Green Bonds Can Leave Issuers in the Red


(The RAND Blog)

Green business growth and finance sustainable development, photo by mihacreative/Adobe Stock

mihacreative/Adobe Stock

by Brian Wong and Ismael Arciniegas Rueda

November 22, 2021

This is one in a series of commentaries on environmental finance and green bonds.

To achieve the Biden administration's blueprint for solar energy and focus on climate change mitigation and adaptation, state and local governments and companies may need access to capital. The same is true for international governments and corporations committed to the COP26 goals of the UN Framework Convention on Climate Change. Green bonds, which raise capital for projects designed to deliver environmental benefits, may be worth considering. But, like any other financing instrument, they may be best considered through a cost-benefit lens.

The "Greenium" for Issuing Environmental Bonds

To date, green bonds have primarily financed renewable energy projects, but they could also support energy efficiency, urban transportation, water conservation, and sustainable agriculture. With the growth of environmental, social, and governance (ESG) investing, green bonds are starting to play a key role in investment portfolios.

Issuing green bonds can signal a commitment to climate goals. Firms can use their green bond issuances to make their case to ESG equity investors. Governments can show their commitment to the Paris Agreement by undertaking environmental projects and issuing green bonds to fund them, while development banks can further support governments in accessing capital markets.

Adopting higher quality, more consistent standards could reduce the risk that a bond issuer will try to "greenwash" a project.

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As an additional benefit, some jurisdictions offer issuers subsidized interest payments, while others offer tax credits or tax-exempt status for the bonds, making green bonds structurally attractive compared with traditional bonds. Investor requirements mandating green investments also make these financial instruments popular.

At the same time, green bond issuers may offer investors lower interest rates. For that reason, some researchers have identified a green premium—or "greenium"—for green bonds compared to traditional financial instruments. But the evidence for a greenium is mixed. Although a study by the Bank for International Settlements found green bonds to be 10 to 45 basis points lower than similar traditional bonds at issuance, another study on the U.S. municipal bond market found non-green bonds had similar yields to green bonds. More recently, the Climate Bond Initiative's (CBI) July through December 2020 primary market analysis of green bonds found more than 50 percent of issuances exhibited a greenium.

When issuing green bonds, issuers might consider intangible benefits as well as the potential greenium.

Is the Greenium Worth It?

Despite lower yields, ensuring the credibility, transparency, and "greenness" of a bond currently entails increased costs to the issuer compared to traditional financing instruments.

Issuers must conduct additional due diligence in selecting projects, define the use of funds, and acquire third-party certification for their bond to be considered green. Green bonds are certified based on evolving guidelines provided by the CBI and the International Capital Market Association. Once a green bond is funded, in order to ensure re-certification as stipulated by the original commitment the issuer needs to monitor the bond's key performance indicators and provide internal and external reporting, continued third-party independent assurances, and additional investor relations reports.

As the bond reaches maturity, the issuer validates the green rating by comparing the project's environmental performance against commitments. If the funds are out of compliance and the bond is no longer green, the issuer may face a penalty at the end of the bond's life.

Compared to traditional bonds, these considerations increase both time to market for issuers and costs throughout the green bond's life.

Making It Easier to Be Green

When entering the green bond market, issuers may want to consider a portfolio approach, rather than a one-time issuance. This could allow them to evaluate the entire capital pipeline for potential green financing, then develop strategies to streamline processes and reduce the overall costs of issuing green bonds.

In addition, policymakers could promote a widely accepted set of standards for green bonds. Adopting higher quality, more consistent standards could clarify what constitutes a green project, reduce the risk that an issuer will try to "greenwash" a project—claim unfounded environmental benefits—and lower compliance costs for all issuers.

Financing investments necessary to mitigate and adapt to climate change may require many tools. Issuers and policymakers might keep in mind that the objective is to advance climate change risk management while minimizing costs as they consider options. This might mean issuing green bonds when it is appropriate, not simply for the sake of being green. Otherwise, issuers may find themselves in the red.

Brian Wong is a doctoral student at Pardee RAND Graduate School and an assistant policy researcher at the nonprofit, nonpartisan RAND Corporatiom. Ismael Arciniegas Rueda is a senior economist at RAND. This commentary was supported by the John and Carol Cazier Initiative for Energy and Environmental Sustainability.

Commentary gives RAND researchers a platform to convey insights based on their professional expertise and often on their peer-reviewed research and analysis.