Climate change poses one of the biggest challenges of the 21st century.
The conventional investor approach to climate change has focussed on managing risks around ‘stranded assets’- ie, assets that may suffer unexpected or premature write-downs due to regulatory changes, such as fossil-fuel powered factories facing obsolescence as carbon restrictions are adopted. Companies that own potentially stranded assets can be screened out by investors or, indeed, divested.
This approach uses negative reinforcement to discourage environmentally unfriendly projects, but crucially it offers no reward for bond issuers considering more environmentally responsible undertakings. That’s where green bonds come in.
Green bonds provide financing for projects which deliver environmental benefits and contribute to a more sustainable economy. This positive reinforcement is its key advantage. But it suffers from two important drawbacks:
- There is no universally agreed standard for what a green bond is.
- The green bond universe offers only low yields and spreads, especially when compared to a broader global credit portfolio.
Greenwashing
What defines a green bond? Several independent organisations have published guidelines for green bond issuers that promote transparency. However, in theory anyone can issue a bond and call it green. This risks undermining confidence in the asset class.
Greenium
Green bond issuance is expected to grow from the record $92bn in 2016 to more than $100bn in 2017, with more issuers coming to the market. The green bond universe remains strongly influenced by government and supranational entities, which contributed over 37% of issuance in 2016. Because they can issue bonds cheaply, it depresses yields and spreads for the green bond universe compared to the broader credit market (see below).
Chart 1: Relatively low yield and spread
In a low-yield environment, many investors can’t ignore even a minor ‘greenium’ (a green bond premium that reduces the yield for investors but provides cheaper funding for issuers). It could preclude green bonds as a core portfolio holding.
Limited liquidity
The market’s limited liquidity poses a similar challenge. Although it’s not a problem in the Sovereigns, Supranationals and Agencies (SSA) sub-sector, it does matter in the corporate market, where investors tend to buy and hold the longer-dated issues. This is exacerbated by:
- Weak US involvement – there is little participation by US corporates and government bodies. While the market is viable without the US, the absence of American issuance significantly reduces the long-term growth potential of green bonds.
- The myopic definition of green bonds; in addition to the ambiguity of what a green bond is, the definition also ignores the broader range of ‘environmentally aware’ schemes. The Climate Bonds Initiative (CBI) estimates that including ‘climate-aligned’ bonds would boost the size of the universe from $118bn to $694bn. In any case, the CBI definition of climate-aligned bonds suffers from the same fuzziness around standards that green bonds do.
The grass can be greener
One way to enhance both the environmental impact and the potential return involves shifting the emphasis to carbon reduction, accentuating the ‘environmental outcome’ rather than solely focussing on the principles-based approach of green bonds.
This approach preserves the risk and return characteristics of the global credit universe. The low carbon model portfolio has higher yields and spreads, and longer duration than the green bond index while maintaining investment grade credit ratings. The solution’s attributes are comparable to global corporate bond indices.
Chart 2: Model portfolio versus traditional benchmarks
Environmentally aware investors don’t have to be penalised in the performance of their bond portfolios. With this approach, ESG mandates can be respected and environmentally friendly investment can become a viable core strategy within a balanced bond portfolio.
Ilia Chelomianski is associate investment director, Fixed Income, Fidelity International
