Green Bonds: An Answer to EM Sustainability Financing

Emerging markets will require annual investments to more than triple from $770 billion in 2022 to $2.8 trillion by the early 2030s in order to meet rising energy needs while fulfilling climate goals set by the Paris Agreement¹. We believe that the global emerging markets debt market can play a crucial role in satisfying this financing need. With a strong fundamental investment case for emerging markets debt and the asset class demonstrating relatively strong returns over the last two years versus developed markets fixed income, there is an opportunity for emerging markets to tap into the growing green bond market, in our view. Green bonds have proven themselves to be an attractive solution for both sovereign issuers and fixed income investors; They have the same characteristics as a traditional bond, and thus a similar risk/return profile all else equal, but only finance environmentally friendly projects.

Annual EM Investment to Reach Net Zero Emissions by 2050

Source: International Energy Association.

Green Bonds May Satisfy Financing Needs

Green bond issuance is currently on an upward trajectory and on pace for a record year. As of January 2023, total green bonds have raised $2.5 trillion globally to support environmentally friendly projects,² and issuance this year has exceeded the first half of any other year, with over $350 billion of new green bonds issued as of June 30, 2023.³

Since 2016, 19 emerging market governments have issued green, social and sustainability bonds to help fund sustainable investment domestically.⁴ However, emerging market governments only represent 2% of total green and sustainable bonds issued globally with $74 billion raised as of January 2023.⁵ Emerging market sovereign issuers in the S&P Green Bond U.S. Dollar Select Index only accounted for 2.6% of the index market value as of July 31, 2023.

Green Bond Issuance Case Studies

Given the need to transition emerging economies to become low/zero carbon and aligned with global climate goals, green financing directed towards these countries must grow substantially. Fortunately, a handful of emerging market sovereign issuers have already provided several case studies of successful and innovative green bond issuances that can serve as a benchmark for other emerging markets. By partnering with multi-lateral development banks for both technical assistance and credit enhancements to broaden the investor base, the below examples demonstrate how emerging markets can use the green bond market to help satisfy their domestic green agendas while taking advantage of the strong and growing demand for green investments.

Chile

In 2019, Chile issued the first sovereign green bond in the Americas, and in total has issued $6.3 billion equivalent in green bonds through two deals. The initial demand for the country’s first green bond issue was nearly 13 times oversubscribed,⁶ revealing the strong demand for emerging market green bond issuance. The 3.53% yield was the lowest ever obtained by Chile for a similar tenor.

The government of Chile has applied the proceeds to multiple categories of green investment. The 2019 green bond focused on clean transportation, renewable energy, green buildings, and water management. The 2020 green bond directed proceeds to solely clean transportation. These investments are intended to build a low carbon, climate-resilient and sustainable economy as set forth under Chile’s 2030 Agenda commitments and its Nationally Determined Contributions (NDCs) under the Paris Agreement.

Multiple organizations provided support to Chile’s successful green bond issuances, helping to expand the investor base and provide assurance of its green bona fides to investors. The bond was certified under the Climate Bonds Standard and verified by Vigeo-Eiris, and the Inter-American Development Bank supported Chile with technical assistance programs, risk mitigation instruments and guarantees, and anchor investments.⁷

Ecuador

In May 2023, Ecuador tapped the sustainable fixed income market with the “Galapagos bond,” which will finance conservation efforts and sustainable development in the Galapagos Islands. This is an example of an innovative “debt-for-nature” swap in which a portion of a country’s debt is reduced in exchange for a commitment to fund environmentally friendly projects. This was part of the largest debt-for-nature swap to date. $1.6 billion of three Ecuador bond issues maturing between 2030 and 2040 was bought back at prices ranging from 30.5 cents to 53.25 cents on the dollar, and a new $656 million bond maturing in 2041 was issued,⁸ which allowed Ecuador to cut its debt servicing costs. The savings will be used for conservation efforts in the Galapagos islands as well as sustainable economic development to benefit the local community.⁹ The goal is to protect enough areas to have similar results to an 11,500-square mile (30,000-sq km) reserve set up last year that protected migratory species including sharks, whales, sea turtles and manta rays.

