Green Bonds: Five Years After Paris

In an ever-changing interest rate environment, keeping tabs on the numerous corners of the yield market can be difficult. To help investors stay informed, we offer monthly commentary on income investing, covering the latest news, trends and investment opportunities. This month, in celebration of Earth Day, we highlight green bonds.

This year, Earth Day marks not only the annual demonstration of support for environmental protections, but also the fifth anniversary of the signing of the Paris Agreement by the U.S., China and 120 other countries. That milestone established the global target of limiting warming to within 2 degrees Celsius above pre-industrial levels through a rapid and dramatic decline in greenhouse gases. With massive amounts of infrastructure investment needed to achieve that goal, green bonds have emerged as an important financing mechanism to direct capital towards Paris-aligned projects.

Green bonds allow investors with tools to build sustainable core fixed income portfolios without significantly impacting risk and return, and leverage the vast size and diversity of the global debt markets to help achieve global climate objectives. A framework to evaluate green bonds that uses the Paris Agreement objectives as its foundation to identify projects with a role in a net-zero carbon economy can help investors have confidence that their income portfolios are also making a positive impact.

Green Bond Market Growth Continues

The green bond market has started off strongly this year, with issuance of over $100 billion already through mid-April, putting the market on track for another record-breaking year in terms of issuance.¹ Compared to last year, the increase in corporate issuance has been notable, making up about 50% of total issuance. This is perhaps unsurprising in the context of the numerous corporate “net-zero” commitments and increased pressure from investors to address climate risks.

Green Bond Issuance Continues to Hit New Records

Source: Climate Bonds Initiative as of 4/16/2021

In addition, a global policy framework is emerging that aims to enhance transparency around climate risks so that investors can identify climate risks and direct capital in a way that aligns with their own sustainability objectives. In the U.S., the SEC has announced that it will update guidance on corporate climate risk disclosure requirements, and the European Union is implementing new sustainability risk disclosure requirements for companies and asset managers while also finalizing a green taxonomy. The outcome from greater transparency and more reliable and consistent climate-related data may be a stronger flow of capital towards green investments.

At the same time, fiscal spending appears poised to increase and will align with global climate objectives. Focus in the U.S. is now on an infrastructure bill that aims to “build back better,” to fix and update existing infrastructure in a way that helps advance the goal of achieving net-zero carbon emissions by 2050. Global central banks are also taking action, and fixed income markets in particular are watching closely. Just days after Biden’s electoral win, the Federal Reserve (Fed) announced that it had joined a global organization of central banks working towards sharing best practices on climate risk management and mobilizing capital to support the climate transition. The Fed also created a new supervision committee on climate, headed by one of the co-chairs of the Taskforce on Climate-related Financial Disclosures (TCFD). This organization was established by the Financial Stability Board and is focused on enhancing the disclosure of material financial information related to climate so that the marketplace can better identify risks and opportunities.

50 Shades of Green

Investor demand for sustainable fixed income has rapidly increased. Inflows into sustainable fixed income ETFs in the U.S. alone totaled $2.2 billion in 2020, almost four times the total inflows of the prior three years combined.² Within fixed income investing, investors now have greater choice in terms of how to structure their portfolios to align with their sustainability objectives. There is growing differentiation in terms of “how green” different bonds are and whether an investment is aligned with a net-zero economy already, versus those which may be part of a transition towards that objective. The growing number of approaches and labels can cause some confusion. We believe that green bonds will be particularly attractive to a growing base of issuers and investors due to their simplicity, as well as the transparency and impact they can provide, particularly for those seeking “darker” green investments that are aligned with a long-term, net-zero emissions global economy.

A Paris-Aligned Framework for Evaluating Green Bonds

To have confidence in this alignment, however, there needs to be a robust evaluation of the projects financed. We believe the Climate Bonds Initiative’s (CBI) process of reviewing issuance and designating certain bonds as “green” can provide investors with confidence that their green bond portfolio is truly “green”. This process is the foundation of the S&P Green Bond U.S. Dollar Select Index.

The CBI, a global non-profit working to mobilize debt markets for climate solutions, reviews all available information for a given bond issuance to determine whether the proceeds will be used to finance projects or activities that are aligned with their taxonomy. The CBI taxonomy is an extensive list of assets and projects that are needed under the 2-degree warming target established under the Paris Agreement. In particular, the projects are aligned with the goal of reducing greenhouse gas emissions by 50% by 2030 and achieving net-zero emissions by 2050. The taxonomy is grounded in the latest climate science and research from the Intergovernmental Panel on Climate Change and the International Energy Agency, as well as the input of hundreds of technical experts from around the world. It has been developed through an extensive multi-stakeholder approach and is updated regularly based on new climate research and to capture new technologies. This taxonomy has, in our opinion, become the de facto global standard to define green projects and assets.

The CBI’s taxonomy covers projects across eight broad categories. Some projects are automatically eligible for a green bond designation, while others must pass certain screens to be eligible. For example, an offshore wind farm is generally automatically eligible. An onshore windfarm will also be eligible, but only if no more than 15% of the facility’s electricity usage is generated from non-renewable sources. Certain projects are compared against local baselines. For example, financing of green building construction must rank within the top 15% by emissions performance within their local market to be eligible. The taxonomy also has exclusions, such as “clean coal” or more efficient marine transport to transport coal or oil. There are also several areas where more research is needed to determine how to make a project 2-degree compliant, such as hydrogen fuel production. If there is not enough information for the CBI to make a determination or if less than 95% of the proceeds of a bond go towards a climate-aligned project or activity, then the bond is not eligible to be designated as green, and therefore not eligible for inclusion in the S&P Green Bond U.S. Dollar Select Index.

