IFR Green Bonds Roundtable 2015: Part 2

IFR: Is there scope for second-opinion arbitrage, given how many second-opinion providers there are now. Do you need to have standards in your industry?

Pernille Holtedahl, DNV GL: First of all, we all have slightly different approaches, I spoke to an investor the other day who told me she’d also spoken to the other opinion providers and said: ‘what you say is very much in line with what they say’. In terms of how I present our approach compared to other opinion providers, at least we generally agree about how we differ, and I think it’s up to the issuer and the investors who they want to work with.

Maybe our approaches will start to look more and more alike over time because investors may start to agree increasingly on what they’d like to see in an opinion. I wouldn’t go down the standardisation route. It should be the issuer or the investor to say: “I don’t like this approach so I’m not going to buy a bond if you’re going to use that opinion provider”. I don’t think that’s the case today, but I’d much rather see competition [between us] create the best possible product than regulation.

Mike Wilkins, S&P: This resonates quite strongly with us as a credit rating agency because we’ve seen some of the themes here in terms of second opinions, arbitrage and so on applied to credit ratings. A couple of things to state: obviously when we look at Green Bonds what we are looking at as a credit rating agency is essentially as it says on the tin, the credit, When we issue a rating on a Green Bond we are not assessing the “greenness” of that bond at all, we are assessing its ability to repay on time and in full.

That’s essentially all we can do as a regulated entity ourselves, we are not permitted to give an opinion on the greenness of a bond. So that’s got to be clearly stated, obviously there are discussions about what more we can do in this market and there may be opportunities to develop in this way, because it seems to be an investor requirement in this area.

But we are not providing environmental integrity opinions, we are looking at the creditworthiness of the market as it currently stands. This really begs the question of how the market is going to evolve going forward because environmental integrity has not necessarily been seen as an investment benchmark as yet. What I mean by that is that it’s not affecting pricing. Whereas a credit rating will affect the pricing of a bond, will a second-opinion provider and label whatever it may be given to that bond affect the pricing?

When we get to that level of the evolution of the Green Bond market, then we’ll start to see quite a fundamental shift in dynamics in how it develops. The other thing I would mention related to the evolution of the market is the issue of risk transfer. At the moment the corporate Green Bond market growing as it is – and it’s growing at a phenomenal pace – is essentially a market in green-labelled thematic bonds; there’s no risk transfer in terms of credit risk.

Going forward, we anticipate that’s going to happen more i.e. where repayment of the bonds will be linked to the green assets which the bond proceeds are financing and that’s where credit rating agencies like S&P will come in. I come from a project finance background and we have a very well established and comprehensive methodology for looking at project finance risk. That’s what investors will be looking at when they look at the risk transfer issue on Green Bonds, whether for renewable energy or energy efficiency, whatever it may be.

IFR: I wanted to touch on Green project bonds. The project bond market globally is pretty small relative to the amount of assets financed through the bank market, and the bond market has encountered pretty formidable problems in getting its head around project risk it. Will non-recourse structures catch on in the Green Bond market because ultimately non-recourse green projects are as pure-play as you can get. Is credit and the prospect of non investment-grade ratings the issue here, Mike?

Mike Wilkins, S&P: Within the world of project financing typically the initial rating is what it is structured to be: most project and infrastructure bonds start from a blank piece of paper and the aim normally is to get an investment-grade rating. As the years go by, if there’s performance risk or other issues materialise, then it may be downgraded.

Your reference to non investment-grade Green Bonds in the renewables space is because of performance risk. And those bonds are from an older vintage; the transactions that we’re seeing coming across our desks now are much better structured and more resilient to project and performance risk. I wouldn’t anticipate renewables bonds or any other form of Green Bonds where the risk is transferred to the investor for repayment to be structured as non investment-grade from the outset.

IFR: Tanguy: what are the inherent risks in shifting to a non-recourse green bond model as opposed to the corporate green label structure we have today?

Tanguy Claquin, CA-CIB: They are two different markets. On the one side, there is the corporate market which clearly adds a lot of value because you can finance green projects through the balance sheet of strongly-rated corporates, and on the other side you have the project bond market (which is wider than just green) which needs to develop in Europe.

There will be a portion of that that will be green but the green project bond market will not emerge in and of itself, it will emerge as part of the project bond market, globally speaking and clearly, as in the corporate market, the first questions will be credit, liquidity, how solid the structure is and so one and then is it green.

Navindu Katugampola, Morgan Stanley: I would agree with Tanguy. The reality is the majority of Green Bonds we see come to the market do something very specific: they allow you as a corporate to translate your company ethos around sustainability into an investable product. And essentially by crystallising that vision around a Green Bond, you are inviting investors to support it with their capital and you’re generating capital market solutions to help drive your sustainability goals.

That’s quite different to the project finance market and the reality is that investors are saying to us that they like the opportunity to be able to shape and directly influence corporate strategy around sustainability with companies and credits they’re very familiar with.

