ESG: green bonds have a chicken and egg problem

All financial markets experience periods of imbalance. An extreme mismatch between demand and supply, particularly when the former far exceeds the latter, can be very dangerous indeed – setting up distorted incentives for issuance, as the sub-prime mortgage market dramatically demonstrated in 2007.

Today, the equilibrium in the green bond market is starting to worry some observers. Demand for green assets is huge as investors, keen to burnish their environmental, social and governance (ESG) credentials, rush to establish funds dedicated to the asset class.

“Buyside interest in ESG is the next massive disruptive event in these markets. It is as significant as digital disruption,” says Philip Brown, managing director of green and social bond origination at Citi. “It will be huge.”

The problem this creates is the same as it always is in these situations: finding supply. “There is massive interest from the investor side but a scarcity of supply,” Jakob Groot, Danske Bank’s head of corporates and institutions, told the International Capital Market Association AGM in Stockholm in May. “We cannot invent green assets.”

That will not stop people trying. In any market where there are willing buyers, there will be plenty of issuers and intermediaries only too ready to find them something to sell. Accusations of “greenwashing”, or using green bonds to fund assets or projects that do not strictly fit the criteria, are already growing in the market and there is a pressing need to maintain discipline. “I will become concerned if the supply and demand dynamic changes green bond pricing to such an extent that issuers will have a financial incentive to go to the market with something they can define as green,” warns Lars Eibeholm, head of treasury and mandate and sustainability ratings at Nordic Investment Bank.

This is anathema to “dark green” bond investors – those that apply very strict criteria to what they buy. “We are not willing to amend our criteria in order to see the market grow,” says Noelle Cazalis, assistant fund manager of the Rathbone Ethical Bond Fund in London. “We are seen as dark green and are very wary of the risk of greenwashing. All we can do is be as transparent as possible about what we invest in. This is key. We would love to see the green bond sector developing, but just because something has a green bond stamp on it doesn’t mean it will pass our screening process.”

Many do not subscribe to this view. They argue that it is more important to encourage change at the margin, and that a more flexible approach is needed if the huge environmental challenges of today are ever to be addressed. 

“Purist investors that say that they will invest in pure green companies only will be niche,” says David Chen, chairman and head of product development and research at San Francisco-based Equilibrium Capital Group. “They would like to rail against mining companies but have iPhones and use public transport – both of which are made of metal. They fly to conferences in Bali on how to save the planet. The sector gets really wrapped up in purity and then in the same breath talks about planetary-sized problems. This is not going to be solved by $10 million projects.”

What’s the answer? The weight of demand from institutional investors, loudly pledging significant allocations to the sector as part of their ESG strategies, means that there is huge pressure to find more issuers. That requires a change in mindset across the board from politicians, regulators and corporates themselves. “Issuing green bonds doesn’t create green projects – we need favourable policies,” argues Tanguy Claquin head of sustainable banking at Crédit Agricole. “It is a chicken and egg situation because we need the green bond market in place to fund them,” he admits.

So, something has to give. The green bond market needs to find a way to satisfy the huge investor demand for its product, or else the turbulent fate of so many other sectors of fixed income, be it junk bonds, sub-prime RMBS or secondary commercial real estate, could await it. 

Finding projects isn’t easy. When Chen first started talking to investors about a renewable natural gas (RNG) green bond last year, he got some rather perplexed responses. The deal was the first RNG financing in the capital markets to fund a refinery capable of turning dairy waste, one of the largest sources of methane emissions, into vehicle fuel. But it was difficult for some potential investors to see past the cows.

“People asked – what are you talking about? Manure?” Chen recalls today. It was so much more than that. “The project was processing methane from dairy waste, which accelerated damaging greenhouse gas into pipeline-injectable natural gas that was contracted for under a long-term purchase agreement,” he explains. As such, the Arizona-based project was that rare thing – a perfect project for the green bond market and one that should be easy for investors to analyse. “These are key components to qualify as a muni bond,” Chen tells Euromoney. “Traditional muni bond investors knew how to evaluate it – it is not a subsegment of the market like it is in Europe.” Equilibrium Capital specialises in sustainability-driven real asset investment strategies and products for institutional investors. 

Although only $61.4 million in size, RNG green bond, which was led by Goldman Sachs, still ticked three out of four of the boxes that Brown reckons most green bond investors are looking for: “People want incremental dollars to be invested in new assets. They also want large transactions, use of proceeds to be immediately allocated to create an impact and clear, unambiguous, uncomplicated assets,” he says. But, injecting a note of reality, Brown adds, “You can’t have all of those things.”

