While the investment case for green bonds may be good in terms of providing cheaper funding costs for green and renewable projects, they may not really help the corporates issuing these bonds reduce their carbon footprints.
However, newer and more innovatively structured sustainability-linked financial products, such as loans and bonds, are emerging in the fixed-income space that will actually help corporates to not only raise financing, but reduce their respective carbon footprints as well.
The difference between green bonds and sustainability-linked loans or bonds, is that the latter sets sustainability or carbon-reduction targets that the issuing or borrowing corporate must meet as they service the loan. Otherwise, they will pay a higher borrowing cost.
“One new type of instrument we’re seeing in the fixed-income market is called sustainability-linked products,” says Flora Wong, director of sustainable investing and assistant portfolio manager at Fidelity International. “The issuer can use the proceeds for whatever reason they see fit, but they will be pre-determined around improvement of the company’s sustainability criteria.”
This means that if the company fails to achieve the corporate sustainability improvement targets stated in their sustainability-linked loan, for example, the spread that they’re paying will increase.
“This provides financial incentive for the corporate to achieve their sustainability improvement targets in the form of increased cost of financing,” Wong points out. “This will ensure that companies actually improve their sustainability credentials. That type of instrument actually pays for performance as opposed to green bonds which pay for effort.”
The investment case for green bonds, according to Jenn-Hui Tan, global head of stewardship and sustainable investing at Fidelity International, is different from the sustainability case for the corporate issuer of such bonds.
“The idea behind green bonds, which is a good one, is to invest in a security that has ring-fenced the proceeds to be used for investing in green or renewable types of projects,” Tan explains. “The spreads from the same issuer are tighter than traditional bonds not labelled as green. So, clearly at this point in time they are offering a cheaper source of funding for issuers, which is one of the objectives of ESG – to ensure that companies with better sustainability profiles benefit from a lower cost of capital.”
The challenge, however, comes when investors examine how the green bonds are related to the carbon emissions of the corporate issuing these bonds. Just because a company issues a green bond, it does not mean that it is automatically reducing its carbon footprint, according to a study conducted by the Bank of International Settlements.
“So, a company may already have decided to fund a renewable project or put capex in the same direction,” Tan notes. “But they simply issue a green bond to access a cheaper source of funding which doesn’t result in any meaningful change in their emissions profile, relative to if they hadn’t issued a green bond. I think the case is a little bit unclear from a sustainability perspective.”
When investing in green bonds Tan advises investors to closely examine the sustainability profile of the issuer instead of just focusing on the bond issue.
Other challenges that investors face when investing in green bonds and other types of sustainability-linked fixed-income instruments are liquidity constraints and the relatively smaller size of the issues.
“Most of these green bonds are just not big enough for institutional investors to actually invest in,” Wong shares. “Another challenge when it comes to investing in green bonds or similar instruments is the inconsistency in definition across markets. For a global investor to invest in green bonds issued by a Chinese issuer, they might not be 100% convinced by the green credentials, just because the definition for green bonds in China and the type of projects eligible for green bonds issuance may not be as acceptable to international investors.”
Some of these challenges are being addressed by regulators. Last year, China’s central bank revised its definition of green bonds, significantly realigning it better with the international one.
It is also important to note that almost a quarter (24%) of all companies will be carbon neutral by the end of this decade, according to Fidelity International’s annual Analyst Survey, spotlighting the ongoing emphasis on environmental, social and governance (ESG) criteria across a wide spectrum of industries and regions.
And while European companies are further along in this journey, with analysts estimating that 30% will be carbon neutral by 2030, Asian firms are catching up. Almost one in five firms (23%) across the Asia-Pacific region expect to reach the same milestone in this timeframe.
Fidelity International’s Analyst Survey studies the views of its in-house analysts across the world, aggregating bottom-up information from approximately 15,000 individual company interactions to find key trends in the global corporate landscape.