An uncertain future
The social-distancing measures imposed worldwide to respond to the COVID-19 pandemic have resulted in partial shutdowns of economic activity and immediate losses in output in the order of 10 percent of annual GDP (gross domestic product) in many advanced economies. What will this unexpected crisis mean for the green-bond market?
The COVID-19 economic crisis is branded by two defining characteristics, setting it apart from the 2009 recession, which was led by a financial crisis:
First, policymakers promptly acknowledged that a massive fiscal stimulus was needed to support the widespread loss of income. Compared to the financial crisis, the source of the economic problem and its immediate solution were clearer. The consequences of the COVID-19 crisis will be far-flung and impose structural changes in many sectors of the economy. In the early hours of the crisis, though, the need for supporting the revenues of households and firms emerged as essential. Many households found themselves unemployed and faced the immediate loss of income, which would translate into drops in spending much deeper than the ones experienced by the sectors of the economy more affected by social-distancing measures. Many firms, while economically viable, faced liquidity shortages that would have led to insolvency without access to financing incentives. Finally, many employment relationships carrying valuable human capital would have been destroyed, leading to a net economic loss for society as a whole. The answer in the United States was the CARES (Coronavirus Aid, Relief, and Economic Security) Act, valued at US$1.8 trillion—the largest stimulus measure ever seen in the United States. The European Union (EU) provided—on top of massive additional spending from national budgets—a €750-billion Next Generation EU package, financed from raising capital on financial markets.
The second defining characteristic of the COVID-19 crisis is still haunting us: uncertainty about the future. As many countries enter gradual reopenings of their economies, expectations are at their lowest, reflecting a pessimistic outlook. At the same time, measures of uncertainty are still very high—after having experienced in March and April economic levels comparable to those of the global financial crisis (GFC)—including US uncertainty indicators such as the Chicago Board Options Exchange’s (CBOE’s) VIX (Volatility Index)—which represents the implied volatility on the S&P 500 Index—measuring the assessment of the uncertainty in firms’ revenues by financial-markets participants; the US Economic Policy Uncertainty Index, measuring the frequency of newspaper articles on uncertainty about policy measures; and survey-based measures reporting uncertainty about the outlook among firms. The observed increase in uncertainty measures can be interpreted as a perceived increase in the probability of very negative outcomes—for example, future waves of the pandemic leading to protracted economic lockdowns—as well as very positive outcomes, such as the rapid procurement of a vaccine or effective antiviral drugs and a fast rebound of economic activity.
Derailing the focus on climate change and green finance?
The shift in focus of policymakers and markets could derail the attention recently gained by climate-change concerns. Climate-change issues entered muscularly even central-bank policy discussions in 2019. Christine Lagarde, at the time only a nominee for the position of president of the European Central Bank (ECB), had to answer questions by the European Parliament (EP) to the tune of “What are your views on the negative impact of the ECB policy on climate change?” and ” Do you think the ECB should bring its asset purchases in line with the UN’s sustainable development goals?” Similarly, the development of the fast-growing market for green bonds could be hampered. Green-bond issuances essentially stopped at the first peak of the COVID-19 crisis, in February and March, according to data from the Climate Bonds Initiative.
I will argue that the COVID-19 crisis is a blessing in disguise for the green-bond market—a blessing driven by a combination of factors: the large public budgets mobilized by the COVID-19 crisis, the issuance of sovereign green bonds and the possibility of financing assets for which the risk of a fall in demand is increasingly small. Uncertainty has increased over the last months, but the need and willingness to fight the climate crisis is here to stay.
Sovereign issuers to the rescue
The European Commission’s (EC’s) overall budget for 2021-27 will total more than €1.8 trillion, of which €750 billion will be front-loaded as a COVID-19-recovery package. In July, EU governments agreed on an ambitious “green recovery” proposal, including a climate-spending target of 30 percent for the overall multiannual budget. A substantial share of the recovery fund could be financed using green bonds; the ratings agency S&P Global Ratings estimates that €225 billion could be raised by green-bond issuances[i] . Overall, supranational EU-issued debt financing the recovery package will vastly increase the issuance of AAA securities by EU supranationals, which averaged €67 billion per year between 2015 and 2019[ii] . This commitment implies that the supply of green bonds will increase together with the supply of green assets that the bonds are going to finance.
