By William Sokol
Senior ETF Product Manager, VanEck
The Paris Agreement set a target of limiting global warming to well within 2 degrees Celsius above pre-industrial levels by reducing greenhouse gases. Massive amounts of infrastructure investment are needed to achieve that goal, and green bonds are an important financing mechanism to direct capital towards Paris-aligned projects. Green bonds can also help investors build sustainable core fixed income portfolios without significantly impacting risk and return. This blog is intended to answer frequently asked questions about green bonds and more specifically, the VanEck Green Bond ETF (GRNB).
- Q: What is a green bond?
- Q: But how do you know that a green bond is truly “green?”
- Q: How big is the green bond market?
- Q: What are the bonds in GRNB used for?
- Q: How is environmental impact measured?
- Q: What role can green bonds play in a portfolio?
- Q: How do green bonds differ from other types of labelled sustainable fixed income securities?
Q: What is a green bond?
A: A green bond is simply a debt security whose proceeds from issuance are used by the bond issuer to finance environmentally friendly projects. Green bonds are generally backed by the full faith and credit of the issuer and rank equally with other bonds of the same seniority, rather than being secured by the projects themselves. In other words, a green bond is like any other bond except that the proceeds are tracked separately and investors know what their investment is financing. A green bond is defined by the projects it finances, rather than the broader activities of the issuer.
Because a green bond has the same fundamental risk drivers as a non-green counterpart by the same issuer, all else equal, they should provide similar returns. The only difference, therefore, should be the additional transparency provided (although pricing differences can emerge due to factors such as supply and demand or differences in underlying liquidity). We believe this structural similarity has been a critical factor contributing to the success of the green bond market over the past decade.
The additional transparency and reporting that comes with a green bond issue is uncommon in the bond market. Issuers issue green bonds under a framework that specifies what types of projects can be financed under an issuer’s program, as well as how projects will be evaluated by management, how green bond proceeds will be segregated and tracked, and the frequency of post-issuance reporting and type of information that will be included. Issuers not only disclose the anticipated use of proceeds prior to a specified bond issuance in the bond’s regulatory disclosures, but also typically provide post-issuance reporting to investors that provides actual project details and in many cases, expected or actual environmental impacts, such as the amount of new renewable energy capacity that has come online or the reduction in greenhouse gas emissions that result from the projects financed. Many issuers also obtain a second-party opinion on their green bond framework and may also receive certification by third-party verifiers for specific green bond issuances.
Q: But how do you know that a green bond is truly “green?”
A: Green bonds can finance a wide variety of projects that can be considered “green” due to their beneficial impacts on the environment. This can include renewable energy projects, energy efficient buildings and mass transit. It can also include energy transmission infrastructure, research into new technologies that can result in more environmentally friendly manufacturing processes, or financing for electric vehicles. The key requirement is that these projects are disclosed so that market participants have the information needed to determine whether a green bond is in fact green. An issuer who provides this transparency and follows other best practices—such as ring-fencing of proceeds and post-issuance reporting—but does not obtain any other certification, can be considered to have issued a “self-labelled” green bond. However, many investors want additional assurance that the projects financed are indeed beneficial to the environment and aligned with a pathway towards a zero carbon economy.
Fortunately, various taxonomies (a classification system for projects) have been developed, and in an increasing number of markets, regulatory definitions of what constitutes a green project have been established. The projects financed by green bonds can be evaluated against these taxonomies and various regulatory definitions. We believe the green bond taxonomy developed by the Climate Bonds Initiative (CBI) has provided a valuable tool for international investors, in the absence of a global standard. The CBI is a non-governmental organization focused on mobilizing the global fixed income markets for climate solutions. One of the key ways they work toward achieving this is by promoting marketplace standards which provide investors and issuers the confidence needed to build a large, liquid and mainstream green bond market. The CBI taxonomy is the backbone of various labelling and certification schemes, and provides a guide to climate aligned assets and projects. The CBI taxonomy is grounded in the latest climate science and guided by the overall objective of achieving a drastic and rapid reduction of greenhouse gas emissions to limit global warming to below 2 degrees Celsius. The taxonomy provides investors and other market participants confidence that their green bond investment is aligned with the climate objectives of the Paris Agreement.
