Green bonds are a recent market innovation that we first saw only a few years ago. In 2007, the European Investment Bank issued its first “green bond,” which was then followed by a similar bond from the World Bank. Together with the Oslo-based research center CICERO, The World Bank had identified a list of green topics. These topics included climate mitigation projects such as solar and wind installations, funding for new technologies that permit significant reductions in greenhouse gas (GHG) emissions and carbon reduction through reforestation and avoided deforestation. Also included were adaptation projects, such as protection against flooding, the implementation of stress-resistant agricultural systems and a few others.
Since then, the green bond market has grown rapidly at a compound annual growth rate (CAGR) of greater than 50%. With an estimated issuance exceeding USD 40 billion in 2014, compared with USD 11 billion in 2013 (and USD 5 billion in 2012), the market has expanded significantly in terms of scope, average issue size and issuer diversity. The green bond market is still relatively small, with about USD 45 billion currently outstanding versus USD 100 trillion for the global fixed income market. However, the green bond market has the potential to contribute substantially to the scale of trillions of dollars of private and public sector capital needed to combat climate change (see Exhibit 1). Many efforts are now being taken by various organizations to raise investor sensitivity to GHG-related effects.
Exhibit 1: The Road to a Low-Carbon Economy
Several questions arise in regard to this new asset class. First, how can we make sure that the green bonds are really delivering what they promise? Second, will additional pieces of the puzzle be required before we can see green bonds as a universe of its own? Third, if this group is to become a universe, what role can indexing play as part of the green investing ecosystem to attract capital at scale?
First, there are no mandatory or uniform criteria for green bonds. The green bond market, as it stands today, is “self-labeled” with voluntary issuer disclosure standards that vary in scope and quality. It is generally accepted that green bonds are required to direct their proceeds solely into projects that generate environmental, or more precisely, climate benefits. A voluntary set of guidelines (The Green Bond Principles [GBP]) developed by 13 industry participants in January 2014 assumes, among other things, that there is a robust project selection process according to the green criteria and that the use of proceeds is reported. Since the publication of the GBP, 49 institutions have signed up. Although the GBP only provide a voluntary framework, giving enough leeway to the issuer,compliance with them has become the cornerstone of the green bond independent verification process. This third-party verification itself forms part of the requirements, and it represents an important component of the assurance that the bond is green. Going forward, more rigorous standards can be expected to emerge.
Second, we believe that green-labeled bonds may not be all that is needed to define the green fixed income universe. There are quite a few bonds that have been issued without a green label but they have been designed to finance pure green projects, such as wind farms or solar installations. Such bonds, issued either as project finance instruments, project asset-backed securities (ABS) or corporate bonds of pure-play green companies, provide investors the opportunity to get a step closer to environmentally friendly or sustainable investing and to invest directly in projects that mitigate the impact of climate change without any reliance on a green label. We believe that the green fixed income universe would be incomplete without these bonds.
Third, why indexing becomes important for the green bond market. S&P Dow Jones Indices has launched the S&P Green Bond Index and the S&P Green Project Bond Index as separate, but integral parts of the market benchmark for the evolving green bond universe. Both indices apply a set of transparent criteria related to green assets being financed. At a specified green credit quality level, a green bond investor does not have the ability to question the capital efficiency of the associated environmental benefits (e.g., a wind farm in China versus a green REIT in the U.S.), therefore, it is important to have an opportunity to diversify across asset types and geographies. The S&P Green Bond Index aims to achieve transparency and simplicity and to aid in the commoditization of this asset class. The S&P Green Project Bond Index addresses long-term investor objectives such as liability matching, inflation protection and stable, uncorrelated, long-term yields. The two indices happen to have different credit profiles (see Exhibits 2 and 3) and correspond to the specific range of the risk/return continuum that may be a match for different investor strategies.
Exhibit 2: Credit Rating Distribution of the S&P Green Bond Index
Exhibit 3: Credit Rating Distribution of the S&P Green Project Bond Index
The combination of both of these indices may create the much-needed transparency regarding the expected and actual performance of the green assets or projects, which is important for attracting long-term, large-scale and climate sensitive capital for investments.
S&P Dow Jones Indices cordially invites you to a complimentary live webinar for investment professionals where industry experts will discuss the next steps to making green bonds a mainstream asset class. Register here.
For more information, see Green Bond Principles.