When Lietuvos Energija, Lithuania’s state energy provider, issued a chunk of corporate bonds worth $354m last July, it broke several records. It was the first time a Lithuanian company had issued so-called ‘green bonds’, a relatively new financial instrument exclusively funding environmentally friendly projects.

The company’s green bond was also the first to receive the backing of the European Bank for Reconstruction and Development (EBRD), an international bank supporting infrastructure projects in Eastern Europe and Central Asia.

For many companies, issuing bonds with an environmental focus serves as a signal to markets and investors that addressing climate change is a key strategy rather than a mere afterthought. “Green bonds are a tool for corporate issuers that want to communicate how they are thinking strategically about climate change and whether they are investing to capitalise on the opportunities it presents,” said Manuel Lewin, Head of Responsible Investment at Zurich Insurance, a major investor in green bonds.

In an era of increasing concerns over the consequences of climate change, going green makes both environmental and financial sense, according to Darius Kašauskas, Finance and Treasury Director at Lietuvos Energija. “We have become part of the UN Global Compact, and in our strategy for 2020 we set clear goals for renewable energy production, energy efficiency and climate-resilient growth,” said Kašauskas. “At the same time, issuing green bonds fits nicely with our financial strategy and the group’s debt portfolio diversification targets.”

Green bonds attract an increasing pool of investors with green mandates. Lietuvos Energija’s bond received orders from more than 120 investors, encouraging the company to triple issuance from the initial target of $118m. The funds raised will support projects on wind energy, energy efficiency, waste and biomass fuel.

For its part, the EBRD has been issuing its own green bonds since 2010, so it was in an excellent position to help others do the same, and duly invested $35.4m in Lietuvos Energija’s bonds. “There haven’t been many green bonds in our countries of operation, so it was the first time the stars aligned,” said Charles Smith, Senior Funding Officer at the EBRD.

Taking root
Green bonds first appeared in 2007, when the European Investment Bank and the World Bank issued the first bond with an environmental focus. After a few years of modest activity, the market took off in 2013 with the first $1bn bond by the International Finance Corporation, the World Bank’s private sector arm.

That same year, EDF, Bank of America and Vasakronan issued the first corporate green bonds.

Although still a minuscule fraction of the fixed-income market, green bonds have grown exponentially from a value of $11bn in 2013 to $93bn in 2016. Big corporations have backed the trend too; Apple issued a $1bn green bond in June this year.

Bloomberg New Energy Finance forecasts issuance to increase to $123bn this year, while Moody’s predicts a staggering $206bn.

The market will keep growing, according to Beijia Ma, an equity strategist at Bank of America Merrill Lynch: “If you look at the climate investment we have to make up to 2030, there is a gap of between $650bn and $860bn annually, so green bonds could be a tool to mobilise private capital.”

Green bonds first appeared in 2007, when the European Investment Bank and the World Bank issued the first bond with an environmental focus

Green dragon
China was a latecomer to the green bonds market, but since joining, it has rapidly left everyone else behind. Last year, Chinese companies issued green bonds worth $36bn, accounting for around 39 percent of the market.

Research by the People’s Bank of China estimates that the country will need to invest at least $320bn annually in green projects by 2021. Only 15 percent of that capital will be provided by the government, opening up room for private investment.

This shift towards green finance has been approved by the government. According to Sean Kidney, CEO at Climate Bonds Initiative, an NGO promoting green finance: “China is one of the most vulnerable countries to climate risk. Shanghai, for example – a city of 20 million people – is in a lowland area, like the Netherlands. A major storm surge, and the whole peninsula would go down. The government has been made aware of this recently, so it made a decision to move to a green economy very quickly.”

The game-changer for China was implementing regulatory changes that boosted green bond issuance. “The market can change quickly. That happened last year with Chinese green bonds. They became a big part of the market because of the standards being developed in China,” said Miroslav Petkov, Head of Environmental and Climate Risk Research at Standard & Poor’s.

Greenest of them all
As a new instrument with little history and even less investor awareness, green bonds lack a universally accepted framework. What qualifies as ‘green’ is unclear, inviting criticism that some bond issuers have jumped on the green bandwagon solely for PR reasons, a practice known as ‘greenwashing’.