Once the $450 million of total conservation spending is considered, the Galapagos bond will cut Ecuador’s debt by over $1 billion.¹⁰ Ecuador will dedicate $12 million a year from the interest savings realized into the conservation of the Galapagos islands. Ecuador received an $85 million guarantee from the Inter-American Development Bank and $656 million political risk insurance from the U.S. International Development Finance Corporation helping to reduce investment risk and broaden the bond’s appeal to investors.

This Ecuador transaction has an innovative structure that benefits both the issuer from a fiscal perspective and helps to achieve the country’s sustainability goals. This sovereign bond is not classified as a green bond by the Climate Bonds Initiative because more than 5% of the proceeds are earmarked as economic development rather than green projects, resulting in a “sustainable” designation (which is a combination of green and social use of proceeds) rather than a pure “green” designation.¹¹ Nevertheless, we believe this innovative structure provides a useful case study that could be replicated by other emerging markets using the green bond format to finance environmentally friendly projects.

Egypt

In September 2020, Egypt became the first country in the Middle East and North Africa to issue a sovereign green bond. The five-year green bond was originally planned as a $500 million issuance size with a 5.75% interest rate, but due to overwhelming demand, it was increased to $750 million at a rate of 5.25% -- lower than Egypt’s benchmark conventional bonds. With the participation of 16 new investors in the country’s U.S. dollar-denominated bond issuances, there was clear evidence of strong investor demand. The bond’s proceeds align with Egypt’s Vision 2030, aiming to increase the proportion of green projects in the government’s investment budget. Egypt’s green bond will finance clean transportation, renewable energy, pollution prevention and control, sustainable water and water management, energy efficiency and climate change adaptation. In particular, investments aimed at increasing access to potable water through seawater desalination, increasing crop production through wastewater reuse for irrigation and a safer and more affordable commute through Cairo Monorail will be financed.

The Egyptian Ministry of Finance received assistance for its green bond issuance and reporting framework from the World Bank and IFC, and was verified by Vigeo Eiris.¹² The World Bank equipped Egypt with expertise in debt-management strategies and government policies for their green bond issuance.

Indonesia

Indonesia issued the world’s first sovereign Green Sukuk in 2018 and was oversubscribed, signaling strong investor interest. A sukuk is an instrument that generates returns to investors without infringing the principles of Islamic law, or Shariah. Indonesia is the fourth largest sukuk market globally. This green sukuk dedicates 100% of the proceeds to green projects and was verified by Cicero. Indonesia reached as much as 29% more investors with its first two issuances, as compared to normal sukuk issuances.¹³

In 2021, Indonesia issued a 30-year green sukuk, a record in the green sukuk market, which was more than three times oversubscribed. Together, Indonesia’s activity in the green bond market demonstrates the opportunity to tap into strong demand from the Islamic finance market to fund sustainability initiatives.

Indonesia used the proceeds of its green sukuk to fund its commitment to achieving its Nationally Determined Contributions (NDCs) under the Paris Agreement. The NDCs envision a low carbon and climate resilient future as well as biodiversity preservation as Indonesia is home to extensive rainforests. More specifically, the proceeds have been used for investment in sustainable transport such as the double track railway project on the North Java Line and renewable energy, including solar power plant projects, and the management of water retention facilities.

Transitioning to a Low Carbon Economy Through Green Bonds

As the need for investments in climate solutions continue to increase, emerging markets may not have the fiscal resources needed to achieve ambitious sustainability goals. We believe the green bond market provides an attractive option, and emerging markets sovereign issuers can leverage the strong investment case for EM fixed income along with the rise of the global green bond market to fund their green agendas. Several notable green bond issuances provide a roadmap for other emerging markets issuers who have yet to enter the market, demonstrating how innovative structures and strategic partnerships can be utilized to successfully fund the transition to a low carbon economy. Accordingly, we believe there is significant room for growth in the emerging markets sovereign green bond segment of the market.

The VanEck Green Bond ETF (GRNB) seeks to replicate, as closely as possible, before fees and expenses, the price and yield performance of the S&P Green Bond U.S. Dollar Select Index. The index is comprised of U.S. dollar-denominated green bonds that are issued to finance environmentally friendly projects and includes bonds issued by supranational, government and corporate issuers globally.

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