Green bonds – capital market with a green conscience?

#lawvolution

10 June 2018

The financing of eco-friendly projects via green bonds is becoming increasingly popular. In this article, we provide an overview of this capital market instrument.

Neither the affordable electric car nor the energy-efficient smart city has to remain a pipe dream. The implementation of these and other sustainable, green projects has already begun and they are increasingly being financed by a new type of capital market instrument known as green bonds.

A green bond is characterised by the fact that the issue proceeds are used for “green” purposes.  However, the definition of a green purpose is broad. Basically, there are no limits to the innovative spirit of the issuers: the only decisive factor is that the issue proceeds must be used for projects that contribute towards environmental protection.

In principle, a green bond works like any other bond. An issuer who requires capital for certain purposes – in this case, eco-friendly projects – issues a bond on the capital market. The structure, yield and risk profile of a green bond does not have any special features compared to other bonds.

What projects can be financed with green bonds?

The financing possibilities for green projects created by green bonds are practically unlimited.

To understand green bonds, it is crucial to bear in mind that the capital market is a market like any other. It is shaped by supply and demand. The market determines whether, and on what terms, issuers can borrow money from potential investors.

In practice, we see companies and banks but also countries, states, cities and municipalities as issuers of green bonds.

From hybrid cars to offshore wind farms

A wide variety of projects are being financed, e.g. huge infrastructure projects for the generation and delivery of sustainable energy, solar plants and offshore wind farms. Green bonds can also be used to finance the construction of a green building as a starting point for a modern and sustainable city. The same applies to car manufacturers who use green bonds to finance consumer loans for the purchase of eco-friendly hybrid cars. 

Other practical examples include charging stations for electric cars, the purchase of environmentally-friendly public transport, the expansion of bicycle lanes and energy-saving streetlights.

As the examples show, the range of projects for which financing via green bonds is already being used is enormous. 

Short-term profit expectations alone do not determine the success of green bonds

The capital market is largely determined by economic factors. Above all, investors' short-term profit expectations are the driving force behind whether certain securities – such as the green bond – will prevail on the capital market.

Other influencing factors include political or social developments. If the US president announces that the US will withdraw from the Paris climate agreement, the capital market reacts immediately. The price of securities can rise or fall directly as a result.

In addition to purely short-term profit expectations, medium- and long-term profit targets or intangible values can also shape individual investment decisions. Goals such as climate protection and sustainable use of resources can also be decisive. 

Against this background, it is an exciting and interesting development that the market for green bonds is currently showing enormous growth rates.

Strong market growth in industrialised and emerging countries

In countries such as China and India in particular, the market for green bonds is growing rapidly. These countries are reaching the limits of their economic growth due to the significant impact of industry on the environment. There is the realisation that the development and expansion of an environmentally-friendly infrastructure is necessary to ensure further, and at the same time sustainable, growth.

However, there has also been a significant increase in the issuance of green bonds in industrialised countries. With an issue volume of USD 1.5bn in 2016 and USD 1bn in June 2017, companies like Apple demonstrate that the “green cause” is an issue whose intangible and economic value is increasing. The proceeds from the Apple bond, for example, will be used, among other things, to research sustainable materials and for the recycling of smartphones.

How large is the capital market for green bonds?

The market for green bonds is very new. In 2007, the European Investment Bank and the World Bank were among the first issuers.

Experts agree that the green bond market is growing rapidly. However, varying figures are published on the size of the green bond market. One reason for this is that there are still no uniform market standards and the definition of "green bonds″ has not yet been legally defined. Experts estimate that green bonds to the value of approximately EUR 65bn – EUR 84bn were issued in 2016.

However, the high demand for green bonds is clearly reflected in the market. For example, the green government bond issued by France with a volume of EUR 7bn at the end of 2016 was oversubscribed by more than three times – according to public sources, investor offers amounted to EUR 23bn.

Overall, however, the green bond market can still be classified as a niche market. A well-known rating agency determined that in 2016 the green bond market accounted for about only 1.4 % of the total bond market issue volume. Other market participants estimate that green bonds only account for 0.1% of the global bond market. 

How is a green bond issued?

Essentially, the documentation of a green bond issue does not differ from the documentation of other bonds. The decisive factor is that the terms and conditions determine what the issue proceeds are to be used for. In this way, it is contractually determined and ensured that the respective issuer uses the issue proceeds for a green purpose.

There is still no uniform legal basis for green bonds. The framework in which green bonds are currently issued is mainly determined by a number of private initiatives. These private initiatives aim to create transparency for the still young green bond market. These include the Green Bond Principles drawn up in cooperation with the International Capital Market Association (ICMA), leading global investment banks and other important capital market participants.

Development of market standards determined by investors

We now see first market standards being developed on the basis of the Green Bond Principles, among other things. These are primarily determined by the requirements that potential investors place on green bonds. In addition to determining the use of issue proceeds in the terms and conditions, potential investors increasingly expect issuers to outline their green bond strategy in detail and commit themselves to comply with reporting standards throughout the term of the green bond.

Finally, it is becoming increasingly common to provide opinions from independent third parties that verify the results of the use of the issue proceeds and compliance with the green bond criteria defined in the issuer's green bond strategy.

Authors

Dr. Orna Freifrau von Fürstenberg
Senior Associate
Frankfurt