This goes to the heart of the green bond market’s problem: it has lots and lots of willing buyers but not enough suitable sellers. “The sector is being held back by the quality of the projects,” Chen admits. “Quality, scale and repeatability of projects is key. If you are going to take the time to train the buyer, they want to be able to build a programme around it.”

Issuance therefore needs to grow rapidly to meet this demand. Can this be achieved without diluting the principles on which the market was founded?

One option is to expand the universe of issuers by allowing corporates that have non-green operations to issue green bonds against distinct, green-qualifying parts of their business. This will only work if the market can come up with a definition of green that is clear but, more importantly, far more flexible in terms of recognising change at the margin and rewarding behaviour. 

“The market has to buy into the idea of an energy transition,” argues Brown. “Hydrocarbons have a role to play. We need more widely accepted taxonomies of what is green or not.”

That applies to both projects and corporates. “It is very important to help the issuers that are the most polluting to go from brown to green,” Alban de Faÿ, head of SRI fixed income processes at Amundi, said at the recent Stockholm meeting. But it isn’t straightforward. “There are some brown issuers where you have to ask whether you would be confident buying a green bond from them,” he admitted. “The first question we would ask an issuer is whether they have an ESG rating.”

ESG ratings have become a big business, moving away from specialists such as Sustainalytics to the mainstream. In April, Moody’s announced the acquisition of a majority stake in Vigeo Eiris, a Paris-based provider of ESG ratings. According to the Global Sustainable Investment Alliance (GSIA), the volume of assets invested sustainably grew 34% from 2016 to 2018 to reach $30 trillion, so rating them is a huge market opportunity. 

A low issuer ESG rating is, however, a barrier for many green bond investors. In Stockholm, Ulrika Lindén, head of fixed income at Swedbank Robur, was emphatic that a brown issuer would be non-starter for her firm.  “We would not buy a green bond from an issuer with a bad ESG score. Of course not,” she said. 

Cazalis at Rathbone stresses the importance of looking past the green bond itself to the other activities of the issuer as part of the screening process. “For example, Unilever has issued a green bond to increase energy efficiency, but we did not buy it because Unilever does animal testing,” she explains.

This approach is understandable and not unusual. “Some investors feel that you can’t have a high emissions issuer doing a green bond, even if it is for a renewable energy project. Some take a strict approach and say no,” says Suzanne Buchta, managing director and global head of ESG Capital Markets at Bank of America Merrill Lynch (BAML). “But if we want to create a transition we need to crowd in as many issuers as we can and create scale of change. My view is that it is not a switch that you can flip overnight. We require a transition and we need a less purist approach while doing it,” she says.

Industries that are in transition could certainly be a rich source of issuance for the green bond market. But requiring buyers to be less purist at a time when climate change is of greater public concern than ever could, however, be a challenge. 

“Everyone is wondering whether the market will be able to welcome high emitting industries that are transitioning stories. We are not going to be able to get to sufficient scale if we don’t allow this, but it needs a sharp and sound definition of what transitioning means,” says Orith Azoulay, global head of green and sustainable finance at Natixis.

Buchta, who co-authored the market guidance, says that more clarity is required. “You need a standard of what is green. In the Green Bond Principles we wrote guidelines for disclosure and transparency, which has become the market standard. We now need a standard for what categories of activities are green and what are social. The market needs such a standard to be written down.”

Whether or not the market needs such a taxonomy, there certainly seems to be widespread dissatisfaction with the current approach towards ranking and scoring green issuance and ESG programmes. ESG ratings are, as described above, widely available – the two leading providers being Sustainalytics and MSCI. But many, particularly larger, buyers rely on their own in-house scoring.

“Fixed income is a really big universe and the challenge with ESG is that there is not a one size fits all solution,” says Jim Caron, head of global macro strategies on the global fixed income team at Morgan Stanley Investment Management. “Sometimes you have to make changes to scoring while making sure that you don’t defeat the objective. With fixed income you are trying to minimise losses. Governance has the highest related correlation to returns and is the most important factor.” He argues that a more bespoke approach is appropriate. “Due to the importance it places on the different components of ESG, some commercially available ESG research has limited value because credit investors rank governance so highly, whereas research often doesn’t. You need to look at the different sectors, for example the energy sector, which has more challenges than others, and reward good behaviour if we identify positive changes are being made, even if at the margin.”

