Green bonds and securitisation
The new green wave is affecting the capital markets
When borrowing fresh money, banks and business have been focusing on green bonds for some time now. The appeal of sustainable financing options has caused market shares in this segment to rise. Much of the concept is akin to the standard emission of bonds with one key difference: when capital is borrowed, the underlying projects must have an eco-friendly background.
In 2007 and 2008 respectively, the European Investment Bank and the World Bank were the first to issue green bonds. Many others were to follow, including Apple, the Bank of China and, in Germany, the KfW banking group above all. Rating agency Moody’s predicts a global rise in the emission of green bonds to $200bn in 2017, twice that of the previous year. But what exactly makes green bonds so attractive and who decides which bonds ultimately belong in this investment category?
Currently, there are no legally binding regulations for green bond classifications. The only specification is that any capital raised must be used for what are somewhat loosely defined as green projects. Two initiatives aim to make classification more reliable with the aid of certain guidelines, therefore strengthening confidence in the quality of green bonds. Firstly, the International Capital Market Association (ICMA) applies Green Bond Principles (GBPs) to try to bring about standardisation and secondly, the Climate Bonds Initiative (CBI) leans towards the Green Bond Principles but sets more precise boundaries and issues a certificate for relevant bonds.
The GBPs include four core components that issuers of green bonds should be driven by. The first one is the use of proceeds of the bond. This should be indicated clearly and, where possible, also underpinned by figures regarding the ecological benefit. Details can be provided on expected electricity savings, the lower number of cars required, or cuts in pollutant emissions following completion of the green project. While there is a list giving examples of the typical projects that would be eligible – with, for instance, renewable energy or other energy-efficiency measures right at the top – there is virtually no limit to the scope of the issuers’ green mindset. The other components are: the project evaluation and selection process, management of proceeds and reporting. The goal is to document the selection of projects exactly and explain any social and ecological risks transparently. The proceeds of the bonds are to be paid onto sub-accounts set apart from the rest of the company’s assets to segregate them from any business not specifically green. Furthermore, reports on how the proceeds are used and project development are to be published at least once a year.
On the German market, emissions by KfW and other regional development banks account for the lion’s share of all green bonds. The associated proceeds are primarily channelled into renewable energy projects. However, Green Covered Bonds or Green Asset Backed Securities (ABSs) also have huge potential. In 2015, for instance, Berlin Hyp had already issued the first green covered bond. The demand for mortgage loans for buildings complying with green or sustainable building standards is likely to increase sharply in future. In all likelihood, the same applies to the automotive sector. Here the demand for funding low-emission vehicles models is likely to rise as well. Toyota securitised loans for hybrid and electric cars to the tune of $1.6bn just last year. The OECD estimates that green ABS transactions will grow to $380bn by 2035.
In conjunction with the various initiatives to create a European capital markets union, the legislator is emphasising boosting sustainable investments in the EU. Based on the recommendations by the expert group for sustainable investment, the European Commission will probably decide on actual measures in the first quarter of 2018, such as how institutional investors and investment managers will in future take environmental social governance (ESG) aspects into greater account in their investment strategies.
The new supervisory criteria for simple, transparent and standardised securitisations (STS securitisations) could be seen as an indirect incentive for green securitisations. Under article 22, section 4 of the new securitisation regulation, in the case of residential mortgage backed securities (RMBSs) and ABSs for cars, the originator, sponsor and securitisation entity must provide any information available on the environmental footprint of the properties or vehicles which have been financed by the securitised loans if recognition as an STS securitisation is desired. Furthermore, a direct privileged status could be conceivable when identifying risk-weighted assets or capital requirements for green bonds or securitisations.
Considering the increasing importance of sustainability and climate protection, the advantages of green bonds are becoming ever more apparent. Of the active issuers of green bonds on the market to date, the majority have a high rating above the investment grade rating. The esteem in which the usage of the green label is held also manifests itself in the pricing. According to some surveys, the brisk demand for green financial products is, amongst other things, ensuring that issuers of green bonds on average can borrow money at lower spreads. Studies by the Bank for International Settlements even revealed an average benefit of 18 basis points vis à vis conventional bonds. On the other hand, green bonds entail an almost identical risk to conventional bonds because repayment always depends on the issuer’s solvency. Furthermore, risks can arise because of amendments to laws, for example in conjunction with green projects that suddenly no longer attract state subsidies.
In addition to certification by the CBI, there are various ways in which issuers can obtain the appropriate “green seal”. While the Oslo-based Climate Research Institute (CICERO) issues a three-phase certificate depending on how environmentally friendly the project is, Moody’s Green Bond Assessments evaluate the green project on an ongoing basis. The assessment takes place at various intervals, engendering greater trust on the part of the investors because certification can be withdrawn due to non-compliance with the specifications or the green score reduced. Standard and Poor’s assessments specify a scoring value of between 0 and 100, therefore permitting further segregation from conventional products. In addition to providing important support on questions regarding the structure of a green bond, certification is the only extra cost compared with conventional bonds.
The next key step towards more market growth is also undoubtedly the greater standardisation of criteria for classifying bonds as green. Because one thing’s for certain, although green assets are very much part of the zeitgeist, the biggest obstacle preventing higher investments in green products is ultimately how credible these appear to investors. Initiatives such as those from the ICMA and CBI have laid foundations to ensure this is achieved. However, even they only provide a rough guideline, which is why the GBPs recommend that the environmental and sustainability criteria are also attested by an external auditor. The same applies to how the proceeds are used. In this case, monitoring by an auditor is also advised. In future, the aim must be to forge ahead with standardisation and to help issuers to raise green capital with the aid of advice from proficient third parties.
To summarise, green bonds are an excellent way of diversifying the financing structure of businesses and banks. Order books for green bond emissions are often over-subscribed and, alongside the benefits of possibly tapping into new groups of investors, these sorts of bonds are effective publicity for projects that deserve it.