The sustainable bond market beyond 2020 - green bonds strike back

2020 was a turbulent year for the green bond segment but all's well that ends well, says Marcus Pratsch, head of sustainable bonds and finance at DZ Bank

Without doubt, 2020 was an exciting year for the sustainable bond market. In the blink of an eye, a pandemic has turned the world upside down. The Covid-19 crisis had a firm grip on the sustainable bond market – with varying effects on the individual segments.

It gave social and sustainability bonds, which already contributed to the diversification of the market with above-average growth in 2018 and 2019, additional tailwind. In 2020, they have proved themselves a suitable financial instrument to raise funds for the fight against the Covid-19 outbreak and for mitigating its negative economic and social impact. The maiden issue of the EU SURE social bond was a milestone for the entire sustainable bond market.

These developments are ultimately reflected in impressive growth figures. While the new issuance volume of sustainability bonds increased by almost 80% compared to the previous year, that of social bonds increased by more than 700%.

In contrast, things were more turbulent in the green bond segment. It experienced lows and highs during the year.

In particular, at the beginning of the pandemic the green bond segment took a deep "breather". As an initial emergency response to Covid-19, many issuers – especially sovereigns, supranationals and agencies (SSAs) - that issue both green bonds and social or sustainability bonds have focused on the latter. As a result, the new issuance volume in March 2020 amounted to only $5.4 billion. This was the lowest monthly new issuance volume since December 2015.

Luckily, a recovery of the green bond segment began as early as in April. This recovery continued steadily in the following months taking the segment to new, unimagined heights. With a monthly new issuance volume of $36.8 billion, the green bond segment set a new record in September.

Ultimately, there was a conciliatory year-end for green bonds. With a new issuance volume of $269 billion, the segment finally still managed a marginal growth of 1% compared to the previous year. And more importantly: in the fourth quarter, green bonds reached its most substantial milestone yet, surpassing $1 trillion in cumulative issuance since market inception in 2007.

"Build back better" must include a green recovery

The furious comeback of the green bond segment shows that "build back better" only works if we also consider the environmental dimension of sustainability.Marcus Pratsch

Without doubt, combating the Covid-19 pandemic and mitigating its economic and social fallout is urgent and has absolute priority. Nevertheless, in the long term, we must not ignore climate targets and risk a climate pandemic. This would have negative economic, environmental and social consequences that are far more serious than those resulting from the corona crisis are. Moreover, most of them will be irreversible.

The positive trend in greenhouse gas emissions we have experienced during the lockdowns in 2020 is not sustainable. In fact, it can be firmly assumed that there will be a "rebound effect" in 2021 and beyond as there was after the financial crisis in 2008. Hence, emissions might soon even exceed the pre-Covid-19 level.

Among the Top 5 highest likelihood risks of the next ten years identified in the Global Risks Report 2021 by the World Economic Forum, four are of environmental nature: extreme weather, climate action failure, human environmental damage, infectious diseases and biodiversity loss.

Therefore, even in the current situation, we should be careful to ensure that we do not neglect the urgent challenge of tackling climate change and other environmental challenges. Rather, the Covid-19 pandemic should be seen as an opportunity to allocate investments required for reconstruction in a way that takes account of all dimensions of sustainability. Besides economic and social projects, climate and environmental protection must also be included.

Hence, the green recovery is an important piece of the puzzle to recover prosperity after the Covid-19 pandemic and to ensure a sustainable transformation. Green bonds will play a fundamental role on this recovery agenda. The European Commission for example intends to raise 30% of its €750 billion ($908 billion) Next Generation EU recovery fund through the issuance of green bonds, hence becoming one of the largest issuers in the segment globally.

Promising news for the green bond segment from different corners of the world

Without a doubt, with the EU a new giant will appear in the green bond segment. Recently, we have also received other promising news from various corners of the world that will further accelerate green bond issuance.

More than 15 sovereign governments across the globe are waiting in the wings to issue sovereign sustainable bonds in the future. Among them, for example, countries such as Austria, Brazil, Canada, Italy, Spain, UK and Vietnam. There is huge potential as just two of the ten largest sovereign issuers – France and Germany – have joined the "Sovereign Sustainable Bond club" so far.

We expect the majority to choose the colour green for their first appearance in the market.

Moreover, it can be assumed that the maiden issuance will not remain a flash in the pan for many. The inaugural green gilt announced by the UK for example is expected to be the first of a series of sovereign green bond issues by the UK government over the next few years as it looks to build a green bond yield curve.

