The green bond market could soon reach $1trn on in annual issuance volume globally by 2023, as governments, supranational entities and corporations make pledges to reduce carbon or have net-zero carbon emissions by 2050.

That is still a tiny part of the $100trn total global debt, but considering the infrastructure upgrades that must be made to cut greenhouse gases –  everything from improving the electrical grid to developing more efficient use of natural resources – the debt markets will play a key role in financing these projects.

“Green bonds are really well-suited to achieve those goals,” said William Sokol, product manager, ETFs, at VanEck, which issues the VanEck Green Bond ETF (GRNB) in the US.

But the market is still relatively new, having launched in 2007, when the World Bank and the European Investment Bank issued AAA investment-grade bonds from multilateral institutions, according to the Climate Bonds Initiative, a global non-profit focused on using debt markets for climate solutions.

Green bonds fit in the larger environmental, social and governance framework, but investors interested in adding them to portfolios should understand their differences.

Funding environmental projects

Green financing has always existed in some respects, such as when municipalities would issue bonds for stormwater remediation, observes Trenton Allen, managing director and CEO at Sustainable Capital Advisors, which specialises in sustainable finance, including project finance.

What is different now is, under the green-bond structure, investors can isolate and track the environmental component of the proceeds’ use, Allen explained, adding that by offering green bonds, issuers might be able to increase their investor base, and perhaps demand for their particular bonds, which may reduce their overall funding costs.

Although the issuer offers additional information about the bonds by explaining proceeds use, Sokol said investors still need to do their standard credit due diligence before buying these.

When green bonds come to market, the Climate Bonds Initiative reviews issuance using a taxonomy it developed based on the latest climate science and research from the Intergovernmental Panel on Climate Change, the International Energy Agency and other experts.

The taxonomy includes a broad list of assets and projects that will help reduce greenhouse gas emissions by 50% by 2030 and will achieve net-zero by 2050. Based on the list, it will designate whether a green bond meets its taxonomy, and its designation is considered the gold standard for third-party certification.

The group’s taxonomy includes eight categories for green bonds, including energy, water, buildings and waste.

Some green bonds get oversubscribed and have a “greenium” – a green premium, which means their yields are lower than a similar non-green bond. However, TD Securities noted premiums in recent green-bond sales have declined, so this may become less of an issue for income seekers.

How green bonds fit with ESG

Ashley Schulten, head of responsible investing for global fixed income at BlackRock, which offers the iShares Global Green Bond ETF (BGRN) in the US, pointed out that green bonds share some similarities with other ESG-type offerings, but they are not interchangeable.

Green bonds focus specifically on the ‘E’ aspect of ESG. Many sustainably-minded investors often consider all three pillars of ESG, so they may avoid buying a green bond from a company that does not consider the social or governance criteria.

ESG investments are subjective, Sokol noted, and an overall ESG score is based on several data points, while green bonds are solely about proceeds earmarked to a project: “You are not necessarily looking at ESG scores or even the broader activities of the issuer.”

Companies that are just starting to address climate change internally may offer green bonds as a way to fund that transition, Schulten remarked.

“Those are the most interesting stories in the green space,” she said. “How can we use this funding tool to help companies go through this really rapid restructuring of the types of businesses they do, even if their parent company might not be the chosen child of today’s ESG portfolio?”

Jim Pratt-Heaney, founding partner of Coastal Bridge Advisors, stressed that investors need to understand the distinction between green bonds and ESG if they are considering green bonds for their sustainable investors.

“You have to look at the broader picture. For instance, if a project sounds really good, but [the issuer] is horrible to their people, I would not call that a green bond,” he argued.

Avoiding greenwashing

Sustainable investing’s popularity has led to some “greenwashing,” in which issuers sell green bonds that do not align with carbon reduction. For example, a few years ago, Spanish energy company Repsol issued green bonds to make their oil refineries more energy efficient.

Mark Haefele, global CIO at UBS Wealth Management, reassured investors that greenwashing is not widespread, and predicted it to become less of an issue as regulations and external reviews become more prevalent.

To identify greenwashing, UBS verifies whether the issuer is only refinancing existing activities or projects they must implement; is investing mostly in non-green business or aims to maintain existing polluting activities for as long as possible; does not set any ambitious environmental targets on a corporate level; and how much transparency it offers.

BlackRock’s Schulten observed there are not huge incentives to greenwash bonds because of the transparency involved in stating bond proceeds. What investors may see are some debates about what can be included as green, such as blue hydrogen, which is made from methane.

“There is this agreement that we really need to stay away from fossil fuel upgrades in green bonds, or if they are extending the life of some of these assets,” she explained. “[Those] have to be decommissioned if we are actually to have any shot of getting to net-zero.”

“Transition” bonds have started to become a small part of the green bond market. These are bonds of companies that are legitimately transitioning from fossil fuels by aligning with Paris Agreement goals to reduce carbon emissions.

“There is this whole spectrum now where you can be dark green or light green,” Sokol said. “Investors can take different views of what they want to invest in.”

GRNB’s methodology does not include transition bonds because, if the bond issuer’s offering does not align with the Climate Bonds Initiative’s definition of green, the firm will not include it.

“As the green finance market expands, there will be the ability to differentiate,” he continued. “I guess the question is whether investors want that lighter green transitionary [bond]. We will have to see.”

Expanding the market
Sustainable Capital Advisors’ Allen said he expects this market to continue to grow, especially if issuers believe there is a way to expand their investor base, and added that if growth continues, it needs to be met by ever-improving transparency into proceeds’ use and metrics that can quantify outcomes such as the amounts of carbon avoided or energy saved.

“As we start to get comfortable with the longer-term disclosure and performance of these particular assets, how are we going to deem impact and how will we evaluate targets?” he asked.

Schulten argued ETF issuers have also become more comfortable with giving information and understanding what data investors want, which helps bring more credibility to the sector. With the green bond markets expected to reach $1trn in annual issuance volume in a few years, she said she would rather see a better market than a bigger market.

“I am not keen on seeing growth just for growth,” Schulten noted. “If growth is there, because the actual projects are there, then great. But let us not widen our standards just to incentivise larger AUM numbers.”

This story was originally published on ETF.com

Please note: The tool is provided by ETF Logic who shall process your personal data in accordance with their privacy policy.