He adds that some scoring approaches can actually create more problems than they solve. “You get greenwashing when you are overly focused on homogenous scoring. For example, real estate might have good carbon rating so will get a good score but that is not right. If you rely solely on outside providers, you are just reacting to ESG, not engaging with it.”

Another approach to boost issuance could be to move down the credit spectrum and encourage lower-rated, high yield issuers to enter the market. There has been some high yield issuance, but growth won’t be easy. “High yield companies are generally smaller with fewer resources to devote to this so there will likely be less attention paid to ESG by some companies,” says Bram Bos, lead green bonds portfolio manager at Dutch investment manager NNIP. “I expect this segment to develop but it will likely be limited.”

Enthusiasm on the buyer side seems to be equally muted. “Investors would like more diversification in IG corporate and FIG sector issuance more than they would like to see more high yield, which sometimes proves harder to execute since a lot of green investors tend to be IG only,“ Azoulay believes. 

Nevertheless, there seems to be enough appetite out there for sub-investment grade deals to get done. In late June unrated German agriculture, energy and logistics group BayWa issued a €500 million five-year green bond, attracting an order book of €750 million. The deal was priced at 3.25%.

A third option is that of pureplay issuance: encouraging firms with good ESG scores to issue bonds that are not specifically backed by particular projects but by the corporate credit. This would open up green bond issuance to a universe of new issuers, but would present a challenge in terms of impact assessment.

“One of the primary needs green bonds are answering to is that for impact measurement, and asset/project level impact measurement is often of higher quality than that at corporate level for obvious data granularity reasons. The impact perspective adds a lot of value,” says Azoulay. It is this characteristic that would enable many investors to get comfortable with high-emitting firms issuing green bonds backed by discrete projects. Pureplay issuance would, however, be harder to evaluate on this metric. “Some issuers that are not capex-oriented companies but are a significant players of energy or ecological transition are a bit frustrated that they can’t be part of this market,” Azoulay says. “This explains the recent success of instruments such as sustainability-linked loans and is inviting us to think on how to demonstrate impact in a robust fashion without going down the route of use-of-proceeds bond.”

Sustainability-linked loan issuance reached $36 billion in 2018, according to Moody’s, but the asset class is growing rapidly. “We are seeing more and more companies in the pureplay space issuing debt in the public markets,” says Buchta. It is a popular green financing alternative for firms that do not have identifiable projects to finance. The green bond market needs to find a way to attract these issuers too. Sustainable loans often include incentives for borrowers to improve their ESG performance, usually through margin reduction. This is something that the green bond market needs to investigate too.

Lars Eibeholm, head of treasury and mandate and sustainability ratings at Nordic Investment Bank

Eibeholm tells Euromoney that pureplay issuance is an important goal. “At NIB we are typically financing capex but we need to get our heads around opex,” he says. “There is a need for retail, capital-light companies in the supply chain and downstream to get involved. They have products that change the behaviour of consumers.”

In June, Danish wind farm operator European Energy issued its debut euro-denominated green bond in June, which was upsized from €120m to €140m. The order book was more than €230m for the deal, which was marketed as a true “pure play” green investment as the company has formal sustainable issuer status. Part of the proceeds will fund new green projects, with the rest used for an early redemption of outstanding 2021 bonds. European Energy currently has more than 500MW of new renewable energy parks either under construction or in ready-to-build status.

A pureplay approach will inevitably throw up a host of new questions for green bond investors. Chen at Equilibrium Capital says that flexibility is needed. “Take Danone – their commitment to sustainability is very real but their sheer size means that the company will not be 100% green,” he says. “They are fully committed but they would not qualify as a pure green play.” The French firm issued a €300m 1% seven-year debut social bond in March 2018. 

Buchta at BAML agrees that the pureplay approach could stimulate issuance: “For pure play companies – if, say, we reduce the definition of green pureplay from 100% to 70% of revenues coming from green activities – green bond funds can include more pureplay issuance, more money will flow to these issuers and, over time, we could see reduced cost of capital for those entities,” she says.

Chen is a strong supporter of non-green issuers being able to finance their energy transition in the green bond market. “If Anglo American’s CEO tries to make mining as sustainable and green as possible, and issues a specific use green bond, would he be accused of greenwashing?” he asks. He believes that investors need to see the bigger picture. “It is true that labour practices and pay scales at Walmart are a problem but their push on sustainable practices on the supply chain has had a dramatic impact.”