Developing expertise in analysing the underlying risk of projects is something quite different and requires a whole new infrastructure to be in place whereas a lot of the environmental, social and governance screening methodologies have already grown up with a lot of the larger institutional investors on the equity side so it’s just a case of translating that and putting it into the fixed-income side. So I would agree with Tanguy there, the two markets are going to involve in parallel but I don’t think the project finance market is going to replace the current use-of-proceeds Green Bond market we are seeing.

Ulrik Ross, HSBC: We have to be very clear about what it is we are trying to achieve. I think we all agree here that what we’re really aiming for is to increase awareness in general with investors and issuers so we can get to that 2o Celsius temperature increase cap. By engaging with investors that’s how we will build up the market. When we talk about the emergence of asset classes, multi-assets, corporates, recourse and non-recourse it has a lot to do with how investors are starting to mobilise around this theme – either via segregated Green Bond funds, or by buying sustainable assets across existing portfolios. The key is to mobilise a corporate strategy around investment policies and sustainability.

What we have seen is that typically for the more sophisticated asset managers with multi product portfolios, project bonds might fit into one of the portfolios but not the majority of other portfolios. In contrast, an investment-grade corporate bond will fit into a lot more portfolios. When it comes to how will it emerge into a multi-product asset class, that’s up to investors and it’s about how they mobilise around it and set themselves up.

What we see is that there are definitely more people starting to implement policies on the investor side. We encourage them also to do it indirectly; we don’t think that a Green Bond portfolio is necessarily the only way to do this. A strong governance and sustainability policy is the way forward.

So you tick the whole portfolio box instead of small sub-portfolios; that will help mobilise a lot more wallet. Multi-assets will see an evolution, it will go slowly because you are merging between credit spectrums, between equity, debt and project bonds but nevertheless the awareness will bring us to a better place.

Our hope, dream and aspiration is that we will go into more risk categories over time and help facilitate new projects that we couldn’t finance in the past. We are moving in the right direction, it will be a slow transition, it will be the investor who will mobilise around it and the more products we get out there, the more people will start to think about it and engage.

Stefan Reiner, Deutsche Bank: On the buyside, we have equity investors who have already put their money to work in energy-efficient equity investments. We’re talking here about directing more of the big portfolios and educating our mainstream investors to put more money into Green Bonds. Project bonds might be difficult for mainstream investors to buy; they fit more neatly in the equity side.

Mirko Gerhold, Commerzbank: I fully agree. On the investor side, there are two different markets that I expect will grow in parallel, albeit with the project bond market remaining smaller than the recourse bond market for the time being. But it’s also important to look at the other side, at the issuer side, because the project bond market basically allows them to transfer the risk to investors and one of the main benefits is issuer credit relief. However typically, as mentioned, the rating tends to be lower, the structure tends to be more complicated and as a consequence in many cases it’s more expensive.

The issuer has to decide whether they prefer going down that route for the benefit of the additional credit relief or because it benefits the overall company strategy and pay the potential additional price or if it’s maybe easier to just issue green use-of-proceeds bonds with recourse, which may translate into cheaper funding terms.

IFR: Which leads me to a core topic here: pricing. At the moment, issuers get no funding benefit from issuing Green Bonds other than potentially through greater buyside diversification which may end up offering them better performance. Shouldn’t issuers get a funding benefit, because after all it’s expensive to all the work to get the Green Bond? And on the flip slide, if investors are really signing up to this concept, shouldn’t they be willing to forgo return in the name of financing greenness and sustainability?

Tomas Lundquist, Citigroup: It’s the core question for some companies in terms of how they look at this. Clearly diversification is an important element, also the fact that they can showcase their efforts around sustainability, as we discussed before. But clearly the pricing element is important, particularly when you look and interact with people in the funding teams.

Even if you don’t necessarily get a funding benefit, I don’t think you pay up either. So the benefit is certainly there and frankly I expect Green Bonds to be stickier in terms of performance in the secondary market. One interesting development is when you go back 12 months, the interest from corporates in general was exceptionally large. The investor side felt a little bit like it was lagging the interest on the issuer side. Today it’s almost the reverse.

So the question comes back a little to your first question: is this a €100 billion market in 2015? If issuers actually issue below expectation while in the meantime you have lots of cash coming into the sector from the investor side, maybe that pricing differential diminishes to some degree and maybe improves further. The way I see it from the investor side is that there’s huge interest embracing this new way of investing. And I think that will make it increasingly compelling for issuers on a relative basis to issue Green Bonds.

Pernille Holtedahl, DNV GL: Investors have a fiduciary responsibility first and foremost so they wouldn’t be willing to invest in Green Bonds if we started asking additional things from them. So I think [the pricing piece] has to grow organically. It would be great to see and perhaps logical to think about a slightly lower coupon, but that needs to evolve organically from within the market and over time.

