Green bonds are financial instruments designed to support environmental and climate related projects while simultaneously protecting the investment capital and any subsequent income. As a form of “fixed income” investments, bonds will typically provide investors with a set cash flow as interest, or less commonly, as dividends. They have a fixed date of “maturity” at which time the investors are repaid their initial capital outflow and the interest that has accrued. Most bonds are issued by governmental agencies or corporations to support major projects as well as day-to-day operations and in the case of bankruptcy, payments to fixed income investors are prioritized over common stockholders.
Green bonds are relatively new. The first were issued in 2007 by the European Investment Bank (EIB) with the World Bank. The initial response was relatively tepid but in 2013 the market exploded with $1 billion green bonds issued by the World Bank Group’s International Finance Corporation (IFC) selling out with an hour. Later that year Vasakronan, a Swedish property company, issued the first corporate green bond. Subsequently numerous corporations, local and national governmental agencies and other entities have issued green bonds resulting in remarkable market growth with an estimated cumulative issuance reaching $1 trillion in 2020.
The funds raised from selling green bonds are ear-marked for specific environmentally positive projects including encouraging sustainability and efficient energy generation as well controlling pollution and mitigating climate change. Other projects have included environmental and ecosystem protection, providing clean water, improving transportation and promoting sustainable agriculture. One of the first projects supported by green bonds issued by the World Bank was the Rampur Hydropower Project that provides low-carbon power to northern India while preventing the release of 12,000 tons of sulphur oxides, 6,000 tons of nitrogen oxides and about 2 million tons of carbon dioxide into the atmosphere each year.
Most green bonds are asset-linked “use of proceeds” bonds that have the same credit rating as the issuer’s other bonds because they are backed by the issuer’s entire balance sheet. Other examples include “revenue bonds” whose collateral is revenue derived from taxes and fees collected by the issuer, “project bonds” that are linked to a specific environmental undertaking, “securitization bonds” used to refinance green projects or support green projects, and “covered bonds” a type of derivative instrument secured by both the issuer and a specific pool of assets.
While many green bonds are tax-exempt, there are some downsides, most notably, the lack of liquidity in these types of investment vehicles. Another problem is that there is no universally accepted definition of “green” which means that the monies may be used for projects the investor may not desire to support such as nuclear power plants. Many green bonds have a higher fund expense ratio than generic bonds due to the increased transactional costs to the issuers from tracking and reporting the use of proceeds. Issuers usually consider these costs offset by the positive marketing benefits of being perceived as a “green” company and the diversification of their investment base. There also remains some confusion resulting from interchanging the terms “green bonds” and “climate bonds.” Most authorities prefer to use the latter term only for bonds issued to address climate change or reduce carbon emissions. And there is an emerging rival for environmentally friendly investments called “sustainability-linked bonds” that are not linked to a specific project whose interest rate payment is dependent upon meeting specific environmental, social impact or business governance (ESG) metrics.
Because most green bonds have the same credit profile as other bonds from the same issuer, these are considered conservative investments that have the additional benefit of addressing some of the world’s most pressing problems. Green bond returns are comparable to “investment grade” bonds, the safest in the marketplace. Green bonds are usually purchased by large institutional investors with an ESG focus, governments and corporate investors. Small individual investors and other stakeholders can participate through ESG focused Exchange Traded Funds (ETF) and mutual funds.