Rates turn Green

Green bonds have been around for some time: the first deals surfaced in 2007 when the multilateral development banks reacted to demand from institutional investors for securities that conformed to United Nations Principles for Responsible Investment (PRI).

Since then, the market has grown steadily, if not spectacularly. Momentum is building, however, and in 2016, issuance of bonds meeting internationally accepted standards of ‘Green’ almost doubled from the previous year, to US$81bn, according to Climate Bonds Initiative (CBI).

The market matured not only in respect to supply but also in terms of issuer diversification and instrument type. The appearance of sovereign borrowers, therefore, was another welcome addition to the range of issuer types in the sector and marks another step in the market’s evolution.

“It is a significant statement by the sovereigns,” said Chris Wigley, senior portfolio manager at Mirova, the ‘responsible investment’ arm of Natixis Asset Management. “They have woken up to the challenge of climate change and these deals demonstrate what is possible. It shows the potential for other issuers.”

Where have you been?

While the appearance of sovereigns may be taken as the start of a new and significant market trend, it is arguably one that is overdue.

“The question could be asked: why has it taken so long for sovereign issuers to make an appearance in the Green bond market?” said Felix Orsini, global head of DCM public sector origination, Societe Generale Corporate & Investment Banking. “They have been the missing key in the market’s development.”

That question can be addressed in a number of ways, from political to structural, but the catalyst to sovereigns launching green bonds at this point in time really stems from the historic agreement reached at the 21st Conference of the Parties (COP21) in 2015. At COP21, world leaders committed to the challenge of limiting global warming to less than 2°C above pre-industrial levels.

France, which hosted the meeting, has long been a key proponent of the transition to a less carbon-intensive economy. It has also been a key advocate in creating the economic and financial environment to encourage that transformation.

The government believes Green bonds may become an important tool in channelling investments towards Green assets, and has asserted its resolve through various laws.

Article 173 of the French Energy Transition Act, for instance, includes measures for the integration of climate-related issues in the financial sector and the obligation for institutional investors to publish climate reporting in their investment decisions.

In addition, it has created an official label for mutual funds, “Transition Energetique et Ecologique pour le Climat” (TEEC), aimed at promoting the energy and environmental transition. Fixed income funds wanting to make use of the label must invest more than 83.5% of their net asset value in Green bonds.

“It is clear that governments are to play a very important role in transitioning the world towards a low-carbon economy through regulation, politics and education,” said Orsini. “After all that effort, it would be strange for them then not to do a bond issue themselves.”

In April 2016, France announced that a Green bond would represent the first issuance of its overall 2017 financing programme. A Green bond that formed part of a county’s overall borrowing plan promised to be a significant development for the market.

“From an investor standpoint, the Green OAT offers sovereign curve liquidity,” said Anthony Requin, chief executive of Agence France Tresor. “Our objective was to insert it into the OAT curve and manage its issuance in the same way as the rest of our borrowing activity.”

That commitment to liquidity is reinforced by its plans to tap the Green OAT due June 2039 throughout the year through its regular auction process, in order to raise the outstanding from its initial €7bn up to as much as the €13bn commensurate with the identified Green-eligible investments for 2017.

“Although €13bn represents the cap for 2017, we can issue more in subsequent years,” said Requin. “We expect to bring the outstanding to similar levels of other OATs: around €20bn– €40bn.”

Bankers agree that the addition of a liquid instrument is significant.

“The domain value of sovereigns is liquidity,” said Orsini. “At a time when the rest of the market has become illiquid, for sovereigns it remains important. Liquid means big.”

“It is a validation of the asset class,” said Jonathan Weinberger, head of capital markets engineering at Societe Generale. “It has given the market a pure rates instrument.”

Pipped by the Poles

Although France was widely expected to be the first sovereign issuer in the market, it was Poland that finally claimed the bragging rights to being the inaugural Green bond borrower, with a €750m five-year deal in December 2016.

Poland’s appearance, as well as taking the market by surprise, also provoked discussion within the sustainable finance community.

