Going Green: a guide to corporate green bonds
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Introduction
Environmental, Social and Governance (ESG) factors have long been a consideration for institutional investors on the equity side, with established ESG professionals focused on these issues. However, it is only recently that these topics have begun to play a part in decision making on the fixed income side with apparent pressure from end investors and increasing reporting obligations from the United Nations Principles for Responsible Investment (“UN PRI”), which a significant number of mainstream investors have signed up to. Increasing consideration has been put on ESG research and ESG characteristics of fixed income investments within the mainstream institutional investors.
As financial crisis concerns recede, the topic of sustainability has moved up the corporate agenda. Encouraged by investor momentum, EDF issued the first corporate green bond in November 2013. This kick-started a new market which has grown rapidly; issuance exceeded $18bn in the first half of this year – and according to the Climate Bonds Initiative (CBI) the market could reach as much as $100bn in 2015.
What are green bonds?
Corporate green bonds are usually issued off an existing Euro Medium Term Note programme and priced broadly in line with a regular bond issue, the key differential being a carefully defined green ‘Use of Proceeds’.
The market has been coalescing around the Green Bond Principles (GBP), a set of guidelines subscribed to by over 20 underwriting banks. The GBP recommend four distinct features a green bond should possess, namely:
- Use of Proceeds should be for green purposes (for example, a utility company might issue a green bond in order to raise capital to fund the creation of a wind farm, or a corporate to fund CO2 reduction programmes);
- Process for Project Evaluation and Selection, which is usually a framework or opinion produced by a third-party sustainability consultant;
- Management of Proceeds, an overview of how the proceeds will be tracked within the organisation; and finally
- Reporting of use of proceeds with third-party assurance.
Investor perspective
The widespread adoption of the UN PRI is a key driver of investor sentiment. Launched in 2006, the PRI initiative has now attracted over 1,200 signatories commanding more than $45 trillion in assets under management. The UN PRI, which include principles such as incorporating ESG issues into investment analysis and decision making processes, continues to promote a long-term focus on environmental, social and corporate governance considerations. The signatories are subject to mandatory public reporting, which is a driving factor in investors’ increased focus on ESG.
The summer 2014 announcement by Zurich Insurance, one of the world’s largest insurance companies, that it is doubling its commitment to green bonds and planning to invest $2bn across the US and Europe is a telling sign that the demand is certainly there for this kind of instrument.
Recent green bond issuances have all reported increased investor participation from green focused investors compared to regular bond issuances.
Recent market developments
The introduction of the Green Bond Principles (GBP) by a coalition of banks in January 2014 was a key step in the development of the green bond market. The GBP carry no regulatory weight, but these guidelines mark a milestone in the development of green bonds and go some way towards defining the market and describing best practice. The GBP are important as they offer an accepted and credible framework to any green bond issuance, which will be key to delivering a scalable market.
To date, the majority of green bonds have been issued by utilities, with names such as EDF (EUR 1.4bn), GDF Suez (EUR 2.5bn) and Iberdrola (EUR 750m) issuing bonds. However, as the market grows, issuances from different sectors are emerging. In March 2014, Unilever issued a £250m green bond in order to fund new factories that have been designed to help reduce the company’s water usage, waste output and greenhouse gas emissions. Also in spring 2014, French property company Unibail-Rodamco used a green bond to raise funds to build environmentally friendly properties.
When Unilever issued its inaugural sterling green sustainability bond in March 2014, it was a first for the capital markets.
Banks are also stepping up their issuance in this arena. In June 2014, Lloyds Bank announced the issuance of the first ESG bond, the proceeds of which were earmarked to fund loans to small and medium-sized enterprises that deliver particularly strong social and environmental benefits. The Lloyds ESG bond expanded the scope of this market by broadening the reach beyond green bonds deeper into social and governance areas, which better reflects the breadth of investor focus and is likely to encourage a wider range of issuers to enter the market.
Germany’s development bank, KfW, issued its inaugural green bond in July 2014, adding another factor to reporting standards: impact reporting. This highlights a key development in the market, as KfW will not only report on where the bond proceeds have been allocated, but also their quantifiable environmental impact.
