Green bonds: an emerging asset class growing rapidly

Issuance of green bonds remains small in the context of the overall multi-trillion dollar bond markets but has been growing rapidly from its inception in 2007.

green bonds marketGreen bonds are debt securities issued to raise capital specifically to support climate related or environmental projects. They are an emerging asset class which is ultimately fuelled by the increasing determination of governments to lower global carbon emissions in order to limit climate change. The European Union has been a driving force in establishing the market, linked to its Renewable Energy Directive enacted in 2009. The green bonds market has grown rapidly to become a global asset class for all sectors, boosted by the UN COP 21 climate agreement in December 2015. Global policy makers see green bonds as a key tool to implement national climate change targets.

Issuance of green bonds remains small in the context of the overall multi-trillion dollar bond markets but has been growing rapidly from its inception in 2007. Issuance rose to USD113 billion in 2016, based on Fitch’s Green Bond database – up 60% from 2015.

The market infrastructure is still in its infancy, although many developments are under way. A cornerstone is the International Capital Market Association (ICMA) Green Bond Principles – a voluntary code focused on the use of proceeds, the procedure for project evaluation and selections, management of proceeds, and reporting. There is also an emerging system of verifiers and assurance providers who examine process and environmental integrity.

External reviews and opinions are important for both index providers and securities exchanges as they help determine the eligibility of bonds for green indices and listings. With issuers in effect unilaterally determining how they use the proceeds of their green bonds, compliance with stated objectives becomes mainly a corporate governance/reputational matter for the issuer. Until standards are harmonised this is a risk to the continued successful development of the green bond market.

For issuers, the green bond market provides an opportunity to diversify funding sources. The rarity of green bonds and the dominance of dedicated buy-and-hold investors focused on the sustainable and responsible segment sometimes drive pricing tighter than for comparable instruments by the same issuer. Issuing green bonds can be seen by investors as an indication that the issuer is cognisant of environmental matters which could affect their business in the longer term.

Most green debt funding is still provided directly by banks in the form of loans. Green bonds still only account for less than 1% of the global bond market so the potential for growth is great. This would be in line with the overall trend of increasing corporate funding disintermediation observed by Fitch.

There is growing demand for green bonds from asset owners such as pension funds, sovereign wealth funds and corporate treasuries. Many investors buy green bonds as part of their general asset allocation. However, demand is particularly strong from investors focused on sustainable and responsible investing (SRI) and those who incorporate environmental, social and governance (ESG) criteria as part of their investment analysis. Many asset managers around the world have established dedicated green-bond funds.

The amount of assets being professionally managed under responsible investment strategies globally is growing rapidly, reaching USD23 trillion in 2016. This equates to 26% of all professionally managed assets globally. Bonds account for a growing share – almost two-thirds of the total in Europe and Canada.

Investors Expect Rising ESG Risk
In Fitch’s latest European Investor Survey, a majority of respondents said they expect the financial impact on their investments from environmental, social and governance risk will increase.