EU poised to launch its first green bond

The EU is set to launch its first green bond this week, as part of the funding for the Next Generation EU (NGEU) budget. This follows a busy 15 months in which the EU has issued more than €90 billion of social bonds to help nation states cope with the coronavirus pandemic.

Green bonds will now come to the fore in financing the recovery, as well as providing resilience against a much greater threat.

In September, the EU published its green-bond framework, which could, over the next five years, govern up to €250 billion of issuance. That will more than double the size of the market in euro-denominated green bonds issued by sovereigns and supranationals.

Now the EU, the biggest issuer in the green-bond market, is about to make its debut. It could issue up to €45 billion a year, roughly equivalent to the green-bond supply from all other EU sovereigns combined.

With worries about inflation, tapering of the central bank buying that has repressed borrowing costs for so long, the potential for rising rates and loss of capital now roiling government bond markets, what is the reception likely to be?

Investor demand for EU issuances of so-called grey bonds has been strong, with many syndicated social-bond deals up to 10 times oversubscribed. More recent auctions of EU bills have also been well bid and often more than 1.5 times covered.

Rates strategists at Bank of America, led by Sphia Salim, observe in a note: “EU green bonds should attract even stronger demand, as most investor groups are on the lookout to grow their green assets.”

It seems likely that through the Solvency II changes to regulations on insurance companies, the European Commission will incentivize more green investments. Banks also will be looking to improve their so-called green-asset ratio (GAR), a measure of financing of sustainability proposed by the European Banking Authority in March this year.

Adoption is likely to be mandated in 2022. The BofA analysts note: “Our bank equity team believes the ratio will have to trend to 100% to meet net zero 2050 – from a preliminary number of 7-8%.”

Meanwhile, since its creation at the end of 2017, the Network of Central Banks and Supervisors for Greening the Financial System (NGFS) has grown from eight central banks and supervisors to now 95 members and 15 observers. It includes reserve managers and big marginal buyers of government bonds.

NGFS's work includes ways to promote investments and monetary policy tools that support sustainable finance.

So, there could be a greenium – a green premium – for any sovereign borrower selling green bonds, which may grow, through frequent taps, into large liquid lines that hold out the promise they will remain tradeable through bouts of market stress and be more easily sold for cash.

Traders observe premiums on green bonds by the big European government bond issuers – Italy, France, German and Spain – of between four basis points and 6bp in maturities from 10 to 20 years.

In late September, another highly indebted European sovereign borrower made its debut in the green bond market with an issue exceeding the previous largest green-bond offering – the €8.5 billion green BTP maturing in 2045 that Italy sold back in March this year.

But this issuer does not sell bonds in euros.

On September 21, the UK issued a £10 billion 12-year green gilt, the first offering under its own green-financing framework to fund the country’s path to net zero through investment in clean transportation, renewable energy, energy efficiency, pollution prevention and control, biodiversity and climate change adaptation.

The deal attracted an order book of just over £100 billion.

Robert Stheeman, chief executive of the debt management office (DMO), points out: “Investor demand came predominantly from domestic accounts who are increasingly integrating environmental, social and governance factors into their investment decisions.”

The DMO is also developing plans for retail targeted offerings of fixed-rate, three-year green savings bonds in which individuals can invest between £100 and £100,000.

Stheeman added that “the deal also successfully attracted new investors to the gilt market, including from overseas”.

Anne Marie Verstraeten, BNP Paribas UK country head, stated in a note unpacking the deal: “This inaugural green gilt demonstrates the momentum in finance to address critical climate and biodiversity challenges on the road to COP26.”

The debut deal was led by structuring advisers HSBC and JPMorgan, who were joined in the lead manager group by Barclays, BNP Paribas, Citi and Deutsche Bank.

Its strong reception has led to high hopes for the next green gilt, which is due – subject to market conditions – in the week beginning October 18. This will have a July 2053 maturity, as the DMO looks to build a green gilt curve.

Bookrunners will be BofA, Merrill Lynch, Morgan Stanley, NatWest Markets, RBC CM and Santander. Issue size is likely to be around £5 billion.

Meanwhile, the debut green gilt will be traded on the London Stock Exchange Group (LSEG) sustainable bond market and available for clearing through LCH Ltd RepoClear. It is also eligible as non-cash collateral for members placing margin with LCH Ltd and LCH SA.

Given lingering tensions around the UK’s exit from the EU and the general incoherence of economic policy under the current government, there seems to be a welcome meeting of minds here on green finance.

Presumably that is because much of the work is being done below the ministerial and political level.

Julia Hoggett, chief executive of the London Stock Exchange, points out: “Public capital markets are key to mobilizing investment in sustainable activities that serve to mitigate social and environmental risk.”

There will be much disappointment if the EU’s first green bond fails to attract a big oversubscription. Announcing the green bond framework in September, budget commissioner Johannes Hahn said: “Judging from the Commission's experience in the first issuance of social bonds and the growing green-bond market, we expect demand for NGEU green bonds to be high.”

The strategists at BofA observe that the NGEU green-bond framework largely follows the International Capital Markets Association (Icma) green bond principles.

Investors will have access to annual detailed reporting on use of proceeds, an environmental-impact report to be published two or three years after the first transaction and reports by EU countries on milestones and targets on environmental improvements ultimately funded through NGEU bonds.

Moodys’ ESG research firm Vigeo Eiris has confirmed in a second-party opinion on the EU’s green-bond programme that the plans outlined for management of proceeds and for reporting represent industry best practice.

Similarly, the UK has sought a second opinion from Vigeo Eiris that its framework is robust and “coherent”. The Carbon Trust also conducted a pre-issuance impact assessment that expressed confidence that the UK's green-financing framework will contribute to achieving net zero by 2050. And the UK will, like the EU, report annually on allocations and at least biennially on impact.

Even though the EU’s own taxonomy is unlikely to become law until the second half of 2022, the NGEU green-bond framework assumes compliance.

There are some intriguing aspects of the EU taxonomy. One is a so-called ‘do-no-significant-harm’ principle attached to eligible green expenditures. This is intended to ensure that green bond proceeds don’t, for example, finance an activity that reduces greenhouse gas emissions but is detrimental to surface or ground water.

Ultimately, while money is borrowed first in the green-bond market, allocations of those funds will be based on individual member states’ own Recovery and Resilience Plans (RRPs).

BofA points out that countries will submit payment requests – more like reimbursement requests – as they reach pre-determined targets and milestones. In some cases, these will require evidence that investments fulfilled the criteria outlines in the plan. Only once milestones/targets are met will the EC pay green-bond proceeds into national budgets.

“This basically amounts to a performance-based approach, where reimbursement requires satisfactory completion of targets,” notes BofA.

Countries need to assign a minimum of 37% of their RRP expenditures to measures that support climate objectives.

The European Commission has already endorsed 23 RRPs, and its assessment is that green expenditures are well above 37% for many of them. This will provide a buffer to ensure that 30% of NGEU expenditures are using green bonds: if an investment doesn’t work out as anticipated in terms of green impact, it can be replaced by another eligible investment.