The green bond evolution

In 2017 the green bond market grew at an accelerating rate, as measured by a 73% year-to-date increase in market value of the Bloomberg Barclays MSCI Green Bond Index. The fact that bond proceeds are tied to very tangible outcomes has led to early interest among investors that care about the impact of their investments. Over the last two years, several passive and active green bond funds and ETFs have entered the marketplace.

The Bloomberg Barclays MSCI Global Green Bond Index is designed to offer an objective and robust measure of the global market for fixed income securities whose proceeds are used to fund projects with direct environmental benefits. This article analyzes the bonds included in the index – as well as those bonds that were excluded from the index – to better understand how the green bond market has evolved and where may face opportunities to grow.

What have green bonds funded?

Most green bonds have been linked to climate change mitigation projects. Alternative Energy projects were the most common use of proceeds, with Energy Efficiency categories showing rapid growth. Sustainable Water projects – such as waste water treatment and watershed conservation – and Pollution Prevention projects – including environmental remediation and recycling – were noted for close to 40% of the index-eligible green bonds issued in 2017. Bonds targeting Climate Adaptation projects made up 12% of index-eligible bonds issued, but were almost exclusively issued by governments.

The environmental benefits of a wind or solar project may be straightforward, but other types of projects frequently inhabit grey areas - begging the question "what counts as green?" The need for clear and transparent standards is a common refrain heard throughout our conversations with market participants. For this reason, each labeled green bond that meets fixed income criteria is subject to rigorous review by MSCI ESG Research to determine eligibility.1 We compare each bond's framework against transparent pre-set criteria, rather than relying on self-labeling or second-party opinions alone.

Since 2014, 87% of the self-labeled green bonds that met fixed income index criteria also met MSCI's Green Bond Criteria with the remaining 13% failing to meet one or more conditions tied to use of proceeds, project selection, management of proceeds, or reporting. In 2017, the most common reasons for ineligibility related to bonds' use of proceeds:

• A public framework on the intended use of proceeds – whether in the prospectus, supplemental documents, or via third-party – is a pre-requisite for eligibility.
• Large hydropower projects require additional sustainability criteria to alleviate concerns around negative impacts associated with large dams. To date, six bonds have been excluded, removed, or left "under review" due to questions around large hydro.
• Energy efficiency projects are the most difficult to assess as it is not always clear which projects go beyond "business as usual". For example, broad categories like "eco-efficient products" are not eligible without further clarification.
• Green mortgages where only a portion of the proceeds are tied to environmental projects may not qualify under the current Green Building criteria. New standards may be required to better classify green Covered Bond and CMBS issuance.
• Social and sustainability bonds do not qualify unless at least 90% of proceeds are dedicated to projects with environmental benefits. To date we have assessed over 15 social and sustainability bonds with disparate range of use of proceeds

Taxonomies for social investments are beginning to emerge – for example, MSCI ESG Research has published extensively on the topic of mapping corporate activities to the UN Sustainable Development Goals (SDGs).2 However, more issuance and clearer definitions are required to classify bonds with the rigor and transparency required of a benchmark index.

Who has issued green bonds?

On average, green bond issuers tended to show stronger management of environmental, social, and governance risks, as measured by issuer-level MSCI ESG Ratings. ESG Leaders – defined as issuers rated in the top two categories relative to global peers (AAA or AA) – made up 45% of index-eligible green bond issuance, compared to only 25% of the Bloomberg Barclays Global Aggregate Index. Similarly, green bond funds tended to show high ESG Quality Scores, with the majority ranking in the top ten percent of funds globally.3

That being said, not all green bond issuers had such a clean profile – 5% of eligible green bonds were issued by ESG Laggards – i.e. rated in the lowest two MSCI ESG Ratings categories (B or CCC). For example Westar Energy had been flagged for high reliance on coal, Hyundai Motor Corporation was embroiled in labor issues, and Three Gorges Finance faced strong opposition to its hydropower dam.

Through numerous market consultations, institutional investors have expressed the view that green bonds should be accessible to even the most polluting companies as a means of incentivizing progress. On that basis, the above-mentioned examples would qualify: Westar's green bond funded investments in renewable energy; Hyundai's funded loans for electric and fuel-cell powered vehicles; and Three Gorges earmarked proceeds for investments in off-shore wind energy, rather than large hydro.

Issuance by low ESG-rated issuers may still be problematic for investors that apply ESG standards as a means of risk mitigation, as credit risk typically still lies with the issuer of the bond. This is particularly relevant as ESG benchmarks become more widely used by fixed income investors and as issuer-level ESG Ratings are increasingly incorporated into institutional investment policies.4

Evolving market characteristics

Compared to more mature and diversified markets, the risk characteristics of the green bond market can change substantially as new issuers enter the space, posing challenges for institutional investors considering dedicated allocations. The emergence of green treasuries, most notably France, shifted the index toward longer duration and lower yields in 2017. But a surge in corporate issuance in the second half kept the sector breakdown relatively stable.

Opportunities for growth

Standards are emerging, transparency is improving, and issuance is growing – all positive signs for the green bond market. However, institutional investors continue to cite limited capacity and diversification as obstacles to dedicated green bond investments. So where do we see opportunities for growth?

The Bloomberg Barclays MSCI Green Bond Index was 14% underweight Securitized relative to the Bloomberg Barclays Global Aggregate Index, indicating an area that is potentially ripe for growth as new standards emerge around green mortgages.

Among Corporates, issuance has been driven by electric utilities, banks, and REITs, while industrials by contrast are largely underweight relative to the market as a whole. By mapping the industries that are over- and underrepresented in the Bloomberg Barclays MSCI Green Bond Index, and comparing this to each industry's average involvement in qualifying green activities, we can identify areas where innovation can unlock future issuance.

Basic industry, capital goods, and transportation are industries where green bond issuance has historically lagged, but where the underlying green assets may already exist. Issuers in these industries seeking to tap new pools of investors could benefit from clearer expectations and guidance, and investors could benefit in turn from a more diversified opportunity set of green investments.

This is where green bond indexes have a role to play in bringing the clarity needed by both issuers and investors to support continued market innovation and growth.