China’s entry into the market has exacerbated the problem, as Chinese standards deviate from European ones, according to Ma: “In China, clean coal could qualify as a green bond, whereas that is not the case elsewhere. And if you look at a lot of the bonds issued in China, some of the proceeds go to refinancing rather than actual green projects.”

In an attempt to address the problem, in 2014 a consortium of investment banks, issuers and investors launched the Green Bond Principles, overseen by the International Capital Markets Association (ICMA). The initiative has helped solve a key issue – monitoring where the money goes.

“Green bonds following the principles hosted by ICMA are especially attractive, given the transparency and accountability concerning the use of proceeds, which is designed to give markets confidence that the bond is serving relevant green purposes (see Fig 1),” said Nicholas Pfaff, Senior Director and Secretary to the Green Bond Principles at ICMA.

A number of benchmarks have also appeared to help investors make decisions. The Barclays and S&P Dow Jones Indices, for example, have both launched green bond indexes.

Before picking a green bond, investors often have to ask themselves whether the issuer has a spotless environmental record. But it is the direction of travel that matters the most, according to Lewin, whose employer Zurich Insurance has pledged to invest $2bn in green bonds.

“Education is important for companies that aren’t green poster children. Even if your track record is not perfect, if you follow the Green Bond Principles and we can see a clear strategy to address climate change, we can make some compromises. It doesn’t have to be the brightest of green, because that will come over time.”

Many investors believe that a lack of common standards hinders growth, but others think there are more urgent issues to tackle. “What matters more than anything now is urgency. We’re so far behind on our climate change goals that we are risking destroying any potential for future civilisation,” said Kidney.

However, international standards could help build bridges: “It would be a problem if we had too much national regulation, because a lot of this money is going to move internationally. The bulk of investment on climate change has to go to emerging markets, and the bulk of the money is in rich countries. If we had different systems, it would put a brake on growth.’’

Credit agencies have a role to play, too. Moody’s has issued a green bond assessment, while Standard and Poor’s has launched a green evaluation service.

There is hope that, at the very least, the market may reach a minimum consensus on what constitutes green in the same way that credit agencies came up with benchmarks to gauge credit risk.

Teething problems
Although the green bond market is growing rapidly, it still represents a tiny part of the overall fixed-income market. An increasing number of funds with green mandates have emerged, but their presence can have a distorting effect on liquidity as demand outstrips supply. These funds also tend to hold on to bonds longer than other investors.

This discrepancy between supply and demand has sparked a debate on whether there is a difference in yield between green and regular bonds. There is still no conclusive evidence on whether a green premium exists, but if there is one, it could harm the market.

Last year, Chinese companies issued green bonds worth $36bn, accounting for around 39 percent of the market

“A lot of institutional investors like ourselves would be forced out of the market if it became clear that there was a systematic green premium, particularly at issuance,” said Lewin. What’s more, issuance itself remains low. According to Petkov: “One of the challenges for issuers is that they don’t necessarily see the benefits of issuing green bonds in terms of low cost. There is an additional cost associated with issuing this type of bond, for example additional reporting.”

Exchanges could provide a solution to the illiquidity trap by raising market awareness and matching potential issuers and investors. In September, the Luxembourg Stock Exchange launched the Green Exchange – a green bond platform that already accounts for around 30 percent of the market.

But the ultimate weapon against illiquidity could be government action, according to Kidney: “The first thing governments can do to grow a market is to get demonstration issuance out to show others and provide liquidity. The poster child for this is France.”

Sovereign bonds
France’s issuance of an $8.3bn green bond in January was largely driven by the country’s desire to be seen as a leader in climate change policy.

“Our main objective was to address environmental issues, based on France’s position on COP21 and its chairmanship of the Paris Agreement,” said Anthony Requin, CEO of Agence France Trésor, a public body managing the country’s public debt. “In the wake of the conference, French authorities wanted to demonstrate that capital markets could help sovereign states finance their transition to a low-carbon economy.”

Providing liquidity was indeed the government’s main priority, added Requin: “This is precisely where sovereign states like France can make a difference on the green bond market. So, we structured this bond around the notion of liquidity, and ensured that our green bond would have the same liquidity as other French government bonds.”

