Key considerations when looking for greener pastures

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AUTHOR S PERSPECTIVE Green bonds Key considerations when looking for greener pastures Clive Smith, Senior Portfolio Manager, Fixed Income EXECUTIVE SUMMARY The green bond market is a relatively new

1 AUTHOR S PERSPECTIVE Green bonds Key considerations when looking for greener pastures Clive Smith, Senior Portfolio Manager, Fixed Income EXECUTIVE SUMMARY The green bond market is a relatively new development with the first issue by the World Bank occurring in While the market is still small it has grown dramatically and is expected to continue growing strongly. Indeed, the development of a material green bond market is viewed by some as being critical to assist in accessing the sheer scale of capital required for a transition to a low carbon economy. Given this, it is important for investors to have at least a cursory understanding of the market and the potential issues to keep in mind when investing in it. This brief paper aims to address some of the more common questions asked about green bonds. What is a green bond? While green bonds may be relatively new, they are simply one of the latest types of themed bonds which trace their origins back to the railway bonds of the 19 th century and more famously, the Victory Bonds issued by the USA during World War II. This has resulted in green bonds sometimes being referred to as the Victory Bond for the environment. In general, theme bonds are designed to: allow institutional capital to invest in areas seen as politically important to their stakeholders that have the same credit risk and return profiles as standard bonds, provide a means for governments to direct funding to desired areas via preferential tax treatment, and provide a political signal to other stakeholders. Before going into definitions, it is worth stressing that financial products cannot be green per se greenness is derived from the uses to which the funds are being allocated (i.e., the underlying assets or activities). So, the definition is ultimately at the underlying assets or activities level. While this sounds straight forward, the difficulty is that the definition of what constitutes a green project will vary from investor to investor. Despite this, it is possible to set down some general criteria as to what constitutes a green project. Green bonds can be broadly defined as fixed income securities issued (by governments, multinational banks or corporations) to raise the necessary capital for a project which contributes to a low carbon, climate resilient economy 1. A growing market As soon as you set out to define the size of the market you are confronted with the issue of clearly defining what comprises a qualifying investment. If you use the very strict definition that the security must be explicitly labelled as a green bond to qualify then, as at June 2016, there are approximately US$118 billion of green bonds 1 See OECD Working Paper No 24 p27. It is useful noting a slight evolution in terminology. In the market s early stages most green bonds issues tended to be climate bonds where the proceeds go to climate mitigation or adaptation efforts. Under the Climate Bond Standards Board Certification requirements, climate bonds (which are a subset of green bonds) are bonds which directly contribute to: developing low carbon industries, technologies and practices that achieve resource efficiency consistent with avoiding dangerous climate change; and essential adaptation to the consequences of climate change. While similar, it is worth noting the definitional nuances between what are referred to as green bonds and climate bonds. Russell Investments // Green bonds: key considerations when looking for greener pastures July 2017

2 outstanding. Alternatively, the Climate Bonds Initiative (CBI) defines a climate bond as having proceeds that must align with their criteria for a low carbon, climate resilient economy (see definition regarding Climate Bond Standards Board Certification in footnote 1). Using this as a definition of unlabelled climate aligned bonds, the CBI estimates the size of the total market, both explicitly labelled green bonds and unlabelled climate aligned bonds as being around US$694 billion in funds outstanding, as at June Of the total climate aligned market, around 78% is investment grade and therefore suitable for institutional investors. While these numbers appear large, they must be viewed in the context of the global bond market which is in the region of USD100 trillion. Accordingly, even using a broader definition of green bonds used by the CBI, the green bond market is relatively small (<1%) and possesses material scope for growth. The obvious question is how large could the green bond market become? Answering this question is problematic and depends on the assumptions made regarding the composition of funding. However, the UN quotes US$1.6 trillion per year in total investment required for a global energy transformation that simultaneously meets emission targets and facilitates an upward convergence of energy usages of developing and developed countries. In addition, the International Energy Agency estimates global replacement costs of existing fossil fuel and nuclear power infrastructure at, at least, trillion. 2 With such levels of required global expenditure, even if a relatively small portion of this cost is funded via green bonds, say 2%-3%, then there is clearly material scope for growth within the sector. The green bond menu Investors need to keep in mind that green bonds are just like traditional bonds and should be viewed accordingly. Just like traditional bonds there are four main types of issuance which may occur namely: asset backed (tied to a pool of green projects or refinancing of green projects) corporate bonds (issued by a green company or funding a green project ) bonds issued by international development banks to fund green projects sovereign or municipal bonds Up until relatively recently, most issuance had occurred in the last two categories. This is unsurprising given the lack of a standardised definition of what constitutes a green bond. In the absence of clear standards investors had to rely on the credibility of issuers who have due diligence and monitoring processes built into their products. For this reason, the initial growth in the market had been driven by organisations like the World Bank which has: (a) global credibility, (b) longstanding relationships with sovereign nations and (c) an ability to access special deals on projects and repayments which lowers default risk. To help the asset-backed and corporate bond markets gain traction, there needed to be a greater level of standardisation for what constitutes green projects. Standardisation, as had occurred in the traditional bond market, assists the growth of the market by not only facilitating greater investor confidence in what to look for, but also by reducing the associated transactions costs. Fortunately, having identified these potential impediments, the industry has risen to the challenge. In November 2011, the Climate Bond Standards Board, a group of institutional investors and environmental non-government organisations (NGOs), established a certification programme for climate bonds. Further, a group of the world s largest investment banks (Bank of America, JP Morgan, Citigroup, and Crédit Agricole Corporate and Investment Bank) established a drafting committee to establish voluntary guidelines on the recommended process for the development and issuance of green bonds. The result was the Green Bond Principles, 2014 (Voluntary Process Guidelines for Issuing Green Bonds) which was released on January 13, 2014 and has been adopted by some of the largest banks. The steps taken to move towards a greater degree of standardisation has assisted the development and growth of the green bond market. While the move towards standardisation should be viewed positively by investors, it is important to note that such programmes are aimed at more clearly determining what should count as a green bond from the perspective of an investor. Critically, such certification programmes do not attest to the financial viability of the underlying project being funded by the green bonds. 2 OECD Working Paper No 10 p8. Russell Investments // Green bonds: key considerations when looking for greener pastures 2

