The role of green bonds in the sustainability transition

As the world looks to reshape its energy infrastructure and industrial processes to accommodate a shift away from fossil fuel consumption, the thorniest issue is how the transition will be financed. Governments and companies across the world have embraced the concept of green bonds – securities whose proceeds are specifically earmarked for projects and activities that benefit the environment.

The concept of green bonds has been around for more than a decade and a half – the first was issued by the European Investment Bank in 2007 and listed on the Luxembourg Stock Exchange – but it has really taken off over the past three years.

Green and sustainability bonds raised $273bn in the first quarter of 2024, according to the non-profit transparency organisation Climate Bonds Initiative. Last year, green, social, sustainability and sustainability-linked bonds raised a total of $870bn, 3% more than in the previous year, but market experts say it only really started growing in earnest in 2021 when it became clear that appetite existed among investors.

The popularity of green bonds has also been boosted by regulatory changes and their impact on rating agency assessments, according to Alessandra Simonelli, Head of Sustainable Development at Banque Internationale à Luxembourg: “This may lead to a realignment of investors’ strategy to incorporate ESG performance, with consequences for demand and pricing.”

Increasingly, the ‘green bond’ category has expanded to incorporate securities that embody a wide range of sustainability approaches.

Wide range of sustainability approaches

Greater choice is also an important factor. Increasingly, the ‘green bond’ category has expanded to incorporate securities that embody a wide range of sustainability approaches. Blue bonds are intended to raise money for the ocean-based economy, social bonds provide funding for social impact projects, and sustainable bonds are used to finance project that combine environmental and social goals. There has also been the emergence of sustainability-linked bonds, which peg the interest rates paid by issuers to their fulfilment of pre-agreed targets in areas such as greenhouse gas emissions.

All these debt instruments, often grouped together under the name of green bonds, are issued by governments, companies, banks and supranational bodies such as development banks to finance sustainability-linked projects and activities. The sovereign green bond market is now well established with participants from all around the world.

For example, in December 2023, Brazil raised $2bn in sustainable bonds, saying the funds would be allocated to initiatives that promote sustainable development. Brazil, Colombia and Ecuador are part of a working group in talks with development banks to launch an issuance framework to raise billions of dollars of low-cost funding for measures to protect the Amazon rainforest.

In Europe, the French government has been the largest issuer of green bonds, using the proceeds to fund measures to mitigate and adapt to climate change, protection of biodiversity and reducing environmental pollution. The European Commission plans to raise up to €250 billion worth of green bonds to fund the Next Generation EU economic recovery package, which will cement its position as a green bond leader.

As with all sustainability-related financial products, there has been concern over greenwashing, and that bond proceeds are not always used as promised.

EU’s Green Bond Standard

As with all sustainability-related financial products, there has been concern over greenwashing, and that bond proceeds are not always used as promised. Variability in the accuracy of reporting and absence of harmonised terminology has also made it difficult to compare products. To remedy this, the EU has drawn up a Green Bond Standard, which aims to engender greater trust and transparency around the green bond label. The measure was agreed in December 2023 and takes effect in December 2024.

Green bonds are also used by companies to finance projects or activities with sustainability implications, such as renewable energy projects, energy efficiency, clean transportation infrastructure, and sustainable water management. France’s Caisse des Dépôts et Consignations, a semi-public institution that is the part-owner of the country’s postal service, the French gas pipeline system and leading wastewater companies, issued a €500m sustainable bond in June 2023 to finance the construction and thermal renovation of social housing, enhance digital access and provide support for the country’s ageing population.

State-owned Paris public transport operator RATP and railway infrastructure operator SNCF Réseau have also issued green bonds to help fund their decarbonisation transition. Green bonds issued by banks are often used to finance sustainability-related lending such as green mortgage loans, or lending to businesses for their own energy transition projects. The World Bank and other supranational organisations such as the European Investment Bank are also among the biggest issuers of green bonds.

In their basic structure, green bonds are like any other debt security. The coupon – annual interest payment – depends on the perceived riskiness of the issuing entity, and will be in direct relationship with yields from traditional bonds from the same issuer. The recently-issued Brazilian bonds were launched with a coupon of 6.25% a year, compared with between 3% and 3.2% for French public-sector entities.

The so-called ‘greenium’ applied to green bonds has diminished in recent years, but as of mid-2024 around 30% of green bonds command a higher price than comparable traditional securities.

The ‘greenium’ effect

One incentive for companies and governments is that there has often been a so-called ‘greenium’ applied to green bonds that allows them to offer lower yields than traditional securities. This has diminished in recent years, but as of mid-2024 around 30% of green bonds commanded a higher market price (lower yield) than similar non-green bonds. Issuers may obtain funding at a lower cost for their sustainability-related projects than they might from conventional borrowing.

Analysts expect the market to continue to grow in the coming years. Rating agency Moody’s forecasts that climate bond issuance could reach $950 billion this year, while rival S&P believes that this year’s volume will surpass $1 trillion. In 2023, the largest issuance came from non-financial companies, with financial institutions close behind, followed by sovereign bonds, other public-sector entities, development banks and local government entities.

For investors, green bonds may offer a means to improve the sustainability of their fixed-income portfolio, which traditionally has been harder to do than for equities. Bondholders are lenders rather than owners, which makes it more difficult to exert their influence to engage with companies to encourage the green transition in the same way that shareholders can do. The green bond market now offers a broad choice of issuers and secondary market liquidity to enable bonds to be traded more fluidly, and it is easier to create a diversified portfolio.

The green bond market now offers a broad choice of issuers and secondary market liquidity to enable bonds to be traded more fluidly, and it is easier to create a diversified portfolio.

The remaining problem is: what happens to the rest of the bond market. Does it become ‘brown’ or less sustainable as the green elements of a business or government investment have their own distinct funding channel? This is a question that has puzzled fixed-income investors and has yet to be fully resolved, although policymakers hope that the trend will gradually drive a broader shift toward sustainability in all aspects of companies’ and governments’ activities.

As with every relatively new area of activity, there have been teething problems with the green bond market. However, it is becoming more liquid and diverse, and regulators are starting to draw up workable parameters for how the green bond designation is used. This should help investors make rational decisions about green bonds and improve their transparency in the market.