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Green government bonds were the fastest growing sustainable bond segment in 2020. First-time issuers accounted for 40 per cent of outstanding sovereign green bonds, according to OECD data, with the governments of Germany, Hungary, and Thailand among those making green bond debuts. 2021 has brought further issues of debt to finance green initiatives by countries such as the UK, and further innovations in green bond structures.
This rapid growth partly reflects the early stage of the green bond market in general and sovereign green bonds in particular, which still account for only 0.2 per cent of OECD government debt. Nonetheless, we expect more governments to issue green bonds as a way of financing large-scale green infrastructure projects and R&D for next generation technologies that will be crucial to achieving the net zero transition. This ‘greening’ of government bonds - the backbone of global fixed income markets - could help resolve some of the pricing, liquidity, and reporting challenges that investors face.
Beware the greenium and illiquidity
High investor demand for green bonds has created a so-called ‘greenium’ (green premium), and the securities frequently offer a lower yield compared to similar bonds without the green label (an exception is China, where greeniums have so far been practically non-existent).
Perhaps the clearest example of a sovereign greenium comes from Germany. On 2 September 2020, the German Finance Agency sold €6.5bn of green Bunds with the same coupon and maturity date as ordinary, non-green Bunds issued a few weeks earlier. The green bond priced at 1 basis point of yield below its vanilla twin and has maintained a lower yield on the secondary market since, trading as much as 7 basis points lower. Two months later, Germany went one better, issuing green and ordinary bonds on the same day with identical coupons and maturities. This November green bond also traded at a greenium.
The popularity of green bonds has led to a tendency to hoard them, reducing liquidity and widening pricing differentials. Those attempting to justify the greenium could argue that green bonds’ relative scarcity should make it easier to sell them. But that is little comfort to those wishing to rebalance portfolios who need to buy green bonds as well. In some cases, a lack of liquidity also increases trading costs.
Reporting standards need to improve
Greater green sovereign issuance should ameliorate these problems. The greenium has dwindled in corporate bond sectors such as utilities where green issuance is high, and liquidity has improved. For green bonds to go mainstream, however, other challenges need to be addressed. Top of the list are inconsistent reporting standards across different countries.
Standards today are voluntary for all green bonds and often ad hoc. Use of proceeds reported at issuance can differ from those that are reported post-issuance, creating a risk that some issuers will overpromise then fail to meet expectations. Variable reporting and a lack of common terminology and metrics can make it hard to know what the real impact has been and to compare investments.
Help is on the way. Investment standards for green bonds are being developed at a global and regional level, most prominently the EU Green Bond Standard. As these are adopted, the green sovereign market will become more investible and act as a benchmark for green corporate bonds. However, rule makers will need to move carefully. Making it too hard to meet definitions of ‘green’ could constrain supply, and risk exacerbating pricing and liquidity challenges.
Sovereigns seek to address transparency hurdles
Green government bonds are often subject to the same spending rules as non-green bonds, which forbid the creation of separate accounts to earmark proceeds for any specific purpose. Elected representatives must also ratify any spending decisions. As a result, governments cannot offer green investors much certainty about how green bond revenues will be spent.
Governments have tried to address this problem in different ways. Poland has changed the law to set up a separate account for green bond inflows. Belgium has made a small legislative adjustment to earmark certain spending against green bond receipts so it cannot be financed again by the same means. Germany’s green bond issues are designed to finance pre-existing expenditure.
Still a ‘trust me’ exercise
However, without more robust certification, the ‘green’ label still carries no guarantee of the use of proceeds and is more of a ‘trust me’ exercise. Investors need to judge for themselves whether an issuer will actually use the funds for green investments and what impact that will have. The lesson from corporates is that green investors do just that. For example, several leading green investors declined to take part in Korea Electric Power Corp’s 2020 green bond issue following concerns about the company’s overseas investments in fossil fuels.
Some investors have turned to sustainability-linked bonds with explicit green targets attached to their coupon payments to ensure greater accountability on how their money is used. Governments may struggle to replicate this model, but we expect more green sovereigns to be issued with specific project and development targets over time.
One example is the UK’s green gilt, the first £10bn of which was 10 times oversubscribed at its September launch. While there are no legally binding constraints on use of proceeds, the UK government has clearly defined the areas of investment it intends to fund, which include renewable energy, clean transport, and climate change adaptation. No more than half of proceeds can go to existing projects, and only those begun the year before. The issue also requires the explicit reporting of social benefits of green projects, such as numbers of workers helped to transition to low-carbon jobs and homes protected against climate change. There is also a world-first retail product, Green Savings Bonds.
These new kinds of vehicles can help finance the energy transition at scale, given the size of global bond markets. But it may take time for the green bond market to mature, for standards to improve and for the greenium disappear. In this context, the maxim “buyer beware” remains as true as ever.