Should the market be far more accepting of the shades of grey that recognition of progress at the margins entails?

There clearly seem to be two schools of thought: that a green taxonomy is essential to maintain the integrity of the market and to make it easier for investors to know what they are buying, and that financing industries in transition and rewarding issuers for changes in behaviour – even at the margin – is the best way forward if scale is ever to be reached. Are the two irreconcilable?

Many investors that have taken a purist route have done so via green funds with clear investment mandates. According to Fitch there were €5.6 billion of assets in green bond funds at the end of 2018, up from around €3 billion the previous year. There are now 16 green bond funds with assets of more than €100 million.

The green bond market itself took 10 years to grow from $1.48 billion in 2007 to $173.61 billion in 2017 and around $180 billion today. It is still a tiny part of the wider $100 trillion global bond market, but growth is accelerating. According to data from Environmental Finance, green, social and sustainability bond issuance grew 32% year-on-year in the first quarter of 2019.  Green bond issuance exceeded $50 billion (up from $39 billion), sustainability bond issuance rose from $5.9 billion to $7.3 billion and social issuance doubled from $2.2 billion to $4.6 billion for the quarter.

Source: Refinitiv

In Europe, where the concept has been the most enthusiastically embraced, market share is still very much single digits. “In Europe green bonds were 4% - 5% of the total market in 2018,” says Claquin at Crédit Agricole. “They will be 6% in 2019 which is 25% growth.”  But it is still a drop in the ocean and given the intense interest, it is telling that the green bond market is still so small.

“Green bonds are still a very young market. The term pulls together US munis, EM financial institutions, European sovereigns and everything else,” says Brown. “But even if you count everything from everywhere issuance last year was $180 billion which isn’t much in the context of global bond market issuance. Supply will come. It is just a question of what form it takes.”

Source: Refinitiv

For this to happen, green bonds must be embraced by all issuers and all investors in the bond market. What does that mean for the pioneers that have got the market this far?

It is not surprising that dedicated green investors take a fairly hardline approach. “Green bond funds are the most vocal because they are the ones who have invested time, effort and resources to define a dedicated investment approach to green bonds,” says Azoulay at Natixis. They are, however, in a minority. “The number of green bond funds is limited (less than 50) and thus they don’t represent a big portion of the green bond books. A much larger pool of green-driven orders comes from investors that have either got green top down commitments or from investors with some ESG integration elements to their investment practices.”

Given the very positive PR that comes with a green bond fund, many investors have, however, chosen this route. “There are two different approaches,” says Bos. “Some clients choose to allocate a certain percentage to specific impact investments, varying from private equity, to loans and bonds. The other approach for institutional clients and pension funds is to make green investments part of their liability matching portfolio, exchanging non-green sovereign and corporate exposure for green exposure of the same duration.”

Deciding to concentrate exposure in a green fund may attract good publicity,  but it raises the question of how the performance of that fund should be measured. “A lot of asset managers or asset owners believe that there isn’t a green bond universe diversified enough to build a dedicated fund that can meet their yield requirements,” Azoulay explains. “Some of them therefore instead have defined top down allocation instead.” 

Environmental Finance collected data for 29 actively managed bond funds for 2018 and found that just seven provided net positive returns. Only two euro-denominated funds registered positive returns: the NN Euro Green Bond fund and the Erse Responsible Bond Global Impact fund, with 0.26% and 0.16% returns respectively. That doesn’t look like a compelling case for participation.

There are two main green benchmarks – the Bloomberg Barclays MSCI Green Bond index and the ICE BAML Green Bond Index. SSA issuers have tended to dominate the market and returns have reflected that. “I don’t believe there is any significant difference in pricing between green and non-green bonds,” says Claquin at Crédit Agricole. “Because there is a bias towards public/SSA issuers in the sector, some green funds may have relatively lower returns because the players are lower risk.”

Buchta at BAML rejects the view that the sector underperforms. “Use of proceeds green bond funds started off as only triple-A as that is all that there was in the market. As we brought more non-triple A issuance the mandates have expanded,” she explains. “The green bond market is a small market and the law of small numbers means that there is much more potential for extremes. So, there is not a large enough data set to say whether or not green funds outperform or underperform,” she claims. For Cazalis, the accusations of underperformance are just plain wrong. “We have had to fight against the myth that ethical funds underperform,” she says. “We don’t use a subset of ethical funds to measure against, we measure ourselves against the IA corporate bond fund sector, and we have outperformed over many time periods.” 

