Ensuring Green Bonds Really Are Green

Around 17 per cent of green bonds do not meet NNIP’s in-house criteria says the firm’s green bond specialist Doug Farquhar.

Farquhar was speaking to delegates at the WM Nexus’ virtual event ‘Multi-Asset Class Strategies in ESG and Impact’.

The client portfolio manager argued that it takes several years to build up the expertise and internal processes – rather than relying solely on external research - to understand the market and to hold issuers to account to avoid greenwashing.

He gave the example of a green bond that did not pass muster. That was offered by the Netherland’s Schiphol airport which sought investors to back a programme to make its buildings more energy efficient but was essentially supporting a polluting industry.

Such a decision was not based solely on the sector – an investment supporting biofuels, hybrid or even fully electric flight – could have met the criteria.

Farquhar began the discussion by defining green bonds in relation to the broader market.

“Green bonds are very similar to normal bonds. The only major difference is that there is a defined use of proceeds and those proceeds must have clear environmental benefits.”

Assessing the current green bond market, he notes it was hit by Covid-19 in the first half of 2020 but has generally recovered in the second half.

Recently, the EU announced issuance €230bn of green bonds as part of its Covid-19 recovery response, while the ECB says green and sustainability linked bonds are eligible for its capital purchase programme.

The market has grown over the last few years with sovereign, semi-sovereign and corporate bonds reaching a market value of €600bn.

China has, in the past, issued a significant amount of debt; it has slowed recently though Farquhar expects it to return soon.

The market has been led by European issuers with 67% denominated in euros and 22% in dollars, despite the latter’s dominance in the aggregate market. It generally maps the broader market in terms of credit risk with 26% at AAA and 22% rated AA, the investment grade segment where NNIP focuses.

Arguably one of the most significant developments has been the growth in the size of the bonds offered – rising from a typical size of an issuance of €200m to around €700m in the last year.

The make up the market has shifted as well with some of the biggest tech firms such as Apple and Alphabet recently entering the market with telecoms also seeking funding for the 5G transition which, of course, sits beneath a lot of sustainable projects such as smart buildings and smart energy grids and electric vehicles.

More specifically the automotive sector is a growing component with recent issuance by Daimler and Volkswagen to fund electric vehicles.

He said: “The main reason to invest in green bonds is you can meet your fixed interest allocation but get environmental benefits. We think companies that issue green bonds tend to be more forward looking and innovative, so the credit quality longer term is better. There is no additional cost – for investors, no ‘greenium’ [extra premium] for issuers.”

Investors appear to get a degree of outperformance from both sovereigns and corporates in comparison with aggregate bond indices. Indeed, the green bond market saw less of a downturn in March and April and a stronger revival.

NNIP launched its flagship fund offering, a mix of both corporate, sovereign and semi-sovereign bonds, in 2016, adding a short duration fund in 2019 which deploys an interest rate future overlay. It launched a corporate bond fund this year with plans to launch a sovereign fund both to meet many institutional investor’s requirements for corporate or sovereign-only investments.

NNIP examines how any bond aligns with their own taxonomy drawing on established standards, considers transparency at point of issue and governance in terms of how issuers select assets and projects.

“We don’t rely on self-described labels or third-party external verification. When we look at the labelled green bond market, we don’t believe about 17 per cent of the bonds are green,” he said.

As dark green investors, NNIP excludes gambling, tobacco, some parts of the fur trade, and types of project related to fossil fuels.

“We look at the issuer themselves to see if they are committed to the transition to a low carbon economy. We have engagement pre and post issuance,” he added.

He gave one example of the sort of bond they invest in - Energie Baden Württembergin, a northern German utility which is embracing renewables and increasingly sending power to heavy industry in the south of the country much of which is still coal power driven.

Much of the rest of the selection process is effectively that of a conventional bond investor considering issues such as the top down macro environment with bottom up security selection.

But combined with that is an assessment of whether a bond is really having an impact.

NNIP report on impact each month. Among other things, it considers how much renewable power capacity has been created and which of the UN sustainable development goals are being met and to what extent.

It produces the striking statistic that for every minute invested in the fund, CO2 equivalent to 31 households or 202 passenger cars annually is saved.

Delegates then posed a number of searching questions.

When you look at the green bond universe, do you see the majority of funds raised for projects or corporate transformation?

