18 December 2015

Advanced Topics in Green Bonds: Rewards

Green bonds offer a unique set of rewards to investors, argues Phillip Ludvigsen

Following on the previous article Advanced Topics in Green Bonds: Risks, this article provides insight into the potential rewards associated with green bonds. As with all investments, investors must balance these two factors in making a final investment decision. What is unique about green bond investments is that both financial and non-financial benefits must be considered; these include greater economic returns (including the potential for monetised environmental attributes), enhanced reputation, first mover advantage, and the potential for regulatory support.

Economic upside

Do green bonds offer an economic benefit over their 'vanilla' counterparts? A recent study (September 2015) by Barclays Research concluded:
"Investors are currently paying a premium to acquire green bonds, at least in the secondary market. Our model finds an approximately 20 basis points (bps) difference between the spread of green bonds and comparable issues, which we see as partly attributable to opportunistic pricing based on strong demand from environmentally focused funds"1

This study used regression analysis between a conventional bond index and a green bond Index in secondary markets. The statistically modeled spread actually started with no pricing advantage in March 2015, and grew rapidly over the next six months. The rate of positive growth was estimated to be about 3bps a month! To put this in perspective, the current 20bps on a $1 billion green bond is a $2 million premium. Typical bond underwriting fees range from 15 and 35bps depending on the size of the offering, the term, and other complexities.

This strong demand in the secondary markets is good news for investors who have had liquidity concerns. Recent transactions seem to point to a growing demand in primary markets, with Brazil, China, and Mexico issuing inaugural green bonds in the past few months. On the supply-side, there is currently a limited number of investment quality green bonds offerings that fully commit to all four pillars of the Green Bond Principles (use of proceeds, project eligibility, management of proceeds, and reporting with third-party assurance). This has allowed issuers to be very selective, selling only to investors who are signatories to the Green Bond Principles or to the Global Investor Statement on Climate Change.2

Although anecdotal, there are a growing number of examples of pricing premiums paid in the primary markets. A presentation by Dentons law firm indicated that observers of the Vornado Real Estate green bond deal saw a pricing advantage of 10 to 15bps.3 For its most recent green bond offering, DC Water stated it enjoyed a lower cost of capital of "2 to 6bps"4. HSBC recently saw significant enhanced interest in its first green bond because the "deal was green." Since the initial offering, the bond is trading at an additional 8bps premium.

Possible explanations for the growing pricing premium are that labeled green bonds may:
• attract a greater diversity of investors seeking environmental impact, thus increasing demand;
• be limited in supply due to market uncertainties (e.g., evolving standards and related costs);
• be inherently less risky (or volatile) than comparable unlabeled green bonds leading to higher risk-adjusted returns; or
• provide additional value (natural capital) by delivering verifiable environmental benefits.

From a practical standpoint, can responsible investors justify paying a premium for quality green bonds? In the past, some fixed income asset managers have argued that using environmental, social and governance (ESG) criteria limits investment diversification. As such, any practice that impinges on maximising returns could call into question their fiduciary responsibility. This line of thought, however, has been effectively countered using various legal theories5,6,7. A recent Principles for Responsible Investment (PRI) report, Fiduciary Duty in the 21st Century, concludes that ESG factors must be considered alongside other factors, such as diversification, in order to meet asset owners' and managers' fiduciary duty8. For international signatories of the PRI, this debate is effectively over.

In the US, the Department of Labor recently issued guidance that supports consideration of ESG-based investments by pension fiduciaries. This new guidance acknowledges that ESG factors may have a direct relationship to the economic and financial value of an investment. If they do, these factors are "more than just tiebreakers, but rather are proper components of the fiduciary's analysis of the economic and financial merits of competing investment choices."9

Reputational benefits

The green bond market offers reputational benefits to all participants. Corporate issuers, such as Toyota, can differentiate themselves from competitors, such as Volkswagen, by adding potentially verified green credentials to their existing brand. Municipalities can benefit by being considered green while potentially leveraging scarce resources through Private, Public, Partnerships (PPPs). Governments and development banks can enhance their international reputation by using green bonds to finance climate mitigation and economic development efforts that are shared across borders. In general, quality labeled green bonds have received favourable press coverage – especially if the bond is a first for a given jurisdiction.

For bond underwriters, green bonds offer an opportunity to grow their reputation as a high-value service provider that can attract a diversity of investors. Lead underwriters pride themselves on their large buyers' network and access to high demand offerings. Given the growing number of responsible investors looking to buy quality green bonds, underwriters have a lot to gain by leading the pack in this new and growing area of debt financing.

In addition, institutional buyers, such as signatories to the PRI, can point to green bonds as hard evidence they are abiding by the principles. This could result in improved PRI signatory assessments, thus bolstering their professional reputation with their beneficiaries (the ultimate asset owners). For retail buyers, certified green bonds that have been third-party verified to an international standard offer a simple way to confidently buy a complex financial fixed asset. For example, green bonds certified to the Climate Bonds Standard 2.0 can help small investors or green bond funds know they are buying an independently verified bond that meets all four pillars of the Green Bond Principles, as well as publicly-stated eligibility and technical criteria.