Caron at Morgan Stanley says that his approach is straightforward. "We are investment managers and our job is to make returns. Clients ask ‘is this going to hurt their returns’, but there is no real cost to being ESG conscious. If you have a choice between bond A and bond B, you choose the one with the higher ESG score, the difference in return between them is not material.”

Bram Bos, lead green bonds portfolio manager at Dutch investment manager NNIP

As more and more investors focus on ESG, more and more green funds will be established. That brings with it a risk of declining manager quality. The entire sector will suffer if new or inexperienced funds underperform in an environment where high returns are clearly already tough to come by. “Green bond funds have been growing significantly, even more than I expected,” says Bos. “Many wealth managers have set up green funds, but you always have to remain critical to the criteria used to include green bonds in portfolios, and whether the product is in the best interest of the client. Some wealth managers don’t have a track record in this sector.”

And things can go wrong. When Mexico City Airport Trust issued $6 billion of green bonds in 2016 and 2017 they were the first green bonds to finance a new airport. The deal was not initially structured as a green bond, and was only labelled as green relatively late in the day. “Mexico City Airport Trust was a very complex deal. It was nearly finalised when the decision was made to call it green,” says Brown at Citi.

Moody’s, S&P and Sustainalytics gave the bonds green ratings. However, incoming Mexican president Andres Manuel Lopez Obrador scrapped the controversial project in October 2018 following loud public opposition to it. The government subsequently launched a $1.8 billion buyback package, but the residual bonds remain outstanding as green bonds. The 2017 bonds were trading at 97c on the dollar as Euromoney went to press, having slumped to 73.5c when the project was pulled.

Climate change affects everyone, so why is the impetus for green bond issuance coming so much more strongly from the buyside than the sell side? Market wisdom has always been that issuing a green bond is expensive and that has put potential issuers off. But the impact can be immaterial.

“The additional cost incurred in issuing a green bond is the external verification and a bit of extra cost,” says Bos at NNIP. The firm’s NN Green Bond Fund now has almost €600m AuM. “We estimate that the additional costs of issuing a green bond are marginal for a €500m issuance size.”

This additional cost for such a deal could be as low as €20,000, but the bonds have to be monitored throughout their lifetime. “The direct cost of green bond issuance is not that significant. But taking on a commitment for disclosure and reporting on the impact of projects can be a deterrent,” admits Maxim Vydrine, deputy head of emerging market debt at Amundi in Paris.

“Issuers ask why they should go through the hassle of issuing a green bond if there is no pricing advantage,” says Brown. “There will be a pricing advantage and arguably we already have it, but we don’t see large investors sticking their hands up and saying we will pay 10bp more. The decision on whether to issue green doesn’t come from the head of funding, it comes from the board. The big advantage is communication. Citi was delighted with the positive communication derived from issuing our green bond and we saw a pricing advantage.” The US bank issued its first green bond in January this year, a €1 billion 3-year fixed rate deal.

According to the Climate Bond Initiative, a London-based not-for-profit organisation, data for 2018 show green bonds already achieving greater oversubscription and spread compression than their non-green equivalents.

The data shows that 72% of green bonds recorded tighter spreads than ordinary bonds after just a day, and 62% were tighter after 28 days.

Another issuer that sees a pricing advantage is NIB’s Eibeholm. By March 31, 2019 NIB had invested €48 million of the €500 million it has allocated to be invested in green bonds issued in the bank’s member countries. “We get better execution with green bonds as they go to a different set of investors,” he tells Euromoney. “In our internal pricing we favour the green and blue loans although it is only a couple of basis points.”

There is, however, an obvious risk of greenwashing, given the pressure to put money to work on green projects. There needs to be clear and unambiguous data on comparative performance. “From a pure investment point of view green bonds are exactly the same as a conventional bond. So, there shouldn’t be significant difference in performance,” says Vydrine. “Green bonds don’t offer a pricing premium, but they tend to be less volatile because they go to more strategic, long term institutional investors. They are locked up and aren’t traded so they don’t create volatility.”