Navindu Katugampola, Morgan Stanley: I think you’re exactly right: the Green Bond investors we see have a double bottom-line. They’re looking at economic return but also social and environmental return as well. What needs to happen for this market to get to a point where Green Bond transactions are consistently pricing tighter than vanilla bonds is you need to have a deeper, more liquid market.

And if you have issuers that build out Green Bond curves, as well as vanilla curves, that consistently trade tighter, at that point in time as an issuer you can point to a clear pricing reference. At this point, what you’re capturing with the Green Bond is, as Tomas said, the opportunity to tap into incremental demand and organically you may see a situation where that incremental demand that you were getting with the Green Bond versus vanilla bond may enable you to organically end up at a better place from a pricing standpoint.

What we can say is you would certainly price no worse than a vanilla deal with some potential for upside, but it would be a mistake to try to force the market to buy more expensive deals, because fundamentally as Pernille said, investors are first and foremost fixed-income investors and focus on the return they are getting.

Tanguy Claquin, CA-CIB: You need also to bear in mind the history of the market. From 2006-07 to 2012, it was a private placement market that was quite expensive to investors, and the market didn’t grow for that very reason. Many investors said it was too expensive. If we’re not careful we may really do harm to the market.

One of the deals that often gets overlooked is Region Ile de France’s €350m Green Sustainability Bond of March 2012 which was the first public trade in this market that was open to all investors and which was marketed as a trade that priced exactly like any other transaction. This was one of the tipping points in the market.

Issuers often have funding strategies that involve diversifying their funding sources be it via other currencies without having an immediate funding advantage but just for the benefit of seeing new investors. This applies to the Green Bond market just as it applies to other markets.

Mirko Gerhold, Commerzbank: I often come across investors expressing interest in investing in Green or other thematic bonds. But the fact is at the core what they’re looking at are the company’s operational activities and they’re very SRI-focused. So even if it’s not explicitly a Green Bond, that element is very important for them, which I think is helpful for how investors approach the market.

IFR: Where are we in terms of documentation of Green Bonds? We don’t have hard ring-fencing of proceeds beyond the use of proceeds description. Absent this, I was curious to understand how we should view mixed-use bonds, where, say 80% of the proceeds are earmarked for climate change or other environmental issues. And generally speaking should documentation be tightened up for Green Bonds?

Pernille Holtedahl, DNV GL: Documentation has to be in place. We have to remember that before the Green Bond principles we hadn’t verbalised all the elements, for instance tracing the use of proceeds. That was definitely not at the forefront of the opinion providers’ thinking back then. That’s grown over time and we’ve all become more conscious of it. You have to be able to track proceeds but it’s not a problem.

I’ve never met an issuer who said that would be a problem, they will always find ways of doing it. Secondly, the investor ultimately decides. If an issuer says this is an 80% Green Bond, are you happy with it and the investor says yes, that’s good enough for us, who am I to judge?

But I would say if you want to call it a Green Bond, it has to be 100% green unless it’s something like 80% very green, 20% neutral. At least that has to be not 20% coal so nothing black. This is just a personal opinion about what I would consider green if proceeds were split but it’s easy for me to say. [In the case of an issue with split proceeds, I would think the issuer could alternatively either just downsize the bond or add in some other assets, to make it so that it’s properly green. It’s as a benefit for the market as well as its integrity that we need pure Green Bonds.

IFR: Mike can you comment on this? We have seen a few issuers come with slightly unclear green intentions as well as mixed use of proceeds. I know you said you look only at creditworthiness and don’t as a rating agency pass judgement on greenness but shouldn’t you?

Mike Wilkins, S&P: First and foremost it’s creditworthiness that our rating addresses so we don’t opine on greenness but at the same time, this is a governance issue as well because if companies say they’re raising money for green purposes and they don’t, obviously there’s a credibility issue, there’s a reputational issue and ultimately you could find those issues have a damaging aspect from the governance point of view which could ultimately impact creditworthiness.

It does need to be monitored. And there’s a clear role for transparency. Let me make the comparison with credit ratings, because credit ratings help with liquidity and provide a benchmark. That’s what you need for the Green Bond market but at the moment there doesn’t seem to be a big issue there, in terms of any murky mixing of proceeds. But the first time that happens, that could create such damage to the market that it’s worth making sure it doesn’t.

IFR: Why don’t you come up with a G rating for Greenness?

Mike Wilkins, S&P: It’s not because we don’t want to. I think it’s more to do with the limitations of what we’re permitted to do under existing regulation. Under ESMA regulation in Europe and SEC regulation in the US, as a regulated licensed rating agency, we’re only permitted to give opinions on creditworthiness. But S&P is part of McGraw Hill Financial, we’re a bigger group and there may be other parts of our organisation that could do this. It’s an area we’re very focused on, not just looking and tracking market, but trying to provide benchmarks and information which could help the investor.