With the accelerating technological shift towards renewable energy, it is becoming apparent that green bonds are set to be a significant global disrupter in addressing climate change. This technology shift is akin to some of the most significant in history such as horse carriages to cars, or more recently, cell phones to smart phones, which occurred, astonishingly, in less than a decade.
Regarding the increasing global response to climate change, we are starting to see the same type of shift towards renewable or sustainable technologies in energy sources, electric vehicles, energy efficient buildings and water treatment. The ongoing development of these technologies will be expensive and very capital intensive, prompting the question of how these projects can or will be funded, but we believe that much will come from the Green Bond market.
The rise and rise of Green Bonds
The World Bank launched the first AAA-rated Green Bond in 2008 in response to demand from large Scandinavian pension funds that were seeking an effective and direct way of supporting climate-friendly projects. In line with its strategy of promoting financing to support climate change mitigation, the World Bank has now issued approximately USD 9.7 bn in Green Bonds, which has helped support nearly 70 key projects around the world1.
This active effort by the World Bank has driven the Green Bond market to grow from a niche asset class to nearly USD 200 bn (as of 31 Dec 2016). We estimate this amount will double by year-end to over USD 400 bn and if the market continues to develop at its current rate, the Green Bond market should exceed USD 1.2 trillion in total issuance and outstanding, by 2020 (see Chart 1).
Chart 1: Green Bonds are seeing huge growth
Source: Bloomberg, Nikko Asset Management estimates
Private investors are leading the way
Strong demand from private investors is helping drive this massive growth, with investment policies shifting in public pension funds and insurance companies also making a significant contribution.
While the current US administration’s pro-fossil fuel / anti-EPA stance, coupled with its denial of climate change, has polarised the market somewhat, it has also mobilised private investors to take a leadership role in the development of the asset class. Our view has always been that the private investor market would be the likely source of much of the required growth in climate change financing if the world was to meet the Paris Accord threshold of no more than a two degree increase in global temperatures in the next hundred years. To achieve this objective, it has been estimated that USD 12.1 trillion in infrastructure investment will be required over the next 25 years - which is 75% greater than most consensus growth projections.
Thus, with the global bond market worth around USD 100 trillion, it will require the reallocation of a significant part of this massive asset pool to allow the necessary funds from private investors to be directed into this infrastructure development via Green Bonds.
A fixed income disrupter
Along with disrupting traditional segments of the global fixed income market, the growth in Green Bonds has also opened up a number of exciting investment opportunities in new fixed income asset classes. For instance, Green Bond investing was initially driven by Multilateral Development Banks (eg. World Bank), but the first corporate was issued in 2013, and since then, corporate issuers have acted as a catalyst, driving innovation, growth and new issuance in the market.
In recent years Green Bond issuance has grown substantially, confirming the validity of the investment approach, and raising expectations of the benefits of further expansion. Many sovereign funds have now indicated their willingness to build on this momentum and have also started issuing Green Bonds.
Poland was the first country to launch a Green Bond, with its EUR 750m issue. France was the first G8 country to roll out a significant program of Green Bonds with EUR 7bn issued in February 2017. China also issued nearly USD 36 bn in Green Bonds last year, with early signs that this figure could double in 2017. We would expect these commitments, as well as others made by governments in Brazil, Morocco, Nigeria, Sweden and Kenya, to encourage even more corporates to become involved and start issuing Green Bonds.
Federal government involvement has also helped to drive and implement “green” issuance in the US municipal bond market, with US state and local governments in Washington State, Massachusetts and New York all now issuing green municipal bonds, many of which have been used to invest in transportation and water-related projects.
We have also seen some issuers of asset-backed securities (ABS) and mortgage-backed securities (MBS) starting to launch Green Bonds, as a way of providing investors interested in combating climate change an access point via these more mainstream asset classes.
Chart 2: A diverse range of asset classes
Source: Bloomberg, Nikko Asset Management
Transparency is critical
When evaluating Green Bonds from an investment perspective, alongside traditional metrics like credit quality, maturity and price, there also needs to be an assessment of the projects that the bond will support. To help with this process, and in order to make this growing asset class more appealing to institutional investors, the International Capital Market Association (IMCA) developed the “Green Bond Principles.” These principles are supported by over 115 institutions that participate in the Green Bond market, and comprise four core components:
- Defined use of proceeds, in which the environmental benefits of every project that the bond will support are clearly specified.
- Continuous project evaluation and selection, in which the bond’s project evaluation and selection is complemented by regular independent reviews of each project’s performance.
- Management of proceeds, in which funding allocations to every project are clearly identified, as are the underlying investment of any unallocated funds.
- Reporting, which lists all projects to which money has been allocated, including a project description, amount invested and expected environmental impact.
As new asset classes of Green Bonds have emerged, so too have new varieties with different ‘shades of green’. It is for this reason that the Green Bond Principles are so important. They help issuers and investors to distinguish between pure Green Bonds, which must meet very strict criteria about the projects they support, and “lighter green” bonds, which have can be used for wider range of projects.
Investor demand has also prompted leading asset consultant, S&P Global Ratings, to create a Green Bond Evaluation tool, which can be used alongside traditional bond analysis. This tool aims to evaluate the environmental impact of each project that is financed by a particular Green Bond.
We believe the strong focus on transparency, coupled with participation by key players in the industry, will not only help issuers when launching Green Bonds but, more importantly will ensure investor demand continues to grow, by clearly setting out the true environmental impact of their Green Bond investments.
A broad market effort
To reach the USD 12.1tn investment threshold over the next 25 years, it will require a significant commitment from all market participants. Green Bonds typically have the same yields and pricing characteristics as traditional bonds. This, coupled with the growing demand, transparency and diversification of Green Bonds, means that the asset class is more and more likely to develop into a mainstream part of an investor’s global fixed income portfolio.
In summary, Green Bonds has in the past been a smaller element of the total global fixed income market. However, with the recent growth of issuance, it will help to meet the Paris Accord at a faster rate.