3 Keep true to your investment objectives While the returns from green bonds, both financially and ethically, may look appealing, investors still need to understand not only the underlying project but also the structure of the overall funding facilities to ensure that they are being adequately compensated for the risks involved. As green bonds should be considered just like any other fixed income investment, below are a couple of the more important points that investors should keep in mind when considering an investment in green bonds. First, green bonds need to be verifiably linked to eligible underlying assets with clear procedures in place to ensure the bond principal is directed towards those assets. This is particularly important when dealing with a corporate bond where it is essential to ensure that the assets the bonds are funding, along with the associated cashflows, are effectively ring fenced. Second, it is advisable that investors should look for green bonds which are structurally as close as possible to traditional vanilla bonds. The danger is that there is a temptation for originators to add complexity to the structure, thereby creating a bond with all the bell and whistles. Yet the adding of such complexity can make it more difficult for investors to value the bonds and understand the risks associated with the investment. Given this, green bond issues which incorporate additional layers of complexity should either be avoided altogether or at the very least scrutinised much more closely. Finally, investors need to remember that a green bond is just like any other bond. Namely the investment is only as good as the underlying project securing the loans. Put another way, just because a project is promising to (a) assist the environment, (b) pay solid coupons and (c) potentially provide tax incentives to bond holders, does not necessarily make it profitable enough to repay the initial debt raised to fund it. For this reason, it is still important for the investor to consider the viability of the underlying projects being invested in and to ensure that the risks associated with the underlying project are in line with the desired risk profile. For investors wanting green bonds which exhibit the characteristics of more traditional defensive style assets, more mature projects which have lower risk cashflows would likely be the more suitable form of collateral. Development-type projects, especially those supporting new and/or unproven technologies, are more suitable for investors seeking materially higher returns with quasi-equity like characteristics on account of the materially higher risk of failure. Investors wishing to support such higher risk projects can still do so via green bonds but may have to assess whether they are better served by making equity investments in such projects given the risks involved. Why would you choose a green bond over a traditional fixed income security? There are a range of reasons why green bonds are particularly attractive. The main reason is that they provide greater scope for investors to support green projects explicitly. This might seem obvious but certain types of green investments may be difficult for many investors to integrate within their existing portfolio structures. Green bonds, however, as highlighted earlier, can be designed with a structure as close as possible to traditional bonds. This makes them a type of investment with which investors are already familiar and so facilitates the effortless integration of environmental initiatives into portfolios. The ability to slot green bonds more easily into existing investment structures and processes is another reason why, in our view, investors should exhibit a bias to invest in green bonds with structures more in line with traditional bonds. Russell Investments // Green bonds: key considerations when looking for greener pastures 3

