Craig Alexander, senior vice president and chief economist for the TD Bank Group – Green bonds could be like victory bonds

10 December 2013: Green MashUp: Green bonds have been around since 2008 when they started being issued by the World Bank. The bonds carry exactly the same credit profile, and pay the same yield, as conventional bonds. What makes them different is that the issuer pledges to direct the revenues to finance environmentally-beneficial projects from curbing emissions to hydro-electric power plants in Chile, to wind farms in Germany.

According to the Socially Responsible Investment Newsletter, the top supranational issuers of green bonds are the World Bank, the Export-Import Bank of Korea, the Asian Development Bank, EBRD, Kommunalbank Norway, and the European Investment Bank.

However, the market is broadening to take in a much wider range of issuers. A particularly promising market segment comprises bonds issued to finance individual renewable energy projects, or portfolios.

And more of these are coming on board with constrained government finances and signs that the world is running out of time in the battle with climate change. Reuters reports that November was a busy month with a spate of deals doubling the total raised in 2013 to nearly $10 billion. All this has fuelled expectations that more will follow.

What’s interesting here, according to the report, is that analysts are saying this could be the tipping point.

Outfits like French power group EDF, Bank of America Merrill Lynch and Swedish property Group Vasakronan have all issued bonds to diversify their investor base. Green Biz reports that Ford and Microsoft invested in $1 billion worth of green bonds issued by International Finance Corporation (IFC), an Aaa/AAA rated global development institution and member of the World Bank Group. Zurich has also said it would invest in green bonds issued by the World Bank, the International Finance Corporation and other development institutions in a bid to become what it says will be the “largest global green bonds investor”.

And in August, the World Bank announced it was launching US$ 550 million dollars of green bonds—its largest US issuance to date.

The role of the World Bank here is significant.

As commentator Sieren Ernst writes, the World Bank has longstanding relationships with sovereign nations. That allows special deals on projects and repayments, substantially lowering default risk. Second, the Bank covers its investments in riskier, lower-yield projects by bundling them with more secure projects such as small hydro or gas switching projects.

Green bonds might well become the main channel through which governments around the world can borrow from the private capital markets. The bottom line is that governments around the world lack the financial resources to meet urgent environmental requirements so green bond or debt instruments are now regarded as a way of raising capital through the markets.

Bonds can be offered in different forms, which will attract different types of investor, from multi-billion dollar pension funds to individual savers. They can be issued by national or local governments, international institutions, private banks or even large corporations. That is why they are starting to get a lot of attention from investors and environmentalists.

They’re like victory bonds

“Green bonds are like victory bonds for the environment, with their exclusive focus on supporting green initiatives, they are a good way to secure large amounts of capital to support many different environmental investments – from renewable energy technologies to public transportation,” says Craig Alexander, senior vice president and chief economist for the TD Bank Group.

Low risk and higher returns

Investing in environmental projects might be lucrative for investors. They are deemed low risk because they are issued with strong credit ratings and they often generate a higher return than traditional benchmark bonds.

Climate Bonds co-founder and CEO Sean Kidney told Smart Planet that green bonds are the way of the future because the world needs action now and governments are taking too long to respond.  “

We have to rapidly speed up and scale up the capital that’s flowing towards climate change solutions, both mitigation and adaptation,’’ Kidney said. “Climate scientists tell us we need a low-climate world by 2050, and we have to move quickly to get there. We have to be moving capital now.

Private money can free up public money for more urgent tasks

“There’s definitely not enough government money to do it all, as well as deal with disasters we’re going to have, especially if you look at the scale of what’s just happened in the Philippines. We need to make everything we possibly can a private sector investment to free up public money for the more urgent tasks.”

The value of the green bonds market is estimated to be somewhere around US$10-346 billion. Now that’s an enormous range but it reflects how new this market is with no standardized formats or benchmarks. And that’s an issue for green bonds.

The downsides include, there are still no benchmarks and little liquidity

As the BBC explains, there are downsides.

There’s no benchmark index to track their performance and investors don’t really know how green the project is. Also, there’s next to no yield with most of them delivering returns of about three per cent. Also, they lack liquidity. There isn’t a lot of secondary trading, where bonds can be resold and make investors money.

Most green bonds mature in three to seven years.  Which means investing institutions would proceed with some caution and we might not yet see a stampede.

Analysts at Euroweek say these are issues for investors who have to show they are delivering the best possible returns for their clients who might be put off by the fact that green bonds offer a lower interest rate than normal bonds.

Investors would also have to justify to their boards that they’re not sacrificing the organisation’s cost of funds for the sake of investing in trendy green bonds. While that remains in place, green bonds will have limited economic value.

That said, green bonds will come into their own. Analysts say green bonds are more likely to attract a new class of investor which mean the institutions will be diversifying their investor base.

Credit risk is the same as for regular bonds

Also, the credit risk would be exactly the same for ordinary bonds, which means the bonds could also attract the interest of their existing client base because they feel they are getting something extra by having made a green investment.

Bragging rights

That means in time they could become the must-have product for companies keen to trumpet their environmental credentials and bankers will be able to brag about green bond mandates up their sleeve. In the end, fashion rules financial markets and if investors want to have an ethical investment policy.

And a benchmark is on the way

Furthermore, as The Wall Street Journal reports, Barclays and  MSCI are now developing much-needed benchmarks for green bonds. Michael Schroeder, the chief investment officer of Florida-based investment firm Wasmer Schroeder told the WSJ that green bonds at the moment are in an “adolescent phase”.

“Some of these things take on almost like a fad status, and I think we’re beyond that point. I think it’s established, but I think it’s still evolving,” he said.

The Journal tells us that a survey conducted in early 2012 by BNY Mellon found that 24 per cent of clients that responded incorporate green strategies in their investment process. Twenty-seven per cent of endowments and foundations and 35 per cent of public pension plans said they did, while the figure was just 16 per cent for corporate pension plans.

Among the respondents that said they didn’t follow green investing strategies, 58 per cent said there was lack of interest and 30 per cent said they believed there was a performance trade-off compared with regular strategies.

But a set of benchmarks could actually make green bonds more attractive to investors wanting to buy debt from companies and governments seen to be environmentally and socially responsible.

Obviously green bonds still have some way to go before they take off in any big way. Once the banks have worked out criteria and standards, they could well become the key instrument for investing in green infrastructure.