The outlook for corporate issuers and investors
Even with this substantial change of pace in sovereign issuances, the global supply of green bonds will still be limited. The real push can come only from private issuers, from the private sector increasing the supply of green projects to finance in capital markets. Green-bonds issuances in 2019 amounted to approximately US$270 billion, according to Climate Bonds Initiative data. This is a sharp increase from a few years earlier; in 2015, the value of green-bond issuances was only $45 billion. The 2019 green-bond issuances still amounted to a minor share of the global bond market, representing between 1 and 2.2 percent of total global issuances.[iii]
Is a deep, liquid market for green bonds still many years away? The world is moving, and the outlook is changing fast. Let me line up some facts, taking as an example the fossil-fuel industry. Total lending and underwriting from 33 top global banks to the fossil-fuel industry in the three years between 2016 and 2018 amounted to US$1.9 trillion—and $600 billion went to 100 companies aggressively expanding fossil-fuels enterprises, according to Rainforest Action Network data. At the same time, the financial industry is turning greener, and this will have an impact on the choices of the fossil-fuel industry. In 2019, 63 percent of the 33 top global banks introduced some restrictions on coal financing. Crédit Agricole, the second largest French bank, announced in June 2019 that it would no longer do business with companies that were expanding their coal operations. The California public employees’ and teachers’ retirement system administers assets valued at $580 billion and committed in 2015 to refrain from making any new investments in thermal-coal firms. Twenty globally significant insurers divested from the thermal-coal industry up to March 2019. In 2019, Amundi, Europe’s largest asset-management fund, committed to phasing out coal stocks from its passive index.
What lining up these facts highlights is that investors’ appetites for greener assets have been rising for years. Investors controlling US$60 trillion of assets under management signed the Principles for Responsible Investment (PRI), committing to account for environmental, social and governance (ESG) factors when choosing investment vehicles[iv] . In March 2019, financial firms with $110 trillion in assets under management supported the recommendations for voluntary disclosures of material climate-related financial risks proposed by the Task Force on Climate-Related Financial Disclosures (TCFD).
So, the demand for green bonds, potentially, is not lacking. Will the current economic trends pushing towards this demand materialize? Many institutional investors—and issuers— are present in the green-bond market, driven by communication and branding benefits. For example, the US$1-billion PepsiCo green bond issued in October 2019 proved critical for the environmental-sustainability image of the company.
An argument can be made that green bonds have a chance to fare better during times of turmoil in the financial market. Institutions with longer-term or hold-to-maturity strategies—such as pension funds and insurance companies—are overrepresented among green-bonds investors, implying that selloffs are less likely when financial markets are under stress. Issuers of green bonds traditionally rank among large, stable entities, often better equipped to withstand a crisis. At the end of May 2020, HSBC, Bank of America, Bloomberg and Morningstar all reported that companies with better ESG ratings outperformed market benchmarks and have been less volatile during the COVID-19 crisis.
Before the COVID-19 crisis, investors still hesitated to include green bonds in their portfolios. This view cannot be ignored. Hiro Mizuno, chief investment officer of Japan’s Government Pension Investment Fund, told the Financial Times in July 2019 that he was not convinced that green bonds would become a “mainstream investment product. For investors, it’s a bond with the same credit rating and the same interest rate—but they have to live with less liquidity[v].” The ECB and academic researchers have found that in some market segments, green bonds are priced at a premium and earn lower returns—evidence that investors are prepared to forgo some income as a result of a skew towards greener investments[vi].
Issuers, of course, are not against a lower debt cost. In June 2019, Chile issued the first sovereign green bond in Latin America, valued at US$1.4 billion, and it was met with demand of almost $7 billion and the lowest interest rate ever paid on a dollar-denominated issuance. Nevertheless, governments are most interested in the expansion of the green-bond market itself, supporting the creation of green-capital markets and direct mobilization of capital towards green activities. Hence, the efforts towards the standardization of criteria for green investments – such as the European Commission Technical Expert Group recommendation on a EU green bond standard released in June 2019 – and those for guaranteeing the liquidity of green issuances. The German Government announced the issuance of a green bond in 2020, tied to a conventional bond issue—what is known as a “twin bond”. The German Finance Agency has committed to exchanging green bonds for the twin conventional bond and to an initial issuance with a minimum value of at least €1 billion.[vii] The Danish central bank (Danmarks Nationalbank) and the Danish Ministry of Finance proposed in 2020 an innovative sovereign ‘green finance’ instrument to guarantee liquidity: a conventional government bond and a green certificate that can be traded separately but kept attached to the bond when a green bond is desired by the investor, enabling investors to support green projects as if they had bought a conventional green bond.
Figure 1: Sovereign green-bond innovation: current working proposal under consideration for a green-bond sovereign issuance by Denmark
Green bonds at a time of high uncertainty
Sovereign issuers at this stage can prove instrumental in boosting the private green-bond market. Ultimately, it is up to national governments to incentivize or directly engage into green investments, and the total amount of resources invested in green projects – however financed – is the only measure of our efforts to contain climate change. Sovereign green bonds, entailing a spending pledge by a sovereign to use an equivalent amount of fiscal revenue to green projects, are on one hand a mean to gather fiscal revenues, and on the other hand a way to commit to green fiscal spending. COVID-19 fiscal stimulus will create both green investment opportunities and additional AAA-rated sovereign green issuances. In the COVID-19 crisis, assessment of future investment and economic opportunities has become harder and shrouded in high uncertainty—except for the awareness of the need to invest in the climate transition and the willingness of sovereign and supranational entities to support a fast acceleration of investment in this sector. Now, we’ll wait for the markets to work and transform the COVID-19 crisis into the opportunity of a generation.
[iii] Journal of Risk and Financial Management, 2020, 13:61
[vi] IFC – Banking on Women-Business Case Update #2, 2019