Aside from growing issuance levels, there have been other market developments that indicate green/ESG bonds have become accepted as an established asset class, as Barclays and MSCI (a sustainability ratings organisation) launched a global family of ESG Fixed Income Indices, filling a critical gap in the market by providing investors with a comprehensive series of performance benchmarks.
As this market develops, it is likely that ESG topics will play an increasingly significant role across the industry – and this trend may not be limited to bonds. In July, Lloyds Bank arranged the first-ever corporate green loan, for Sainsbury’s to the value of £200m. There are important links between the bank and the bond market, such as commercial banks financing early stages of green technology and they are themselves large issuers of bonds. If the green bond market is to develop fully, then the bank market is an important constituent. Banks have been under represented as green bond issuers and creating a scalable model for a corporate green loan should help this.
Considerations for treasurers
Green bonds can offer a number of benefits for issuers with sufficient green capital expenditure requirements, who may already be accessing the capital markets. These benefits include the ability to diversify the company’s investor base by bringing in investors who are particularly focused on environmental factors. A green bond may attract investors who might not otherwise have been interested in investing in the issuers’ regular bonds. There are also internal benefits to issuing a green bond, in particular the exercise often embeds an issuer’s sustainability agenda into the way that they finance themselves, broadening the reach of this sustainability deeper into core areas of their business.
Corporates thinking of issuing a green or ESG bond should first look at their sustainability agenda and ESG research from third-party sustainability rating agencies which cover most public companies (e.g. Sustainalytics, Vigeo and MSCI) to determine how they are rated compared to their industry peers. It would be challenging for issuers with very low ESG scores, or any current controversies, to benefit meaningfully from a green bond issue.
Alongside their sustainability credentials, potential issuers should have sufficient planned green and/or social capital expenditure to support the target issuance size of the bond.
It is often the case that future green capex programmes are smaller than target benchmark size, in which case proceeds can be used to refinance existing assets or a broader set of assets included (e.g. assets with a strong social benefit).
If a decision is made to proceed with a green bond issuance, the issuer will need to engage a third-party sustainability consultant who will work with them to create a framework specific to the green bond issuance. This document describes in detail how proceeds are expected to be used and how this will be reported to investors and is used as part of the suite of marketing documents for the bond issue.
Issuers should aim to work closely with their banks to produce detailed investor Q&A, particularly if a roadshow is required. As a relatively new market there is a variety of opinion around green/sustainability issues that leads to a diverse range of investor questions. The issuer should be prepared to answer questions not only related to the credit or the selected Use of Proceeds, but also to their wider sustainability agenda. This can be a good opportunity for issuers to engage in dialogue with their key investors on a wider range of issues not usually covered during a bond sale to the benefit of both sides.
A further consideration is reporting and third-party assurance, which is becoming an increasingly important requirement in this area. Investors expect to see Use of Proceeds reports verified at some level by an independent third party, and issuers will need to factor this in to their cost and resource planning.
Looking forward
The market for corporate green bonds has come a long way in a short time, but remains nascent. Momentum is significant and each new deal is nudging the market forward in some way.
Moving forward we expect to see a wider range of corporate issuers entering the market to finance a range of environmental and social investment programmes. There have been indications from auto manufacturers, food manufacturers and retailers looking at the green qualities of their energy efficiency investments. A number of banks are considering bond issues based on the environmental and social impact of various lending books. Other issuers are looking at more socially focused issuances, particularly in the healthcare and education sectors.
We note that investors are starting to discern the most important features of corporate green/ESG bonds. The most common priorities we have come across are the level of environmental/social impact, the issuer’s wider sustainability agenda and quality and transparency of investor reporting. We expect to see increasing levels of standardisation to the point that this eventually becomes another weapon in the treasurer’s funding armoury that is relatively simple and low cost to implement.
As the corporate green bond market establishes, we expect new ‘green’ focused money to flow in. As standards cement and familiarity with green risks and opportunities increases, we expect to see a second wave of development where investors look for more direct exposure to green assets, e.g. through project or asset backed bonds secured by renewable energy or other green assets.