Claquin at Crédit Agricole, reckons that the difference between green bonds and the rest of the market is minimal. “To say that overall the green bond market tends to be a buy and hold market is a step too far,” he says. “When you sell a green bond, you don’t sell only to green bond investors – we will sell to all types of investor trying to be active in this space. You need normal liquidity providers to be there. Depending on the trade there could be between a few percent to 15% of green fund buyers. This can have impact on the liquidity of the bond but it is a second-level effect.”

As Eibeholm observes, green bonds will likely become drivers of liquidity rather than the reverse. Azoulay has crunched the numbers. “People usually assume that green bonds are less liquid. Based on the fact that quite some green-driven investors tend to be buy-and-hold it seems a fair assumption,” she agrees. “But it is extremely hard to demonstrate considering the overall liquidity conditions on the bond market overall. A significant number of green benchmark size issuances are part of generic bond market indices.

“A few months back we did the exercise of comparing green bonds to non-green comparable issuances (where available) and came to the conclusion that there was no obvious pricing difference in the primary market, though some segments did show some signs of tighter pricing (SSA especially) and the green feature seem to offer narrower NIPs against secondary (for FIG and SSA). Interestingly, especially for recurrent SSA issuers, a “greenium” appears on the secondary market,” she points out, seconding Eibeholm’s position.

If, as he suggests, issuance can be cheaper in the green bond market than elsewhere, then why aren’t issuers queuing up to get involved? The market needs to be far more flexible about where green assets might be found. “The first-wave green bonds gave investors their cake and the ability to eat it,” says Chen. “Many were issued by institutions (DFIs) so you got the full faith and credit of the issuer – you got security – and you got the green aspect as well.” These bonds were very easy to analyse as a result. “The DFIs presented green projects and debt in a security format that folks were used to. They understood how to evaluate it and where to put it in the portfolio. Green finance was for sustainability-driven projects and renewable energy projects.”

That early growth from renewables is now largely complete, however. “The early growth was from renewable energy assets but that is done now,” says Brown at Citi. “The market has to embrace complexity. Even the largest financiers of renewables, KfW and EIB don’t have an endless supply of these assets. We don’t see enough investment grade corporate issuance. Many companies have a limited amount of renewable and energy efficient assets on their balance sheets. We look for a better consensus and understanding of what defines green away from real estate and renewables.” 

There are two potential engines of growth: inorganic growth, where new issuers are persuaded to issue, and subsequently organic growth, where existing issuers issue more. Claquin at Crédit Agricole says that this will be the more interesting phase – if and when it comes. “It is difficult to judge the pace at which large issuers will adjust to the concept,” he says. “We are still in the inorganic growth phase. Over the next two to four years green bonds will become 15% of the primary market. But this depends on policy.”

This raises the thorny issue of incentives. “We don’t need financial incentives for issuers, we need politicians and regulators to focus on the real economy,” insists Eibeholm. “Politicians should look at unsustainable subsidies and outline clear policies to allow the transition. Disclosure is essential for optimal capital allocation and the capital markets can assess the risks if the information is available,” he says.

Although green bonds cannot create green assets, having a defined set of boxes to tick would make it clear exactly what makes an asset green. The argument for such a taxonomy is that it will drive growth by simplifying the process for potential buyers. It would be cheaper for them and facilitate retail investment in the sector.

Many claim, however, that the effect could be quite the reverse and issuance will be restricted: The EU released its taxonomy for ESG investment on June 18 under which market participants reckon that potentially 70% of current issuance outstanding would not be compliant.

“A different approach would be to have a taxonomy mapping the high level in sectors,” says Eibeholm. “Here the individual countries would outline where they are in the process of complying with, for example, the Paris Agreement. It is a moving target. The idea of linking it to national contributions is good – it could be a step towards creating an overall global sector taxonomy,” he says. And he believes in the buyside using its clout to achieve this objective. “Investors buy a lot of government bonds so if countries do not comply, for example, with the Paris Agreement they could contemplate not buying their government debt. That is where the capital markets really have power.”

The fastest way for the green bond market to grow has always been for it to be less green. Is that what opening it up to non-green issuers will mean? Not necessarily. But for growth to be achieved there also needs to be a move away from a strict issuer-proceeds driven approach, to engage as broad an issuer universe as possible. That is the only way to stop investor demand distorting the market’s equilibrium and creating unwelcome incentives to issue.

