Green Bonds: a simple way to invest in sustainability

Green bond issuances are expected to grow rapidly as more capital is mobilized to fund projects that reduce global carbon emissions, address climate change, and protect the environment. How can individual investors add these green investments to their portfolios?

By GreenPortfolio Team

April 22, 2021

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The green bond market

Green bonds enable corporations and governments to borrow capital to fund projects that promote environmental sustainability and a low carbon economy. Examples of green projects include renewable energy infrastructure, energy-efficient buildings, clean transportation, and waste management and recycling.

 

These climate finance instruments, first issued in 2008, established a framework for eligible projects, external reviews, and reporting - an innovation that provided investors with transparency and accountability, according to the World Bank, one of the first green bond issuers. Since then, the model has been used by corporations, national and local governments, and supranational institutions to cumulatively issue more than $1 trillion of these green debt securities. Notably, more than half this capital was raised during the last two years alone, and issuances in 2021 are on track to surpass those in 2020 – a record year. Still composing just one percent of the total fixed income market, however, green bonds have the potential to mobilize significant public and private investment in the shift towards carbon neutrality.

The structure of a green bond

Green bonds have a simple structure akin to a conventional bond, providing regular interest or coupon payments until a specified maturity date when the bond’s principal is returned. Though the capital raised through a green bond is reserved for defined environmental sustainability projects, the bond is generally backed by the full credit of the issuer as with a conventional bond. This means for an investor, assessing the overall risk and return potential of an investment in a green bond is similar to researching a conventional bond investment.

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How to identify a green bond

The market relies on issuers themselves to indicate a bond as green – categorized as ‘labelled’ green bonds. Reporting requirements for green bonds are voluntary, but most issuers follow a recognized framework for disclosure in order to provide transparency into the planned use and management of the capital raised.

 

Green bond standards include:

  • Green Bond Principles (maintained by the International Capital Markets Association)
  • Climate Bonds Standard (maintained by the Climate Bonds Initiative)
  • National green bond standards

 

The Green Bond Principles set out requirements for “Use of Proceeds, Process for Project Evaluation and Selection, Management of Proceeds, Reporting”. The Climate Bonds Standard additionally provides definitions of eligible green projects. Green bond standards are still in development by many governments, including the European Union which encompasses one of the larger markets for green bond issuances.

 

Issuers will often also engage a qualified institution to conduct an independent external review of their bonds, which can provide verification of the environmental benefit of the planned use of proceeds as well as guidance on the quality of reporting. The Climate Bonds Initiative offers a certification for bonds that are externally reviewed for their alignment with the Climate Bonds Standards; these bonds are then indicated as ‘certified’.

 

Bonds that do not follow a recognized green bond framework but raise capital for issuers whose primary activities address climate change or environmental sustainability are considered ‘unlabeled’ green bonds. Examples include renewable energy companies or electric vehicle manufacturers that issue conventional bonds or bonds issued for green infrastructure projects. Unlabeled green bonds, which are considered as part of the sustainable finance bond market, may require additional research to assess how proceeds will be used.

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Green bonds as ESG investments

What if a project is green but the issuer is not? Governments and corporations issue green bonds to finance projects with a focus on climate and environmental benefits, but there is no requirement for issuers themselves to meet Environmental, Social, and Governance (ESG) criteria. Some portfolio managers apply ESG factors or other criteria to issuers, screening out certain industries or issuing companies and governments. Other managers consider a wider range of issuers and look for a clearly defined framework for use of proceeds and reporting in order to direct their investments.

While this distinction is not always straightforward and there are ongoing debates on whether the use of proceeds structure is the best model, the transparency offered by green bond frameworks is one response to concerns about greenwashing in ESG investments. ESG investments face criticism in part due to the lack of standardization and low accountability in reporting. The green bond standards, which provide insight into project evaluation and encourage external reviews from an independent firm, introduce accountability.

Investment options for individual investors

Bond funds, which hold a portfolio of bonds, provide a simpler way for individual investors to invest in green bonds and to reduce risk.

 

First, funds are easier to transact than individual bonds, which often require large minimum investments and offer less transparent pricing. Second, funds reduce the credit risk associated with investing in a single issuer by allowing investors to diversify their portfolios. Additionally, portfolio managers can also more easily screen for green bonds that provide quality disclosure and expand the portfolio of bonds to include unlabeled bonds, which may not follow traditional green bond standard for disclosure. Because the composition of a bond fund changes frequently, however, interest payments are more variable than those of an individual bond.

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Two types of green bond funds to consider: index funds and managed funds

An index fund replicates the performance of an index by holding its components. Indices following the global green bond market have various methodologies. For example, the Bloomberg Barclays MSCI Green Bond Index includes both labeled and unlabeled investment-grade bonds with requirements on the use of proceeds. The S&P Green Bond Index, using a different set of criteria, screens only for bonds that are labeled by the Climate Bonds Initiative. Indices also vary in composition of credit quality, currency, geography, maturities, and other factors, which should be considered by investors that invest in a fund that tracks their performance.

 

Portfolio holdings in managed funds are researched and selected within a set strategy, generally with a goal of outperforming market benchmarks. Portfolio managers may consider labeled and unlabeled green bonds as defined in the fund strategy. Managed funds often carry higher fees than index funds, but seek higher returns, though performance may not be realized.

 

When researching a fund, investors should review information on the fund’s portfolio, returns versus benchmarks, and fees. GreenPortfolio conducts this research and takes a closer look at the composition, performance, and expense ratios of several green bond funds.

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