Sovereign green bonds are a relatively new entry to the market (see Fig 2). Last December, Poland became the first country to issue green bonds, followed by France a few weeks later. Several emerging economies, including Nigeria, Morocco and Kenya, have similar plans in the pipeline.

As with corporate green bonds, however, investors have to tread a fine line to define what is truly green. In Poland’s case, critics pointed out that the country’s economy is still reliant on coal, while the government is sceptical of climate change. Some have gone as far as claiming that the bond will be used to release funds for fossil fuel projects.

Piotr Nowak, Undersecretary of State at Poland’s Ministry of Finance, dismissed these claims: “We have strictly stated that some businesses and projects cannot be eligible because of their own circumstances, policies and regulations, and are excluded from the use of green bonds proceeds.”

As with corporate issuers, however, the direction of travel might be more important than the current station. Nowak continued: “The Polish Government is not particularly green, but its green bond properly allocated assets to green investments, and had good disclosure around it. It also created an interesting internal dynamic. as many Polish companies subsequently contacted the ministry of finance to enquire about issuing their own green bonds.”

Unlike corporations, governments have to meet targets to reduce carbon emissions. Innovative financial instruments can help them do that by diversifying their investor base, as in the case of Poland.

“We experienced solid participation from green accounts that otherwise cannot buy our bonds because of their investment policies. Our green bonds attracted many new investors, especially those with green mandates,” explained Nowak.

Government intervention
Liquidity is just one area where government action is possible. Advocacy organisations such as the Climate Bonds Initiative support the adoption of ‘capital steerage’ policies that will help increase scale and reduce risks associated with green bonds. Proposed measures include tariffs, tax incentives, subsidies, green mandates for sovereign wealth funds, and green quantitative easing.

An expert group on sustainable finance set up by the EU is currently exploring some of these measures.

For their part, many issuers welcome government intervention. “The EU and its members, as active participants in the Paris Agreement, could create some incentive systems for investors and issuers to embark on green financing more actively,” said Kašauskas.

However, it’s important to note that not everyone agrees with this approach. “This is a very diverse and dynamic market, with different types of investors and issuers,” explained Smith. “If you focus too much on policy, you could make it less diverse and more fragmented, and ultimately reduce the issuance potential.”

Different attitudes towards policy partly reflect cultural differences. The market in Europe and North America is largely self-regulated, whereas China and India have taken a more heavy-handed approach. India’s Securities and Exchange Board issued green bond requirements in May, while China is exploring providing tax incentives that would reduce funding costs for issuers and investors.

Chinese authorities helped the market grow, said Ma, but that does not mean the policy can be replicated elsewhere: “As with anything climate-related, you don’t want the entire market to be predicated on subsidies or financial incentives. Sometimes that happens in the initial stages of adoption, but in the long run you want these things to be able to stand on their own two feet.”

Another idea that has been floated is that green bonds could have different regulatory weightings, effectively reducing capital costs for issuers and investors. But, for many investors, drastic measures of this type would be a step too far. “What should not be done is tinkering with capital requirements, as some activists advocate. Introducing incentives on the demand side might have unintended consequences,” said Lewin.

Perhaps the least controversial policy is also the most feasible one: using green finance to fund sustainable infrastructure. A case in point is Mexico City’s new airport, which has launched a green bond programme that could reach $6bn by 2020, according to S&P Global. “Green bonds open up a larger pool of investors, and that attracts more resources to projects like ours,” said Ricardo Duenas Espriu, CFO at Mexico City Airport Trust.

Green future
The future of the green bond market depends on its financial viability. Optimists hope that, in the long run, the market will deem the greenest to also be the fittest, as companies that reduce their climate-related risks through green finance may also see their capital costs declining.

Incidentally, this could solve another problem facing the financial sector. “There is more capital now than at any time before in the history of the planet,” said Kidney. “Lots of that is in very low-interest instruments.

At the same time, we have to invest $50trn in green solutions over the next 30 years, so all we have to do is to match these two problems.”

For the time being, the market is full of high expectations. Citigroup expects the value of green bonds to grow to $1trn by 2020. This is also the target the Climate Bonds Initiative has set.

It’s not unrealistic either, according to Kidney: “If we double the market each year, we will beat $1trn. So, I’m not optimistic, but I am very hopeful.”