And investor demand will only grow from here. “The investing world has been forever changed because the ecosystem of ESG is being incorporated into the plumbing of what we do,” says Caron at Morgan Stanley. “So even if only 10% of clients have actively sought changes, the other 90% of investors will get change by default.”

By this token, ESG criteria will eventually be the norm across all investment management. That should be on the radar of every corporate for which this could potentially be a problem. There is the very real prospect of non-ESG compliant assets becoming unfinanceable. “No issuer comes to this with malign intent,” says Brown. “Every CEO thinks very carefully about ESG and sustainability.  Stranded assets are likely to become a bigger problem for many businesses in the future.”

Larger institutions, such as banks, could have many assets on their balance sheets that might cause problems down the line. Reducing lending to brown industries is not only good PR, it removes a potential future refinancing headache as well. For example, BNP Paribas has been proactive in reducing its support for coal mines and coal-fired power generation and plans to increase its total financing for renewable energy to €15 billion by 2020. And JPMorgan has stopped financing private prisons.

There is no doubt that attitudes are changing, but it could take a long time for financial institutions to catch up with reality. Brown at Citi gives a small insight into the administrative burden that green issuance presents for a very large bank such as his, with very large numbers of assets on the balance sheet. “The challenge is in identifying assets on our database which haven’t been tagged as green,” he says. “You can’t just hit a button.”

Nevertheless, Henrik Norman, president and chief executive at Nordic Investment Bank had some brutal advice for banks at the Stockholm meeting. “I recently visited an international SiFi in Europe and they made a great presentation on ESG,” he said. “But when I asked what they did themselves there were no holes in their ignorance of what their own institution was doing. That institution will be sued one day.”

US government sponsored enterprise (GSE) Fannie Mae is the world’s largest issuer of green bonds. Having launched its multi-family green MBS programme in 2012, the agency had issued more than $50 billion green bonds by the end of 2018.

The GSE issues through its MBS programme and through a Green REMIC (real estate mortgage investment conduit) called GeMS. The green programme targets a reduction in energy or water consumption in the multi-family properties that it lends to. To qualify for a Fannie Mae green loan, the property must either possess a nationally recognized, current Green Building Certification or make property improvements that target reductions in either energy or water use.

“For every dollar spent retrofitting properties through a Fannie Mae Green Rewards loan, $1.85 has been created in economic output,” says Chrissa Pagitsas, vice president, enterprise ESG at Fannie Mae. “Our over $50 billion of green bond issuance through year end 2018 has resulted in over 500,000 apartment units being renovated to be more energy efficient, water efficient and more comfortable for families and individuals.”

Fannie Mae's Chrissa Pagitsas at the ICMA AGM in Stockholm in May

Fannie Mae underwrites the projected energy and water savings from the tenants’ bills and a Level II ASHRAE (American Society of Heating, Refrigeration and Air-conditioning Engineers)-standard energy audit. It also offers a slightly lower all-in interest rate on green loans than borrowers can get for a non-green loan. In June, fellow GSE Freddie Mac followed suit, launching a new CMBS programme to securitise loans made in its Green Advantage programme, through which borrowers are required to make energy and water efficiency improvements to their properties.

Pagitsas has pioneered this concept at Fannie Mae, but emphasises the importance of realistic targets when trying to drive change. “We need to make green bonds a commodity product and for that we need scale of issuance,” she says. “We can have a minimum standard but make it a target that people can achieve. There is a lack of understanding of how much it costs to reduce emissions by 50%,” she tells Euromoney. “We did an analysis of how much it costs to reduce energy and water use by 15% each and the cost is approximately $460 per unit in an apartment building. To reduce energy consumption alone by 50% the analysis estimates the cost jumps to $7,000 per unit. So, if an apartment unit has 100 units, the cost jumps from $46,000 to $700,000 or 15 times more.”

As a rare issuer of large volumes of green bonds, Fannie Mae is in a very good position to evaluate the current dynamic in the market. “The argument that there is not enough supply is being used as a shorthand for a host of other issues,” she claims. “I would argue that there is not enough supply of the exact type investors are comfortable with today. Investors have varying levels of resources to conduct ESG research. It’s generally easier to decide to invest if the issuance is in euros, AAA, a covered bond or corporate debt issuance and a dark green investment. The opportunity is to have green bond issuances that reflect the diversity of the current fixed income market and include MBS.”

