series of articles we take a deep dive into the state of the green bond market. But before we go any further, what exactly is a green bond?

The market for green bond-labelled financing has experienced exponential growth since the first corporate green bonds were issued just over five years ago. In the 3rd quarter of 2017 alone, there were over US$27 billion in green bonds issued globally. More than 70 green bond deals came from over 60 issuers, resulting in a global market of $200bn in outstanding green bonds for the year. In short, US organisations see green in green.

What is a green bond?

A green bond is a debt financing instrument similar in form and operation to any other bond instrument - save for the fact it is labelled ‘green’ and that the proceeds of the instrument are to be used to fund climate change projects. As with a conventional bond, a green bond issuance involves an investor providing upfront funding to the issuer with the issuer promising to repay the principal plus interest.

It’s important to note that the pricing of a green bond is no different to the pricing of a conventional bond, with the price remaining dependent on the underlying creditworthiness of the issuer.

So why are they so popular? Essentially, a green bond is a means for a bond issuer (whether government or private sector), investors and the financial markets to identify and prioritise investments which genuinely contribute to addressing climate change.

This opens up a wide range of applications for green bond finance including projects which focus on clean energy production, as well as projects which focus on emissions reduction. Green bonds may be used to fund:

• traditional ‘green’ projects such as renewable energy generation projects, including wind, solar, hydropower, geothermal;
  
  
• energy efficiency projects and industries (including energy efficient products and technology, energy capture systems and industrial processes that are eco-efficient or offer ‘cleaner’ production);
  
  
• agriculture and forestry (including forestry that reduces carbon loss or delivers substantial carbon sequestration);
  
  
• clean transportation projects (including non-diesel rolling stock, fuel efficient vehicles and certain bus rapid transit);
  
  
• water and waste management projects (including recycling and composting);
  
  
• information technology (including fibre-optic cable investments and low carbon infrastructure); and
  
  
• low carbon building and infrastructure projects (including rail and infrastructure to protect against the consequences of climate change).

This leads us to ask, how do we know that a project meets the standard required in order for the bond to be labelled ‘green’?

Green bond standards

The industry is still largely self-regulated with little formal regulatory involvement or oversight in the green bond market, and there is no single global green bond standard which an issuer must adhere to in order to label a bond ‘green’. There are a number of recognised green bond principles and standards which provide guidance on what is required in order to obtain green bond status.

The market leader in green bond regulation is the Climate Bonds Initiative, an international organisation who have developed (and continue to develop) the Climate Bonds Standard (CBS). As well as developing the industry standard, the Climate Bond Initiative provides important market data about the global bond market and industry participants.

The CBS sets out the requirements for issuers seeking Climate Bond Certification from the Climate Bonds Initiative, it also details the criteria and process to be followed both pre-issuance and post-issuance. The CBS incorporates the International Capital Markets Associations Green Bond Principles which are a voluntary set of process guidelines for the issue of green bonds.

There are also a number of other green bond standards which have been published by various financial institutions and Government agencies. India, China and a number of European countries have all published guidelines and regulatory policies on green finance as the market has developed.

Financial markets respond

Financial markets have also responded to the increased prevalence of green finance by establishing various exchanges and secondary trading platforms to increase the depth of the market and the options available to investors. The development of green bond indexes across a number of currencies reflects the evolving use of green finance instruments, the S&P Green Bond Index is one such index which tracks the global green bond market.

But, due to the lack of regulation, there remains a risk that investors are ‘greenwashed’.

In September 2016, the Luxembourg Stock Exchange responded by introducing the Luxembourg Green Exchange (LGE), the world’s first trading platform for green, social and sustainable securities which meet internationally recognised standards. The Luxembourg Stock Exchange was the first to list a green bond (back in 2007) and listed over half of all green bonds. With the establishment of the LGE, greater access and depth is given to those wanting exposure to the green bond market as well as ensuring transparency and accountability between issuers and investors. The LGE has a strict listing process which includes compliance with the International Capital Market Associations green bond principles and the Climate Bond Initiatives climate standards. In addition, issuers must obtain robust external reviews have an obligation to report back to investors post-listing. The LGE currently lists over 150 green, social and sustainable bonds with a value of over €72 billion.

The cost of going green

While green bonds have some additional transaction costs, where the issuer is required to monitor and report on the use of proceeds, and the continued ‘greenness’ of the project, the benefits far outweigh these costs as the issuer is able to highlight the greenness of their business and attract investors that may not otherwise be interested in investing in their bonds. In addition, it enables a business to market themselves as authentically ‘green’ or ‘eco-friendly’, adding to their social licence.