Although Poland’s decision to issue Green bonds was broadly welcomed as sign of its commitment to sustainability, there were a few sceptics, since Poland has such a heavy reliance on the coal industry in generating its electricity requirements.

Differing views highlight the importance of transparency when it comes to the use of proceeds.

Countries traditionally work under conditions of universality when it comes to revenue collection and tax spending. Universal systems, paid for through tax receipts and public funding, are seen as effective ways of pooling resources in order to fund services as a whole rather than assigning specific income streams individually.

That practice is anathema when it comes to Green bonds, where transparency around the distribution and use of proceeds is a prerequisite for the investor. Not only are borrowers required to identify specific, climate-related projects for which the receipts are destined, but they also need to show that they are squeaky clean as well as Green in using the revenues through the lifetime of the projects. This ordinarily requires the presence of an independent second party opinion.

Poland approached the issue of transparency through an innovative Green bond framework, allowing for proceeds to be set aside in a designated “Green cash account” for disbursement into identified eligible projects that promote its transition to a low-emission economy. It also committed to annual reporting on the projects and has retained the services of second party opinion provider, Sustainalytics.

For France, the methodology was different. It opted for a three-pronged reporting approach to give a unique level of transparency.

“Investors were satisfied with nominal equivalence in the use of proceeds raised for the eligible projects,” said Requin. “Hiring of an external auditor validates the use of proceeds.”

It employed the services of Vigeo Eiris as its external auditor.

Annual reports will be produced on the allocation of proceeds, verified by the auditor, there will be annual disclosure of the performance of its investments and the additional overlay comes from ex-post impact reporting.

Greenbacks for Green assets

Sovereign deals are launched into ready demand. The France issue is a case in point, with 200 investors taking part in the transaction, as opposed to the 100 investors taking paper at its last 20-year issue, in 2016. And many of those buying into the deal were unusually public in their support.

That suggests “Green” makes a difference in terms of widespread appeal, and it is clear that the depth of demand for ethical investment is increasing.

By the end of 2016, for instance, the PRI had reached 1,600 members representing some US$65trn of assets under management. These assets rest in the hands of investors with long-term obligations and considerations to clients.

“Many investors – particularly emerging market debt investors – are starting to consider the implications of sustainability challenges to GDP, foreign investment and a government’s ability to raise income from taxes,” said Archie Beeching, senior manager, fixed income, at the PRI. “Investors are looking at outright national sustainability as a way to identify long-term risks to creditworthiness.”

At present, there is no explicit link between ESG risks and the credit ratings of bonds, although by using a Green bond route the borrower is showing its commitment to financing climate-related projects – as well as incurring the expense of reporting and external auditors.

“For sovereigns, however, if Green financing is being used to improve resilience of their infrastructure to the impacts of severe climate change, then this could be credit enhancing,” said Michael Wilkins, head of environmental and climate risk research at S&P Global Ratings.

A link to creditworthiness, considerations to economic risk and just the presence of a growing number of funds transitioning their strategies towards sustainable investments would suggest there is a case for Green bonds to eventually trade inside outstanding paper.

The appearance of sovereigns in the market may herald the start of that process.

“Once there is more supply in the market, it might attract more funds,” said Weinberger. “The combination of resilience, performance and liquidity could be the catalyst for bonds to trade at a premium.”

The post-launch performance of the Green OAT, although still relatively illiquid in comparison to the rest of the curve, shows that there is potential for borrowers to be rewarded for providing transparency.

“The price action has been good,” said Requin. “We launched at 13bp over the OAT due 2036, but by early March, the Green OAT was trading at 8bp over. It went through the OAT curve.”

The experience of Poland and France is sure to pull more sovereigns into the market, and there is no shortage of names said to be preparing an appearance.

Nigeria has announced its plans to launch a Green bond in its domestic market, while there has been regular talk of issuance coming from Sweden, Canada, Italy, Austria, Japan and China adding to liquidity of the sector.