In the face of climate change and escalating environmental challenges, the financial industry is undergoing a transformation marked by a growing commitment to sustainability. New investment standards – such as environmental, social, and corporate governance (ESG) investing – has led to the growth of a number of financial instruments and transparency mechanisms in the financial sector to attract more investments in sustainable and green projects. At the forefront of this shift are green bonds, a financial instrument designed to fund projects with positive environmental or climate-related impacts.
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What Are Green Bonds?
A traditional bond is a debt security where the issuer – usually a government or corporation – borrows money from investors. The issuer promises to pay back the principal amount (face value) at the bond’s maturity date and pays periodic interest payments to bondholders. The funds raised from traditional bonds can be used for various purposes, including general operating expenses, capital projects, debt refinancing, or any other financial needs of the issuer. There are typically no specific restrictions on how the funds are allocated. Bonds can be issued by governments (government bonds or treasury bonds), municipalities (municipal bonds), and corporations (corporate bonds). They may or may not have an explicit focus on environmental or social considerations.
A green bond, on the other hand, is a type of bond designed to raise capital for projects and initiatives with environmental benefits. The issuer commits to using the funds for environmentally sustainable projects, such as renewable energy, energy efficiency, green buildings, sustainable agriculture, and other initiatives aimed at mitigating climate change or promoting environmental conservation. Thus, in addition to evaluating the standard financial characteristics (such as maturity, coupon, price, and credit quality of the issuer), investors also assess the specific environmental purpose of the projects that the bonds intend to support.
The distinguishing feature of green bonds is the earmarking of funds for environmentally friendly projects. Issuers are required to provide transparency and disclosure regarding how the proceeds will be utilised, ensuring alignment with recognised environmental standards. Green bonds appeal to investors who prioritise sustainability and environmental responsibility. These investors seek to support projects that contribute positively to the planet while earning a financial return.
Examples of Green Bonds
Several multilateral banks have issued bonds supporting the financing of “green” projects, including the following:
- The African Development Bank (AfDB) serves the development needs of its member countries and issued a first US$500 million green bond in October 2013, building on previous experience with clean energy bonds for the Japanese retail market. The proceeds are allocated to support the financing of climate change solutions as part of a broader strategy to support inclusive and sustainable growth in Africa.
- The European Investment Bank (EIB) issued a €600 million (US$653 million) Climate Awareness Bond in 2007 that focused on renewable energy and energy efficiency. Instead of a fixed coupon, the bond returns were linked to an equity index (such a bond is commonly referred to in the bond market as “structured”).
- The International Bank for Reconstruction and Development or (IBRD) – a lending arm of the World Bank Group – launched the first labelled green bond in 2008 in the amount of 3.35 billion Swedish krona (approximately US$440 million). It responded to specific demand from Scandinavian pension funds seeking to support climate-focused projects through a simple fixed-income product. Since 2008, the World Bank has issued approximately US$18 billion equivalent in Green Bonds through over 200 bonds in 28 currencies, supporting about 70 climate mitigation and adaptation projects around the developing world.
Growth of Green Bonds
The green bond market has seen exponential growth. The market reached its most substantial milestone in early December 2020, with US$1 trillion in cumulative issuance since market establishment in 2007. Green bonds enjoyed a 49% growth rate in the five years before 2021, according to Climate Bonds, whose analysis suggests the green bond market annual issuance could exceed the $1 trillion mark by 2023.
Investors have increasingly become aware of the risks of climate change to their portfolios and, through mechanisms such as the Task Force on Climate-related Financial Disclosures (TCFD), they are also beginning to report on such risks. Additionally, stakeholders are pressuring the investment community to employ heighted environmental, social, and governance (ESG) policies.
Green bonds address some of these changes to the new landscape. They offer investors a platform to engage in good practices, influencing the business strategy of bond issuers. They provide a means to hedge against climate change risks while achieving at least similar, if not better, returns on their investment. In this way, the growth in green bonds and green finance also indirectly works as a disincentive for high carbon-emitting projects.
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Which Is Better: Regular or Green Bonds?
Compareing a green bond with a regular bond would require the issuer to issue them almost simultaneously and with almost identical terms – including currency, structure, yield, and maturity. This is very rare. However, we can still attempt to compare them based on the following points:
- Risk and Return
Traditional bonds often carry lower perceived risks compared to riskier assets like stocks. The return on regular bonds is primarily driven by the fixed interest payments, and their prices may fluctuate based on changes in interest rates. Green bonds, while sharing many characteristics with regular bonds, come with an additional layer of scrutiny regarding the environmental impact of the projects they finance. The risk-return profile can vary based on the issuer and the specific green initiatives funded.
- Market Liquidity
Traditional bonds typically enjoy high liquidity, facilitating ease of buying and selling in the secondary market. This liquidity is beneficial for investors who may need to adjust their portfolios quickly. The liquidity of green bonds has been improving, but it may not match that of regular bonds. However, as the market matures and gains broader acceptance, liquidity is expected to increase.
- Pricing
It is generally accepted that green bonds are priced very close to regular bonds; that is, investors are not willing to give up return or pay extra for the green aspect of the bond and related reporting. However, observers of this nascent market point to growing demand and preference for green bonds by a growing number of mainstream investors. Anecdotally, investors in green bonds have been able to sell at higher prices than conventional bonds because of the rarity of green bonds. Depending on demand and supply trends in specific markets, differential pricing for green bonds relative to other bonds could emerge in the future.
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