Post-corona recovery catalyst for green bond market

The Netherlands has recently joined a group of just fifteen countries that have issued green sovereign bonds. Since the Covid-19 outbreak, the importance of sustainable growth in the context of economic recovery seems to have increased. Green government bonds can be an important means to support this, and new countries are increasingly ready to join the group.

At the end of May, the Dutch Finance Ministry issued its first report about what happened with the proceeds of last year’s issue of the Dutch green government bond. What projects and activities were financed and what are the associated non-financial results?

In 2019 about 20 percent was allocated to support energy-saving measures and sustainable energy production, 30 percent to the Deltafonds to invest in water safety, and 50 percent to the management and construction of our railway network. This has led to an estimated savings of 6.84 megaton of CO2 emissions over the past two years.

Now Sweden has issued its first green government bond. PGGM has notinvested in it, however, because we do not invest in sovereign bonds issued in Swedish crowns. Sweden does have one of the most ambitious climate goals in the world, and the green bond framework reflects that goal well. It received the ‘dark green’ stamp from Cicero, an agency that provides independent advice about how robust the green bonds are. Cicero works meticulously on the basis of climate science and is awarding this stamp for the first time on green government bonds.

The next player that entered this market is Germany. This month Germany published the details of a green bond programme that suits its climate goals, like phasing out coal by 2038 and increasing the percentage of renewable energy to 65 percent in 2030. With 12.7 billion euros of identified green expenditure, Germany will become the largest issuer of green sovereign bonds. At the first issue, PGGM was able to invest 133 million euros.

Germany wants to build up a fully green interest curve quickly from short to 30-year terms in order to become the green ‘benchmark’ in Europe that it already is for regular or non-green government bonds. This would serve as a reference point for other potential issuers of green bonds and give the market for sustainable financing an extra boost.

The Germans are introducing a new aspect by issuing the green sovereign bond as ‘twins’. The green bond has exactly the same characteristics (duration, coupon) as the already existing non-green government bond. Thus, banks can exchange the green and non-green twins for each other at the German agency at the same level of interest during their lifetime. The interest level differs from that of the non-green twin only when it is issued. Germany wants to create additional transparency about whether investors are prepared to pay for green bonds and how much difference in interest they will accept.

What do we think of this? Governments are the most important players to achieve the climate goals of the Paris agreement, given their investments and subsidies, but also through consistency in the climate policy they implement, so they are considered to be reliable partners of the private sector. Green sovereign bonds are a means to communicate the climate policy to the financial markets in a credible way and serve as a reference point for the private sector - including in the field of impact measurement and reporting.

That is why we are cheering on the increase in this type of bonds. On the other hand, the credit risk is identical to that for non-green sovereign bonds and it is not possible for investors to exert any influence over the democratically determined expenditure. As investors, must we accept a lower level of interest for the green twin or not?

Recent research¹ has shown that when green bonds have a lower volatility than comparable non-green bonds, institutional investors comply with their fiduciary duty if they pay a small premium for green bonds as the risk-return does not worsen. Although that could be a substantiated reason for a small premium of a few base points, it seems in practice to be primarily a question of supply and demand of green bonds. The amount of capital put in funds that only want to invest sustainably is often growing faster than the issues of green bonds themselves.

It may seem hypocritical to cheer on the added value of green sovereign bonds but not be willing to pay up for them. If other investors however are prepared to pay considerably more because they can only invest in green bonds, then we are happy to leave it to them. At least until supply and demand are more evenly balanced.
Talking about supply: the EU will soon be the new giant in the bond market with an AAA rating, possibly issuing up to 225 billion euros in green bonds in the coming years as estimated by S&P. That’s an exciting development we shall go into later.

¹Green Bond Risk Premiums: A Twin-Bond ULFP Approach (Ulf Erlandsson, juli 2020)