4 Issued (USDbn) What would a green bond portfolio look like? The nature of any green bond portfolio will depend upon the specific investment guidelines used by the investor. However, the general characteristics of a representative green bond portfolio can be implied by considering the issuance characteristics of the market 3. Figure 1: Green Bond Issuance by Issuer Commercial Bank Asset-backed security (ABS) Development Bank Corporate Sub-sovereign/Municipal Sovereign Source: Green Bonds Highlights 2016: Climate Bond Initiative (Jan 2017) Historically, the majority of any portfolio was, and still is, likely to comprise a majority of government related entities as, to date, they have comprised the major issuers of green bonds. Yet, as highlighted by Figure 1, as the market has grown, so has the range of issuers, providing greater diversification. Most notably corporate issuance, which effectively didn t exist prior to 2013, has evolved to become a material and growing part of the market. To date, a relatively small proportion of funds are being raised via securitised vehicles. This is somewhat surprising, given the bias with green bonds to ring fence cashflows to and from a project. However, it does suggest that there will be increased scope for securitisation to play a more significant role in issuance in the future. Figure 2: Green Bond Issuance by Use of Proceeds Energy Building & Industry Transport Water Waste management Agriculture and Forestry Adaption 3 The complicating factor in considering potential portfolio characteristics is that the nature of the market is evolving rapidly over time as the market matures. For this reason Russell Investments takes the issuance patterns of 2016, as reported by the Climate Bond Initiative January 2017, as being broadly representative (i.e., potentially more representative than considering the cumulative outstanding issuance). It is also worth noting that the quoted CIB statistics include both explicitly labelled green bonds and unlabelled climate aligned bonds. Russell Investments // Green bonds: key considerations when looking for greener pastures 4

Source: Green Bonds Highlights 2016: Climate Bond Initiative (Jan 2017) To date, the usage of funds has been dominated by projects associated with alternative energy and increasing energy efficiency.

5 Source: Green Bonds Highlights 2016: Climate Bond Initiative (Jan 2017) To date, the usage of funds has been dominated by projects associated with alternative energy and increasing energy efficiency. However, it is worth noting that, while energy related projects are those investors would most readily associate with green bonds, they also include other types of non-energy related projects such as those targeting sustainable water and pollution prevention. Such a spread of uses should assist investors to diversify their portfolios not only by project but also by usage. Figure 3: Green Bond Issuance by Region Source: Green Bonds Highlights 2016: Climate Bond Initiative (Jan 2017) Most significant is that green bonds are rapidly becoming a truly global market. With issuance having initially been dominated by supranational and then non-supranational issuance from Europe and North America, the demand for funds by geography has been steadily broadening. The standout is the recent growth in issuance from Asia and most notably China. This not only means that there is increasing diversification in issuers and usage but also across geographies. Conclusion Green bonds are an exciting new development which provides scope for investors to incorporate more efficiently their support for green projects into existing portfolio structures and processes. Accordingly, as the market develops, both in size and standardisation, this will provide potentially attractive opportunities for investors. However, investors need to keep in mind that just because a project is green does not necessarily make it a good investment. Green bonds must be viewed just like any other fixed income investment in terms of ensuring the quality and security of the underlying project/collateral which is being funded by the bonds. Russell Investments // Green bonds: key considerations when looking for greener pastures 5

6 References Climate Bonds and Climate Change: The State of the Market in 2016 : Climate Bond Initiative (June 2016) Green Bonds Highlights 2016 : Climate Bond Initiative (Jan 2017) Defining and Measuring Green Investments: Implications for Institutional Investors Asset Allocations : OECD Working Papers on Finance, Insurance and Private Pensions, No 24 (August 2012) The Role of Pension Funds in Financing Green Growth Initiatives : OECD Working Papers on Finance, Insurance and Private Pensions, No 10 (September 2011) Green Bond Principles, 2014: Voluntary Process Guidelines for Issuing Green Bonds (January 13, 2014) Russell Investments // Green bonds: key considerations when looking for greener pastures 6

7 FOR MORE INFORMATION Contact Nicki Ashton on or nashton@russellinvestments.com, or visit russellinvestments.com/au IMPORTANT INFORMATION Issued by Russell Investment Management Ltd ABN , AFS Licence (RIM). The Author s Perspective is an internal Russell Investments publication in which Investment Division authors may record and share individual views and thought leadership on a broad range of topics. The conclusions and opinions in an Author s Perspective do not necessarily reflect the views of the Investment Division or Russell Investments. As these views have not been widely vetted or established as official views of Russell Investments, they may be subject to further development and modification. Therefore, these publications may be freely distributed within Russell Investments, but should not be shared directly with any external audience. This document provides general information only and has not been prepared having regard to your objectives, financial situation or needs. Before making an investment decision, you need to consider whether this information is appropriate to your objectives, financial situation or needs. This information has been compiled from sources considered to be reliable, but is not guaranteed. This document is not intended to be a complete statement or summary. Copyright 2017 Russell Investments. All rights reserved. This material is proprietary and may not be reproduced, transferred, or distributed in any form without prior written permission from Russell Investments. First used: July 2017; AUST Russell Investments // Green bonds: key considerations when looking for greener pastures 7

Many Shades of Green. Disclosure Documents in Green Bond Offerings

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