The Climate Bond Initiative Taxonomy Overview

Source: Climate Bonds Initiative

The Transition to Net-Zero

We believe the CBI taxonomy provides investors with confidence and clarity that their investment is financing projects that have a place in the transition to net-zero carbon and beyond. While capital must flow immediately to these types of projects, there has been growing attention on the transition towards 2050. Certain activities, such as electricity generation from coal, have no role in a net-zero world, and capital spending should be focused on remediation or decommissioning. But such spending would not be considered “green” by most investors.

There are also activities that can help to transition the world from “brown to green” but may not play a role past that. An example is “blue” hydrogen production which is heavily dependent on natural gas and therefore produces a high emissions footprint until zero-carbon “green” hydrogen production is viable. Investment in transition-related projects should not lock in a dependency on fossil fuels. For example, natural gas powered electricity generation with carbon capture may be a viable transition investment given the relatively short lifespan of these assets (15-20 years). However, because leakage of greenhouse gases cannot be fully curbed, these assets would not have a longer-term role and would not be eligible for a “green bond” designation by the CBI.

A Growing Sustainable Bond Ecosystem

Given the important role that transition-related companies and projects will play in getting the world to net-zero, there has been growing focus on a “transition” label to distinguish these investments from the “green” label that projects with longer-term roles to play are given. Many investors may choose to participate in financing the transition, and a pure green bond strategy may be “too forward looking” in that respect and provide exposure to a different set of issuers.

Another growing part of the sustainable fixed income market has been “sustainability bonds.” For these bonds, issuers do not earmark proceeds for specific projects but instead must satisfy broader ESG-related key performance indicators (KPIs) or otherwise pay a higher coupon. These bonds may provide issuers with greater flexibility outside of the CBI taxonomy, and might appeal to a company without a large green project pipeline. While not necessarily inconsistent with green investment, these types of bonds may be harder to align with a 2050 net-zero pathway and provide investors with little insight into how issuers actually achieve goals. There may also be difficulty measuring or monitoring the KPIs in a standardized way. Nevertheless, this area of the market has seen increased issuance and is worth watching.

Other sustainable bond investors may prefer an approach that focuses on the issuer rather than individual bond issue. A “brown” company can, after all, issue a “green” bond if the project financed is aligned with the taxonomy. The green bond structure naturally allows for forward-looking investment to bring non-Paris aligned companies into the net-zero economy, and many investors find that to be an appealing aspect. Other investors prefer to take broader environmental, social and governance (ESG) factors into account and might screen investments by the issuer’s ESG score. We believe such an approach requires a more subjective assessment and may rely too heavily on backwards looking data or a company’s own reporting, and also may not provide the transparency and impact that many investors seek. However, as ESG data continues to evolve, these strategies also have a role to play in the sustainable fixed income space.

Interestingly, although green bonds are focused on the projects financed rather than the issuer, the universe of green bond issuers, perhaps unsurprisingly, generally compares favorably from an ESG perspective versus the broader fixed income space in terms of not only environmental, but also social and governance risks. Issuers also tend to be less involved in major ESG-related controversies. Green bond issuance can signal a firm’s commitment to ESG priorities, and the broad green bond market includes issuers who are proactively addressing climate risk. We believe ESG scores generally reflect these dynamics.

Source: Morningstar as of 1/31/2021. Sustainability Score measures the degree to which a company's economic value may be at risk driven by ESG factors and is rendered on a 0-100 scale, where lower scores are better, using an asset-weighted average of all covered securities. Environmental Risk, Social Risk and Governance Risk scores measure the degree to which a company's economic value may be at risk driven by environmental, social or governance risk factors after taking into account a company’s management of such risks and are rendered on a 0-100 scale, where lower scores are better. % High/Severe Controversy represents the market value weight of a portfolio in which the issuer is involved in controversies rated high or severe.

ESG Investing: Not One Size Fits All

Ultimately, the emergence of different approaches to sustainable investing is a positive development for sustainable fixed income investors. It indicates the ongoing development of a large and liquid climate related bond market, which is itself part of the broader sustainable finance ecosystem. There is no “one size fits all” in the world of ESG investing, and there is room within a diversified fixed income portfolio for multiple approaches. Greater choice and differentiated approaches will help to attract more capital and help investors structure a portfolio aligned with their risk/return and sustainability objectives. As climate risks become more understood and incorporated into asset pricing, we expect that green bonds, transition bonds and sustainability bonds may all reflect varying degrees of risk and reward.

Reducing the friction cost of information gathering is crucial to attract more capital, and tools like the CBI taxonomy are crucial in that regard. Common definitions and market-accepted labels provide confidence and clarity to both investors and issuers, helping to attract more investment into the space. We believe the transparency, simplicity and objectivity of the use of proceeds approach will continue to find growing appeal in the marketplace, and believe that green bonds provide fixed income investors with a way to invest in the transition to a net-zero carbon economy and beyond.