Green government bonds: The promise and the pitfalls
By Kris Atkinson, Portfolio Manager, Fidelity International; Ana Victoria Quaas, Investment Director, Fidelity International; and Ben Traynor, Investment Writer, Fidelity International
Green sovereign debt issuance is on the rise and could dramatically improve liquidity and standards across the green bond market as a whole. Investor demand is high, but it is important both not to overpay for green sovereigns and to monitor what issuers do with “green” funds.
According to OECD data, green government bonds were the fastest-growing sustainable bond segment in 20211. First-time issuers accounted for 40% of outstanding sovereign green bonds with the governments of Germany, Hungary and Thailand among those making green bond debuts. Further issues of debt to finance green initiatives have come from countries such as the U.K., and there have been further innovations in green bond structures.
Governments are increasingly turning to green bonds.
This rapid growth partly reflects the early stage of the green bond market in general, and of sovereign green bonds in particular; the latter account for only 0.2% of OECD government debt1. Nonetheless, we expect more governments to issue green bonds as a way of financing large-scale green infrastructure projects and R&D for next-generation technologies that will be crucial to achieving the net-zero transition. A “greening” of government bonds – the backbone of global fixed income markets – could help resolve some of the pricing, liquidity and reporting challenges that investors face.
Beware the “greenium” and illiquidity.
High investor demand for green bonds has created a so-called ‘‘greenium” (green premium), and the securities frequently offer a lower yield than similar bonds without the green label. (An exception is China, where greeniums have so far been practically non-existent).
Perhaps the clearest example of a sovereign greenium comes from Germany. On September 2, 2020, the German Finance Agency announced that it sold 6.5 billion euros of green Bunds with the same coupon and maturity date as ordinary non-green Bunds issued a few weeks earlier. The green bond priced at one basis point of yield below its vanilla twin, and has maintained a lower yield on the secondary market since, trading as much as seven basis points lower. Two months later, Germany went one better, issuing green and ordinary bonds on the same day that had identical coupons and maturities. This November green bond issue also traded at a greenium.
The popularity of green bonds has led to a tendency to hoard them, reducing liquidity and widening pricing differentials. Those attempting to justify the greenium could argue that green bonds’ relative scarcity should make it easier to sell them. But that is little comfort to those who wish to rebalance portfolios and need to buy green bonds as well. In some cases, a lack of liquidity also increases trading costs.
Reporting standards need to improve.
Greater green sovereign issuance should ameliorate these problems. The greenium has dwindled in corporate bond sectors such as utilities, where green issuance is high, and liquidity has improved. For green bonds to go mainstream, however, other challenges need to be addressed. Top of the list are inconsistent reporting standards across different countries.
Standards today are voluntary for all green bonds, and often ad hoc. The use of proceeds reported at issuance can differ from that reported post-issuance, creating a risk that some issuers will overpromise and then fail to meet expectations. Variable reporting and a lack of common terminology and metrics can make it hard to know what the real impact has been, and to compare investments accurately.
Help is on the way. Investment standards for green bonds are being developed at a global and regional level, most prominently the E.U. Green Bond Standard. As these are adopted, the green sovereign market will become more investible and act as a benchmark for green corporate bonds. However, rule makers will need to move carefully. Making it too hard to meet definitions of “green” could constrain supply, and risk exacerbating pricing and liquidity challenges.
Sovereigns seek to address transparency hurdles.
Green government bonds are often subject to the same spending rules as non-green bonds, which forbid the creation of separate accounts to earmark proceeds for any specific purpose. Elected representatives must also ratify any spending decisions. As a result, governments cannot offer green investors much certainty about how green bond revenues will be spent.
Governments have tried to address this problem in different ways. Poland has changed the law to set up a separate account for green bond inflows. Belgium has made a small legislative adjustment to earmark certain spending against green bond receipts so it cannot be financed again by the same means. Germany’s green bond issues are designed to finance pre-existing expenditure.
Still a “trust me” exercise
However, without more robust certification, the “green” label still carries no guarantee as to the use of proceeds and remains largely a “trust me” exercise. Investors need to judge for themselves whether an issuer will actually use the funds for green investments and what impact that will have. Still, the lesson from corporates is that green investors will do just that. For example, several leading green investors declined to take part in Korea Electric Power Corp.’s 2020 green bond issue, following concerns about the company’s overseas investments in fossil fuels.
Some investors have turned to sustainability-linked bonds that have explicit green targets attached to their coupon payments, to ensure greater accountability regarding how their money is used. Governments may struggle to replicate this model, but we expect more green sovereigns to be issued with specific project and development targets over time.
One example is the U.K.’s green Gilt, the first 10 billion pounds of which was ten times oversubscribed at its September launch2. While there are no legally binding constraints on the use of proceeds, the U.K. government has clearly defined the areas of investment it intends to fund, which include renewable energy, clean transport and climate change adaptation. No more than half of the proceeds can go to existing projects, and only to those begun the year before. The issue also requires the explicit reporting of social benefits of green projects, such as numbers of workers helping to transition to low-carbon jobs and homes protected against climate change. There is also a world-first retail product, Green Savings Bonds.
These new kinds of vehicles can help finance the energy transition at scale, given the size of global bond markets. But it may take time for the green bond market to mature, for standards to improve and for the greenium to disappear. In this context, the maxim “buyer beware” remains as true as ever.