China's aim to go carbon neutral by 2060 and its push to bring its domestic green bond standards closer to the international ones will also be a driver for more issuance. The latest Green Bond Guidelines published by the People's Bank of China have reduced the gap with international standards on eligible projects. The second-largest world economy and the largest Asian green bond market will no longer allow green bonds to fund clean coal projects, for example.

Many non-Chinese asset managers previously had to exclude Chinese green bonds from their portfolios, as the inclusion of clean coal was not in line with their internal environmental, social and governance (ESG) investment policies. Its removal from the eligible projects will make investing in China's green bonds much more attractive for non-Chinese investors and the ambitions to open the onshore market to foreign investors might even drive further standardisation.

We also expect accelerating growth of Japan's burgeoning green bond market. The world's third largest economy and Asia's second largest green bond issuer is aiming to cut greenhouse gases to zero by 2050 and become a carbon-neutral society bringing Japan in line with the European Union. In the past, the growth prospects of the Japanese green bond market were very much limited by its national energy policy still reliant on coal power.

The aim to go carbon-neutral by 2050 and the public announcement that responding to climate change is no longer a constraint on economic growth will require more funds and this could definitely boost green bond issuance.

A look across the pond reveals that President Joe Biden is turning words into action. He has moved to reinstate the US to the Paris climate agreement just hours after being sworn in as president.

The Biden Administration is also considering reversing Trump's ESG rule change. President Biden has great ambitions when it comes to green investments. In his election programme, projects that directly or indirectly promote climate protection add up to $2 trillion. That is more than twice as much as the European Union has earmarked for its Green Deal. And a not insignificant part could also be financed through green bonds. This is the historic opportunity to make "America green again".

There are also signs that more and more central banks – giving their role as anchor investors - are warming up to the idea of buying green bonds. Recently, the Federal Reserve has joined the Network of Central Banks and Supervisors for Greening the Financial System (NGFS). Sweden's Central Bank ("Riksbank") has recently announced that it will increase its asset purchasing programs and to include green considerations in it. The purchase program will target, amongst others, sovereign green bonds and municipal green bonds as well as corporate green bonds whose issuers comply with the UN Global Compact.

Furthermore, the Bank for International Settlements (BIS) has launched a Euro-denominated, open-ended fund for green bond investments by central banks and official institutions in January 2021. The launch follows the successful introduction of a first USD-denominated green bond fund in 2019. With cumulative $2 billion, still a small but shiny light – expected to grow considerably in the nearby future.

Forward ever backwards never: The annual new issuance volume is steadily approaching the $1 trillion mark

Given the prominent role environmental topics will play on the recovery agenda as well as the promising news from different corners of the world, we are confident that the green bond segment will strike back in 2021 and beyond.

We forecast that the new issuance volume of green bonds will increase by 30% to $350 billion. Green bonds are expected to account for more than 50% of the new issuance volume in the total sustainable bond market in 2021. In about two to three years, the annual new issuance volume should approach the $1 trillion mark.

A look beyond the green edge: The other segments of the sustainable bond market

We have shown earlier that the Covid-19 pandemic must not be used to ignore the environmental challenges facing our blue planet. At the same time, we must not risk economic death for fear of virological death. It is therefore important to create a recovery scenario that encompasses all four dimensions of sustainability, with the aim to build a more sustainable tomorrow rather than simply rebuilding yesterday.

Hence, the "S" will remain a crucial element of the sustainable transformation and recovery in 2021 and beyond. We expect growth in the social bond segment and sustainability segment to continue in 2021, though to a smaller degree than in 2020. We forecast new issuance volume in the social bond segment to increase by 20% to $170 billion and new issuance volume in the sustainability bond segment to increase by 25% to $85 billion.

Furthermore, target-linked issues are becoming increasingly important, especially in the non-financial corporate segment. Compared to "use of proceeds" bonds they offer more flexibility for issuers as the use of proceeds could be used for broader (general) purposes. Hence, we expect a threefold increase of the new issuance volume of sustainability-linked bonds to around $30 billion in 2021 – well aware that they are not suitable for all socially responsible investors.

In addition, transition bonds have the potential to become their own asset class. A sustainable world won´t be reached by solely focusing on companies which are already 100% "sustainable". To successfully work through the sustainability agenda, we must not exclude anyone from sustainable funding. In this context, it is important that transition is not limited to environmental transformation alone. There is also a social and a governance-focused transformation.

To conclude, we expect the total sustainable bond market to grow by 25% to $655 billion in 2021.

Contact: Marcus Pratsch
Email: marcus.pratsch@dzbank.de