Realised environmental attributes

By definition, green bonds must carry an environmental benefit. It is possible to quantify the value of these anticipated environmental benefits; for example, the value related to natural resources (e.g., air, soil, water, biodiversity, etc.) is referred to as Natural Capital. TD Bank, in its 2014 Corporate Responsibility Report, stated:

"The reduction in atmospheric emissions achieved through projects funded by the TD green bond has a natural capital value of $356,200 per year."10

Although this environmental attribute was never monetised, it does represent a potential avoided cost of carbon on society. For those jurisdictions that have viable carbon markets, green bonds could fund carbon reductions, resulting in additional financial yields to issuers and/or investors. Unfortunately, some green bond offerings state that the terms 'green bond' and 'green project' are not defined and that no additional security (e.g. monetised environmental benefit) should be expected by the investor. If the resulting environmental attribute is monetised, who owns it?

Investors should understand that there may be economic value to the environmental attributes they helped finance. Excluding this value from a green bond should be a point of discussion, if not negotiation, with issuers.

First mover advantage

In 2012, roughly 25% of all the world's financial holdings were considered to be under some form of ESG assets management11. But the labeled green bond market is currently just a small fraction over the total $100 trillion global bond market. As the labeled green bond market grows, driven by the benefits listed above, the opportunity lies with 'first movers' to capitalise on market share and customer loyalty.
Organisations that start early have more time than competitors to accumulate and master knowledge in issuing, implementing, and verifying green bonds. First movers can use this position to pre-empt access to scarce expertise and experience. It also allows them to build a base of customers who would find it inconvenient or costly to switch to new service providers.

In general, gradual market evolution and innovation provides first movers the best conditions for long-term dominance. Given the recent pull-back in geometric growth and ongoing development of the Green Bond Principles and Climate Bonds Standard, the barriers and challenges appear to be growing for new entrants. Thus, current participants will likely enjoy the long-term benefits from being leaders in this emerging market.

"Too green to fail"

If climate change is the environmental issue of our age, then failure to address it is not an option. Trillions of dollars will be needed to finance climate-related mitigation, adaptation, and resilience12. Green bonds offer a potentially lower cost of capital for creating domestic jobs and improving local infrastructure. This economic and environmental resiliency appears to be translating into political clout. For example, it's possible that the state government of California would consider stepping in to help a fast growing 'green behemoth' such as Tesla Motors during tough times13 . Similarly, the Spanish renewable power company Abengoa, which has issued several large green bonds, is facing potential bankruptcy; however, calls for the Spanish government to financially step-in have already begun14. The company employs 28,700 people around the world and its potential bankruptcy would be the largest in Spanish history.

It remains to be seen if green bonds will be given any special treatment by regulators. Perhaps a harbinger, the Securities and Exchange Board of India (SEBI) has started drafting a framework that will define requirements and may include incentives for issuing domestic green bonds15. It seems the Chinese government is not far behind in developing a national green bond standard.

For many, the green bond market and its underlying assets have come to represent more than just simple debt. Investors need to consider the potential for greater economic value (including monetised environmental attributes), enhanced reputation, first mover advantage, and the potential for favourable new regulations.

The next installment of Advanced Topics in Green Bonds will address potential actions to minimise the risks while maximising the rewards.

Phillip Ludvigsen is a senior associate at New Jersey-based First Environment and is a certified responsible investment professional by the Responsible Investment Association

If you would like to contact the author of this report please e-mail pludvigsen@firstenvironment.com.

You can access the First Environment Website by clicking here.


Barclays Credit Research, "The cost of being green," 18th, September, 2015, https://www.environmental-finance.com/assets/files/US_Credit_Focus_The_Cost_of_Being_Green.pdf.

Schneider Electric Issues 200 Euro green bond, Environmental Finance, 9th, November, 2015, https://www.environmental-finance.com/content/news/schneider-electric-issues-200m-green-bond.html.

Dentons Canada, green bonds – Deal Survey, Bill Gilliland, February, 2015, p. 38, Link to Dentons Survey.

DC Water, Investor Relations announcement, August, 2015

The Network for Sustainable Financial Markets, UK Law Commission Fiduciary Duty Consultation, January, 23, 2014 (Link to NSFM article).

"The Time has Come for a Sustainable Theory of Fiduciary Duty in Investment," Hofstra Labor & Employment Law Journal [Vol. 29:115], pp. 116-139. 2012. (Link to Youngdahl article).

"Do the Fiduciary Duties of Pension Funds Hinder Socially Responsible Investment?", Benjamin J. Richardson, Banking and Finance Law Review [22 B.F.L.R.], pp 146-201, 2007.  (Link to Richardson article).

Fiduciary duty in the 21st Century, UN & PRI report, August, 2015, http://www.unepfi.org/fileadmin/documents/fiduciary_duty_21st_century.pdf.

US Department of Labor, New guidance on economically targeted investments in retirement plans from US Labor Department, October 22, 2015, (Link to Press Release). 

How we are building the Better Bank, 2014 Corporate Responsibility Report, TD Bank, May 2015, p.46

Business for Social Responsibility (BSR), Trends in ESG Integration and Investment: Summary of the Latest Research and Recommendations to Attract Long Term Investors (2012).

Vast cost of Artic change, Nature, Vol 499, July 25, 2013. Link to Nature Article 

Is Tesla too green to fail?, John Sainsbury, Globe and Mail, August 7, 2015. Link to Globe and Mail article

Spanish solar energy firm Abengoa facing $29.6 billion bankruptcy, http://www.news.com.au/finance/business/other-industries/spanish-solar-energy-firm-abengoa-facing-296-billion-bankruptcy/news-story/aa119d77a29f11e16e9839e425fc30c0, December 1, 2015.

"Sebi to make corporate, green bonds investor friendly,"  The HINDU, November 30, 2015,  http://www.thehindu.com/news/cities/mumbai/sebi-to-make-corporate-green-bonds-investor-friendly/article7930545.ece.