Is any sovereign worth the greenium?

Governments looking to take action on climate change may have just spotted the only free lunch in finance: the green sovereign bond.

The market is growing from a small base, with 2021’s tally of $68.8bn (£52bn) issued representing a fourfold increase on the previous year and the EU planning to fund €225bn (£192bn) of sustainable activity with the instruments by 2030.

The green bond idea is a simple idea: you can attract more investors because they’re very keen if you promise to use the money for green stuff – it’s as simple as that

Sean Kidney, Climate Bonds Initiative

Countries issuing green debt have so far enjoyed varying levels of reduction in financing costs compared with their standard paper, making the bonds a no-brainer for any treasury department eyeing new projects to meet their climate goals.

At the low end of the scale, the UK’s second green gilt yield of 1.41 per cent was estimated to be around 1.5 basis points lower than the fair value of a conventional gilt by Insight Investment, while high demand allowed Egypt to tighten pricing by 50bp during the sale of its first green bond, according to multiple news sources. Egypt’s green debt now trades at a spread of 75bp, according to the Climate Bonds Initiative.

“The green bond idea is a simple idea: you can attract more investors because they’re very keen if you promise to use the money for green stuff — it’s as simple as that,” says Sean Kidney, the initiative’s chief executive.

Kidney expects Saudi Arabia, Russia and possibly even the US to join the market in the near to medium term, and points out that oversubscription has been a feature of most issuances.

This oversubscription attests to the green debt’s popularity with investors, who see an easy opportunity to align another section of their portfolios with their values.

While two of the UK’s largest pension funds, the BT Pension Scheme and the Universities Superannuation Scheme, passed on the country’s record-breaking inaugural green bond in September, questioning the high premium and short maturity — which made it a poor match for pension schemes’ long-dated liabilities — the issuance was wildly successful and the £10bn 12-year notes were over 10 times subscribed.The USS participated in the country’s second issuance in October, a £16bn 32-year bond.

With green bond frameworks requiring any money raised to be clearly earmarked for green projects, and other sustainable sovereign debt like social bonds still in their infancy, standard government paper is not going anywhere. But what role should the two variations play in portfolios, and is it credible for environmental, social and governance strategies to stick with vanilla?

Picking up greater yield

Just as for governments, relative value continues to be at the forefront of professional investors’ minds. 

“The one issue green bonds do face right now is [that] there is a lot of demand for them,” Federated Hermes senior credit portfolio manager Nachu Chockalingam told a conference by the UK Sustainable Investment and Finance Association in November, arguing that the green premium on display in both corporate and sovereign bond markets requires the use of proceeds to be of significant quality to justify a higher relative value.

“We as investors need to think about which makes the most sense to invest in,” she said.

“We do want to support decarbonisation of a company, but does it make more sense to [buy] the green bond and have that direct benefit in terms of decarbonisation, or if we are so confident in the company’s approach… can we live with buying the non-green bond and essentially taking that pick-up in spread?”

She added: “There is a lot of vagueness in the use of proceeds right now,” explaining that in her area of expertise in corporate markets “some companies will have specific projects that they have committed to use the proceeds for, other companies might try to use the proceeds to refinance other lines that they have that might already be financing green projects.”

Chockalingam also believes that continuing issuance from the EU will start to see idiosyncrasies between different bonds emerge, with accompanying variations in market pricing.

Others worry about the level of scrutiny on which activities standard bonds will fund. James Alexander, chief executive of UKSIF, says: “If all the green stuff has been put into the green bond, what’s left in the non-green bond or the non-sustainable bond, and do you want to go anywhere near that?”

We do want to support decarbonisation of a company, but does it make more sense to buy the green bond and have that direct benefit in terms of decarbonisation?

Nachu Chockalingam, Federated Hermes

Alexander says he would like to see costs of financing rise for fossil fuel-promoting countries as has happened for oil and gas companies, but adds: “On the other hand, if the country does have a solid transition plan that does align to net zero, that we all believe is [credible], presumably that makes that bond okay.”

This could see the spread between green and brown bonds widen further, as investors demand a risk premium for exposure to a government’s inaction on climate risks. High costs of financing are already on Australia’s radar, with the country’s treasury department concluding in November that it could have to pay up to 300bp above the benchmark interest rate in the event that it would end up “the only developed country not to adopt a net zero target”.

Green bonds can be defensive

Analysis of standard sovereign debt as relating to only leftover or environmentally risky projects will be a powerful call to action, but this is not yet entirely reflected in the structure of sovereign capital structures or the reporting requirements of investors in them.

From a reporting perspective, for example, UK investors in standard UK gilts will benefit from decarbonisation progress even where this is funded by green gilts, since government guidelines for the implementation of Task Force on Climate-related Financial Disclosures reporting directs asset owners towards using the emissions of the country as a whole.

Green and non-green bonds are also identical in terms of credit risk, since use-of-proceeds bonds are not secured against the cash flows of the projects they fund.

Instead, Kidney says the major financial attraction to investors is the reduced market risk in an instrument that is so oversubscribed that owners rarely want to sell off.

“Fixed income investors are first and foremost defensive. So you’ve got a product…that doesn’t lose its value in downturns, that’s gold dust,” he says.

“In other words…investors in the green bond market [are] much more confident in what the future holds.”

Katie Prideaux, analytics product specialist at FTSE Russell’s The Yield Book, says that the primary cause for the appearance of a greenium may be their scarcity, and that increased issuance could see some cases of greenium begin to lift.

“You can still look to support climate goals through standard bonds,” she says of investors choosing to duck this temporary greenium.

The recency of green bonds’ emergence also means that their presence in a country’s capital structure is a poor indicator of a country’s performance on sustainability issues.

“You can issue a lot of green bonds but you might still have quite a high temperature change,” says Prideaux, referring to the Beyond Ratings Claim model she uses to assess sovereign issuers’ climate change trajectories.

The opposite example comes in countries such as Norway, which has already built large amounts of renewable energy infrastructure without recourse to green debt markets.

“While all the green bond issuance is going on, there’s obviously a lot of investment that needs to go on in non-green things…that doesn’t necessarily mean ‘bad’,” adds Prideaux.

No country yet passing threshold for ‘transition gilts’

Viewed under this lens, standard government bonds could become a vehicle for investors to express their view on the credibility of a nation’s transition plans in the round. But Kidney says this should not obstruct the growth of green sovereign bonds, which themselves create a powerful incentive to align with net zero.

“In theory, we do want governments who are acting with alacrity to be more rapidly supported in the market, and this is something we’ll be working on next year with a number of parties, on how to link the green bond market to the performance of an entity. But the assessment tools are not there at this stage to make it easy for investors,” he says, detailing plans for a system of certification of companies’ and countries’ broad set of policies. 

He adds that no government has yet aligned its policies with the emission-reduction targets required by 2030 to limit global warming to 1.5C, as modelled by the Intergovernmental Panel on Climate Change.

As such, a credible transition framework for sovereign bonds could not reward countries with low rates based on performance, and green bonds will therefore remain an important incentive for governments, especially in emerging markets where countries are typically faced with high costs of borrowing, to embark on green projects.

“Do note there is no major economy in the world that has a basket of policies that are sufficiently ambitious yet,” says Kidney.

This article originally appeared on Sustainable Views