Green bonds gaining appeal, but for how long?Green bonds gaining appeal, but for how long
A few years ago, Norway’s sovereign wealth fund, which is a substantial pool of resources, thanks to the country’s control of about half of the North Sea’s oil reserves, announced it would no longer invest in environmentally unsound industries such as coal power, and would begin unwinding the unsustainable investments it already held. Although investment activism was certainly nothing new, Norway’s move involving one of the world’s largest and most stable investment funds brought the idea to mainstream attention.
A number of other governments and large institutional investors have since followed suit, and while the recognition that the climate-related moral hazards represented by some investments probably should not be ignored is by no means universal yet, it is growing.
S&P Global Ratings recently announced it would start taking climate risks into account in its credit ratings assessments and placed nine oil and gas companies on its CreditWatch list, implying a possible ratings downgrade in the future.
The growing sentiment that business should at least try to be a little more responsible for a change has led to the rapid expansion of so-called green bonds, securities with some kind of environmental hook. These can be bonds that are issued to fund a specific venture, such as a renewable energy project, or have some other strings attached, such as the issuing company complying with specific environmental standards. An example of the latter is the new set of guidelines imposed this year by the European Union (EU), which requires asset managers to detail how sustainability factors are considered in their investment decisions.
The new EU rules are interesting, because they are not creating a set of behaviors (for a change), but rather institutionalizing a trend that already exists. Between the end of 2018 and November 2020, the assets of euro-denominated bond funds labeled as sustainable more than doubled from $21 billion to $48 billion. According to data from HSBC, as of the third quarter of 2020 about $780 billion in green bonds have been issued worldwide since 2015; about $168 billion of that was issued in the first eight months of 2020.
That total would likely be even higher were it not for central banks’ keeping interest rates low for other economic reasons. The low interest rate environment forces fund managers to seek out higher returns, and unless they are bound by other conditions — such as the EU rules, or specifications from investors to only invest in sustainable securities, or at least not invest in those issued by unsustainable companies, like coal producers — they opt for the better returns the increasing “interest penalty” the growing preference for green bonds imposes on nongreen ones.
However, that paradox of social acceptability being inversely proportional to profitability appears to be disappearing quickly. Up until now, the difference in what interest a bond issuer has to pay on a “dirty” bond compared with a green one might be tolerable, but as investors impose more constraints and demand more green bonds, the costs of dirty bonds are going to become financially unsustainable from the companies’ point of view. This will accelerate even more quickly if, as S&P hinted, environmental sustainability or the lack thereof becomes a factor in credit ratings.
Then the bond market environment will change, and in fact may already be arriving at the point where high demand for green bonds will boost their returns because companies will have to compete for investors’ attention. Nongreen bonds will have few takers and thus be prohibitively expensive, or their issuers may find themselves shunned by the market entirely. For the period of time that companies that are not already in a position to issue green bonds are remaking themselves and their business activities to be able to do so — and they will, because companies need to issue debt all the time — green bonds will continue to be a discrete and rapidly growing segment of the securities market.
How long that might last is anyone’s guess at this point, but it will end, and for the sake of what it represents for environmental concerns, we might hope it ends sooner rather than later. Eventually, a recognizable acceptable level of sustainability behind any debt issuance will become a universal prerequisite to issuing debt in the first place, and green bonds, at least according to how they are defined now, will become the norm. Until then, the green bond market offers some promising opportunities; as with any financial market, whoever moves the fastest is likely to earn the most.
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