By Jamie Johnson
What are green bonds?
Green bonds are bonds that specifically raise money for projects that benefit the environment. A bond is a financial instrument that is generally publicly issued to raise capital. The green bond market is growing rapidly and is expected to reach $1 trillion next year.
When can a bond be called a green bond?
There are typically no specific laws on when a bond can be called a green one. However, green bonds are subject to regulations around ensuring that bonds have an accurate disclosure and do not mislead investors. Thus, a project that is completely unrelated to the environment will not be able raise green bonds.
Some jurisdictions have specific regulations on where the capital raised from a green bond needs to go in order to label the bond as a green one. For example, in India the Securities Exchange Board has specific rules on what an issuer is obliged to do. Nigeria also requires a study to show that the firm can realistically be expected to meet the sustainability goals of the bond issuance.
How is a green bond issued?
There are four main stages: the creation of a written framework, third-party review, the updating of legal documents and the listing itself.
The creation of a framework is outlined by the prospectus. The prospectus is the general document for investors that provides an overview of the company and gives an indication of how the capital raised from the issuance will be used. The framework will explain how the bond relates (either directly or indirectly) to a business activity that is environmentally sustainable.
Getting third-party review will involve the issuer getting another actor to provide some reassurance that the bond is being used for an environmentally sustainable project. This stage is optional but it would be difficult to justify not having a third-party review. The most popular form of third-party review is getting a second opinion from a sustainability consultant. There can also be a formal rating allocated to the bond. Moody’s and Standard & Poor’s both offer services whereby they assess the environmental credentials of the bond.
The issuer will also need to get the required legal documents for the transaction. In the first instance, there will need to be an offering document. This is where the issuer will explain how the capital is used to finance a sustainable project. In addition, the issuer will point out any risks. These will include things such as the third-party verification being withdrawn at a later date. The issuer will also need to get an underwriting agreement with any relevant banks.
After the three steps above, the issuer can issue the green bonds on the market. After this point, depending on what they bind themselves to in the agreement, they might have to meet certain targets that they have set out. Otherwise, they will have to pay a higher interest rate.
Why do green bonds exist?
There are three main reasons why green bonds exist: the growing demand for sustainable investments, the need to distinguish a product and the need to satiate society.
Investors are increasingly preferring sustainable investments, even at the expense of the performance of their portfolio. This is part of a broader trend towards environmental, social and corporate governance (ESG) investing. What this means is that investors would be happier to invest in a green bond that might have lower returns than other bonds but which is beneficial for the environment.
Green bonds also provide a way of distinguish an issuance from other bond issuances. Saying that a bond is a green bond instead of a regular one means that it might receive more media and investor hype. Consequently, the issuer might find it easier to raise a larger amount of capital at a lower cost.
There is also a need to satiate society because of the growing political and social pressure on companies writ large to do more for the environment. Issuing a green bond provides a clear signal to society that the company cares about the environment. What this means is that they might be subject to less political scrutiny and retain consumers who care about sustainable companies.
What are the downsides of green bonds?
There are two main downsides to green bonds: the reputational risk and the legal risk.
In terms of the reputational risk, there can be a concern of the extra scrutiny that comes from the media looking at the issuer. There could be allegations that the project is not as sustainable as it would be. This extra scrutiny could mean that the firm’s reputation is damaged on net.
There is a legal risk from using the sustainability label too. An investor could challenge the issuance if they demonstrate that using the term sustainability for this project is unfair. They could also show that the issuer did not comply with the relevant sustainability and disclosure frameworks. Critically, this could mean that the issuance is delayed or cancelled and so the company will not be able to raise capital until later.
British government announces green gilts – (November 2020) Rishi Sunak, the Chancellor of the UK, announced that the UK will sell the UK’s first green gilt next year. This means that the UK government will itself issue a green bond. This forms part of the British government’s broader strategy to invest more in sustainability programmes.
Suzano issues sustainable debt – (September 2020) Suzano, a Brazilian company that makes pulp and paper, has announced that it will issue debt that involves penalties if carbon emissions targets are not met. If the targets are not met, Suzano will have to face interest rates that have increased by 0.25%. This marks a change from most green bonds, as companies do not typically hold themselves to specific targets.
Nafin issues Mexico’s first green bond – (October 2015) Nafin, a development bank, issued Mexico’s first green bond to raise $500 million. The debt was paid across 5 years and had an interest rate of 3.375%. The debt was used to fund wind energy projects in Mexico.