Can Green Bonds Tackle Climate Change?

In the midst of crises, it is crucial to steer financial flows in the right direction. Public capital alone is not sufficient. Fixed-income financial instruments to raise capital through the debt capital market, green bonds- also known as green gilts- are one of the most leading innovations in the sustainable finance area over the last 10 years. They include securitised bonds with exposure to bills, receivables, auto loans and mortgage-backed securities (MBS) and those green bonds play a very important role in tapping the financial markets to help the transition to a low-carbon economy.

Green Bond Nations

Recently, sovereign issuers entered the market. Poland with the first to market in December 2016 issued EUR 750 million of sovereign credit (external debt). France then came to market with the largest issue on record of EUR 7 billion (USD 7.6 billion) in January 2017. The country retapped the market two more times in 2017, thereby increasing the size of the bond to USD 10.7 billion. Currently, at USD 23.3 billion outstanding, the bond has been tapped twice in 2018 and three times in 2019. By the end of 2018, sovereign bonds from Belgium, Fiji, Indonesia, Ireland, Lithuania, Nigeria, and Seychelles inflated the category to USD 29 billion. Diversification in the green bond market includes bonds from major core segments of international financial institutions such as the European Investment Bank as corporates and municipalities increasingly recognise green bond issuance as a way to fund environmental projects. Diversification of issuer types over time can be illustrated in Exhibit 1.

Central Banks in the Hot Seat on Financial Sustainability

Central banks are increasing their purchases of green bonds with proceeds earmarked for sustainable projects. The ECB already owns 20% of the eligible euro-denominated green debt, having only started buying corporate bonds in 2016. Many at the ECB, including Lagarde, consider favouring ‘green’ debt in corporate bond-buying schemes as a radical move. This is because it would ditch the market neutrality principle that currently requires the ECB to buy bonds strictly in proportion to outstanding totals. The Bank of England and the Dutch central bank are both including climate focus among the criteria used when conducting bank stress tests while China’s central bank is accepting green bonds as collateral. The usually reticent Bank of Japan is joining the other central banks, with Governor Haruhiko Kuroda recently listing climate change among the biggest challenges that the world economy faces. Last November, Sweden’s Riksbank sold off the bonds of Australian and Canadian provinces with high greenhouse gas emissions, demonstrating that central banks’ $10 trillion-plus in reserves may prove a potent tool in the climate fight.

Green Bonds as a Financial Instrument

The launch of the sustainable climate bond strategy recognises the pivotal role of banks as they help in the environmental transition for European corporates and for small and medium enterprises (SMEs). In the first half of 2021, green bond issuance by European banks reached USD 100 billion, driven by a record USD 33 billion in the first half of 2021 alone. Banks’ commitments to finance the green economy is expected to keep issuance strong. Theoretically, green bonds represent the perfect financial instrument to raise money, while involving the private sector in the global effort to achieve the SDGs. However, the lack of international consensus on what makes up a green bond, makes it hard to evaluate the environmental benefits and sustainable impact claimed by issuers. Secondly, transparency and reporting are still weak in the green bond market, which still relies on voluntary reporting. Since the market has started to grow, it faces a risk: Bonds labelled as green are not actually green at all. The lack of transparency and ambiguity surrounding green bonds, therefore, has an impact on investors’ trust which could lead to dissuading them from investing in green bonds altogether.

Central banks, including the U.S. Federal Reserve, have recently expanded financial crisis-era lending as part of an asset purchase program to provide support to many parts of the fixed income markets. With certain ETFs, high yield bonds and some collateralized loan obligations (CLOs), now eligible for investment or financing under various programs, central bankers contemplate the incorporation of sustainability criteria into other initiatives. While financial markets have been brought back to order, the focus has been turned to the fiscal response of governments worldwide. The change in focus highlighted the replacement of lost household income and provision of relief to businesses until the economy fully reopens. Given the gravity of the economic downturn, additional rounds of fiscal stimulus are likely.  The agenda already included Green Investment globally, prior to the recent shock, with extremely ambitious programs proposed in Europe and the United States.

The massive challenges faced by debt-burdened governments as they address climate change require private capital to play an integral role to finance the infrastructure enabling the transition to a low carbon economy. Green bonds are expected to make up a larger share of the global debt market following the promotion of green finance promoted by Government. The significant growth in the green bond market has gained the interest of ESG-focused investors as well as traditional fixed-income investors. With green bonds, fixed income investors find that they can make a positive impact while fulfilling their investment objectives.