Younger and more socially conscious investors have increased demand for Environmental, Social and Governance (ESG) compliant portfolios. This in turn has driven demand for a new class of ESG compliant bond more commonly referred to as “green bonds”.
Green bonds are bonds that are used to raise capital specifically for environmental and sustainable projects. This year, the green bond market size reached a record $1 trillion. Since their launch, only ten years ago, labelling bonds as “green” has become an easy way for companies to promote their ESG profiles and fit their securities within the ESG or green mandates that now abound. Some green bonds tie lower coupons to meeting ESG targets.
After an unclear and rather opaque set of initial definitions, the market has evolved to accepting, for now, the International Capital Market Association's (ICMA) definition which is that projects are green if they are aligned with these objectives: climate change mitigation and adaptation, natural resource conservation, biodiversity conservation and pollution prevention and control. We still regard this categorisation as quite vague.
For example, a shipping company might wish to improve the fuel-efficiency of its ships and issue green bonds in the name of reduced fuel usage. But, if the main driver of this decision is a higher profit margin through reduced fuel costs, then we ask is this really a green bond or just a conventional one? The issuance of a green labelled bond could feel more like a PR project rather than genuine concern for the environment.
Due to these issues of “greenwashing” (the act of exaggerating or falsely claiming ESG credentials), projects linked to green bonds have to be closely monitored, by both issuers and investors. This increases the cost of issuing green bonds relative to traditional bonds. The compensation for the issuer is the aforementioned PR exposure and demand from ESG portfolios. The investor faces higher monitoring costs with no additional yield in 85% of green bond issuances, apart from a cleaner conscience.