Funding. It’s one of the most common struggles when trying to move a sustainability project forward. Fortunately, a new form of capital for companies committed to environmental-related projects is on the scene – Green Bonds.
What Makes a Bond Green?
The World Bank categorizes Green Bonds as “fixed income, liquid financial instruments that are used to raise funds dedicated to climate-mitigation, adaptation, and other environment-friendly projects.” Terms and conditions are similar to traditional bonds, but are issued specifically for the purpose of raising funds to combat climate change.
The market for Green Bonds is smaller than corporate bonds. In 2014, the market for Green Bonds more than tripled to $36.6 billion, and is projected to reach $50-70 billion in 2015, while the global bond market is around $78 trillion.
There aren’t any hard and fast rules as to what constitutes “green,” so financing teams work with offerers to determine the appropriate “green” use-of-funds requirements. One set of requirements might be for any general green building investments; but another might be specifically for the construction of LEED and ENERGY STAR certified buildings.
While the financing team has the final say, early adopters have been pushing for the requirements to reflect the offering firm’s environmental, social, and governance (ESG) values, rather than a sweeping set of requirements as defined by the financial industry. If you need an argument to get involved early, this is it.
When to issue a Green Bond?
As interest peaks, many are still trying to define the ideal circumstances when a green bond is the right capital strategy. Does the interested firm have an existing appetite for debt? Does the firm have an interest in investing in ESG issues? If the answer to both of those questions is yes, then a Green Bond should be on the table.
Green Bonds also signal that the offerer is committed to ESG issues, which increases demand from tenants, occupants, consumers, and investors – presenting additional sources of funding in the future.
Because of the smaller supply of Green Bonds, recent demand has been high. This high demand can introduce the offering firm to new investor relationships that would have otherwise passed on a traditional bond opportunity. Rachel Kyte, World Bank group vice president said that “[Green Bonds] are providing green investment opportunity for an ever wider investor group, including those who wish to divest and diversify from fossil fuel-intensive portfolios, and they have proven that a stream of investor capital exists for green assets.”
Like any bond offering, Green Bonds require attestation for use-of-funds to confirm that the funds are used as intended. This isn’t a new requirement for auditors, but it requires the review of new types of information, presenting a potentially frustrating learning curve for auditors and offering teams.
Additionally, companies that offer Green Bonds haven’t necessarily seen beneficial pricing – though it hasn’t been worse. Pricing has been comparable to traditional bond offerings, so the financial value has to be inherent in the ESG investments and any publicity it delivers.
The Future of Green Bonds
While the Green Bond market continues to grow at a fast clip, how will they affect the market one, five or 10 years from now?
There is pressure to provide industry-wide standardization, such as these recommended standards released by GRESB, an organization that assesses the sustainability performance of global real estate portfolios.
As debt providers get better at incorporating sustainability risks into probability of default (PD) and loss given default (LGD) models, there may be further innovation in debt products that compete with Green Bonds. According to GRESB, “a recent study conducted on 80,000 CMBS loans found 20-30% lower default rates associated with ENERGY STAR labeled and LEED certified buildings.” Debt providers should pay more attention to these factors than they have in the past.
With interest rates at historic lows and the high volatility in equity markets, debt financing has been popular. We’ll watch the Federal Reserve System in the coming months – a rate increase will impact the preference of firms to raise debt. Green Bonds could see more differentiated pricing as the bond market becomes more competitive. This could trigger greater growth rates in Green Bond investments than we’ve seen recently.
Since Green Bonds are investment-grade offerings, will private or non-investment grade corporations offer them to attract new capital? With the growth in green banking, this could be the tool that brings Green Bonds to a new market. Non-investment grade companies tend to be the organizations where the stability and financial benefit of ESG investments can make a positive difference in both bottom line returns and credit risk.
There is much to be determined for the future of Green Bonds and how investor expectations will evolve. We look forward to seeing how things develop and positively affect our environment and our capital markets.