“There are a broad range of categories. A lot relate to efficiency, around energy waste and water use. We see a lot for greening buildings, from financial institutions to redevelop and retrofit property. There are more innovation uses, so electric vehicles and supply chain activity. It is very much focused on capital expenditure, though with some green financing for operating expense reduction.”

What are the greenwashing red flags?

“There are a few different things we look for. There were some issues in the US with a project which combined retail and residential property. They promised the world - the biggest fuel cell, LED lighting. When they started construction, they hit commercial challenges and stripped out all the green technology.

“We look at controversies with the issuer and how trusted they can be.

“We look at the legal wording within the prospectus which can have no commitment around the green benefit.

“There are sector specific issues. We have seen an oil and gas firm issue a bond which the market deemed not to meet the green label. They were improving energy use and efficiency, but it was about reducing the cost of refining, making oil and gas more competitive with renewables.”

What happened when the developer didn’t fulfil their promises?

“They were investigated by the SEC in relation to the bond, which embarrassingly gave them a clean bill and then changed their minds. There was no penalty. At the moment, if an issuer takes the finance and uses it on something that isn’t green, there is no recourse. On sustainability-linked bonds the coupon is linked to delivery, yet it is early in that product’s development.”

How often do you engage with issuers?

“We engaged with 93 issuers last year. That was both pre and post issuance. If we invest, we will meet them every two years to talk about how they are getting on.

“That is part of why it is quite difficult to launch a green bond now. You have to create your own database, and four or five years into the market it is quite difficult to gather all that data.”

What is the incentive to issue a green bond?

“There are two real benefits. Issuers demonstrate their commitment to sustainability as a function of their business model. That is becoming more important to corporates and with sovereign issuance they can meet commitments under COP21. They also get investor diversification. It means investors are coming in who they may not otherwise see. We see oversubscription levels are higher.”

Is it the same issuers over and over again?

“Within the market, we see two categories – some come to the market once to get that marketing benefit around sustainability and some come back frequently. We think Apple will be repeat issuers and the Telcos given the cost of 5G deployment. Utilities too, are being tightly regulated on the environment and see it is a good way to raise capital.

“Industrials are underrepresented and FMCGs. There are some we would like to see more of. With the recent German sovereign issuance, they have committed to be repeat issuers and they are going to build the yield curve over different durations.”

Are you reporting both negative and positive impacts?

“We try to do net as much as we can. It depends on the quality of the data from the issuer. There is no defined level. Some do it at a project level and some at a portfolio level.

“For climate change adaptation, it can mean pouring a lot of concrete for flood defensives. Adaptation is quite difficult as a category within the SDGs. It requires a lot of thought and dialogue.

“With the EU green bond standard, it is going to be really helpful for the issuers. You get defined metrics and the quality of the data will improve.”

At what point do you start engaging with a company to help them improve their standards?

“Due to the size of the fund, we talk to issuers prior to issuing and can discuss their framework. We give extensive feedback, where we don’t think the metrics are challenging enough or the quality of the post issuance reporting is as high as it could be.

“We held 93 meetings last year. It is a big commitment but when there is the lack of standardisation, as an active dark green investor, we need to know that what we are investing meets our requirements.”

What is the benefit of using bonds to make an impact rather than other assets?

“The transparency you get sets the market apart. With sustainable equity, there is not the same transparency in terms of what they are spending Capex on. We are seeing more borrowing – why wouldn’t you do it through this sort of product?”

What is the level of impact for companies that are aiming to transition? For example, Apple is using more recyclable material – it is an improvement – but overall still not good for the environment?

“Some is about refinancing existing projects, some is about total or absolute impact, some about reduction of a poor impact. We look at transition in terms of the length of time it will take to realise that environmental benefit. The longer the amount of time taken the greater the benefit it needs to deliver.”

Do you have a favourite in the portfolio?

“We bought the Daimler green bond, not Volkswagen as it still has a high controversy rating because of ‘Dieselgate’. But Daimler is interesting in terms of the ability to scale up to produce electric vehicles as they become the norm.”

Where are the biggest areas of growth?

“There has been an increase in the value of social impact bonds in response to Covid-19, but we don’t think it will grow as rapidly as the green bond market. It is harder to quantify the impact. Sovereigns have started to issue at lot - Germany, Sweden, Luxembourg and Poland with France the biggest to date. There will be more sovereign issuance. On the corporate side, sectors that have been under-represented are coming in.”

John Lappin is Contributing Editor at WM Nexus