Pagitsas is against the concept of having a taxonomy – saying that rather than classifying the product this would set minimum standards. “The green bond market can grow but we need to keep it simple,” she argues. “We should define the mosaic of what a green bond should be rather than set minimum standards. With a consistent dictionary or taxonomy of terms, investors can then compare issuances easily and decide what is green enough for them. We need to simplify green issuance, not dilute the impact of green issuance.”

The green bond market had its best first quarter since 2013 this year. More than 82 deals were issued from 27 countries for a total volume of $36.13 billion – a 17% increase on the first quarter of 2018. US issuance led the pack, dominated by Fannie Mae’s green bond programme.

Europe has long been the trailblazer for green bonds and both issuer and investor engagement is strongest in the region. Despite the fact that the US was the largest source of issuance in the first quarter, with 14 deals worth $9.2 billion according to Linklaters, the impression lingers that the world’s largest bond market is a laggard when it comes to green issuance.

“It is a challenge that the US has not taken larger share of the green bond market,” admits Tanguy Claquin head of sustainable banking at Crédit Agricole. “But the US bond market is so large that once they decide to do it, they will take a very large market share, so I am not so concerned about this. Climate change could be higher up on the agenda. In order for the market to have additionality this needs to start to happen. Even if only 1% of the total market goes green this would be very significant for the US.” Suzanne Buchta, managing director and global head of ESG Capital Markets at Bank of America Merrill Lynch, says that the issuance gap is closing. “Last year there was a ninefold increase in US corporate and FIG activity from 2017, on top of activity in the municipal space,” she says. “2018 European green bond issuance was likely still ahead of US issuance because of the huge SSA transactions in Europe.”

There is a widespread perception that the SEC places a higher administrative burden on the green bond issuer in the US than elsewhere, but Buchta disputes this. “For US issuance, the investor needs to be made aware of everything in the bond documentation itself, not as part of a separate document,” she says. “There must be no non-factual information in the documentation, nor forward-looking statements. Everything that bond investors are using to make their decision should be in the bond documentation.” That does not seem to be too much of a deal-breaker.

There still seems to be less engagement on the investor side, however. Jim Caron, head of global macro strategies on the global fixed income team at Morgan Stanley Investment Management, finds a marked difference in approach between investors in the US and elsewhere. “In the US, less than 35% of inbound queries mention ESG,” he reveals. “In the Nordics and the Netherlands all queries do.”

David Chen, chairman and head of product development and research at Equilibrium Capital Group in San Francisco, sees a difference in approach between geographies but says that does not necessarily mean a lack of appetite in the US for green bonds. “In Europe institutional investors have a greater propensity to have a specific allocation to green bonds,” he says. “In the US you don’t find that as much. You don’t have hard allocations. If the quality is there it will find its way into the portfolio.”

China is the second-largest green bond market globally, with US$42.8 billion of issuance in 2018, a 12% increase year on year. Elsewhere in Asia Pacific, Japan is relatively advanced in adopting ESG investment strategies, while other countries are moving more slowly. In April this year, Japan’s Government Pension Investment Fund (GPIF) invested in a $500 million green bond from The World Bank as part of a broader push to stimulate ESG investment in the country. It has a strategic investment collaboration with the issuer and will also invest in green bonds from the IBRD and the IFC.

“There is a need by pension funds and other institutional investors to fulfil their green commitments,” says Maxim Vydrine, deputy head of emerging market debt at asset manager Amundi in Paris. “This is a particular challenge in emerging market as there are not many options. So, they are very keen to see this solution.” Amundi launched The Amundi Planet – Emerging Green One fund in March 2018 with €1.42 billion assets under management. This included a $256 million cornerstone commitment from the IFC. The fund aims to deploy $2 billion in emerging markets green bonds over its seven-year lifetime. 

“It is the IFC’s ambition to kick start green bonds in the emerging markets and we have partnered with them on this,” says Vydrine. “We have created a diverse portfolio of emerging market bonds with a commitment to be 100% green by year seven. By the end of 2018 we were 16% green which is ahead of plan. The captive investor base in emerging markets is quite small – most don’t really care whether a bond is green.”

Stimulating supply can be much more of a challenge in emerging markets. “A lot of institutional clients want to see investors more aligned to greenness but find it very challenging in emerging markets due to a lack of projects,” says Vydrine. “The momentum is growing – in China and India the issuance of green bonds is driven by the commitment of the government. In other countries it is a bit slower but we are trying to persuade on their benefits. But the benefits are less tangible.”