The VanEck Green Bond ETF tracks the S&P Green Bond U.S. Dollar Select Index, which is comprised of U.S. dollar denominated green bonds designated as green by the Climate Bonds Initiative. We believe this additional screen provides confidence to investors that the bonds included are not simply self-labelled as green, but have been assessed against a transparent and rigorous taxonomy by an independent organization that is grounded in climate science and reflects the input of multiple stakeholders including experts from academia, industry, international agencies and other non-governmental organizations.
Q: How big is the green bond market?
A: The green bond market has grown significantly since the first green bond was issued in 2007. Issuance has generally increased each year over the past decade, reaching $300 billion in 2020. Year to date, issuance has already far exceeded that amount, with over $410 billion in new green bond issuance through November 19, 20211. Growth in the market began to accelerate in 2013, following the adoption of the Green Bond Principles, which established best practices around the issuance of green bonds as it relates to use of proceeds, the assessment of projects, management of proceeds and reporting. Since then, other initiatives by policymakers to establish clear standards and definitions have helped to spur growth, in addition to large benchmark-sized sovereign issuances. More than anything else, increased demand from a wide variety of investors has driven the growth of the green bond market, as investors seek out solutions to build sustainable fixed income portfolios. With this growth, the market has become increasingly diversified as corporate and sovereign issuers joined multi-lateral development banks, and an increasing number of municipal, emerging markets, asset-backed and high yield issuers have also issued green bonds.
Green Bond Issuance Has Grown Significantly
Source: Climate Bonds Initiative, as of 11/19/2021.
The S&P Green Bond Index, which is a broad-based index that tracks the global green bond market, had a market value of approximately $1.1 trillion as of 10/31/2021, versus $110 billion five years prior – reflecting an annualized 5-year growth rate of nearly 60%. This tremendous growth provides investors with a greater ability to tailor portfolios that are structured to their unique investment objectives. For example, the global green bond market is over 60% euro denominated, reflecting the primary sources of both supply and demand globally. For U.S based investors seeking to build a climate aware bond portfolio, a broad global green bond exposure may mean overweights to low or negative yielding euro denominated bonds and a relatively low exposure to U.S.-domiciled issuers. The U.S. dollar segment of the market, although only a portion of the global market, is over $200 billion in market value and well diversified. As a result investors can target U.S. dollar denominated green bonds so that they can build sustainable fixed income portfolios without having to sacrifice yield or assume currency risk. In addition, the costs and sometimes unexpected tax impacts of currency hedging can be avoided.
Although the global green bond market has grown significantly, it is still relatively small in the context of the $100 trillion global debt markets. We expect the market to continue to scale up significantly over the next few years to help fund the investments needed to achieve the objective of the Paris Agreement and to significantly reduce greenhouse gas emissions by 2030, providing a potentially attractive way for investors to participate in the transition towards a zero carbon economy. It should be noted that green bonds are an important piece of the financing solution to achieve these objectives, but are part of a broader set of green funding solutions including sustainable bonds, sustainability-linked bonds, green loans and private debt. However the longer duration of green bonds are particularly well suited for long-lived cashflow producing assets, and the reporting they provide aligns with the general desire for transparency and greater importance on dual-materiality by both regulators and investors. As such, we believe green bonds will remain a crucial piece of the funding mix for green infrastructure and other environmentally friendly investments going forward.
Q: What are the bonds in GRNB used for?
A: As shown in the chart below, the majority of the projects financed by bonds in GRNB’s portfolio fall into three broad categories: Renewable Energy (41%), Green Buildings (24%) and Clean Transportation (19%).
Projects Financed by Green Bonds
Source: VanEck and issuer reporting, as of 9/30/2021.
The use of proceeds among bonds in GRNB align closely to that of the global bond market. Perhaps unsurprisingly, renewable energy has remained a primary recipient of capital over the past few years. Given the investment needs within the energy sector alone to transition to a net zero economy, this is unlikely to slow down in the foreseeable future. Several U.S. utilities, including MidAmerican Energy, Duke Energy and Xcel Energy, have issued green bonds to finance solar and wind projects across the country. In addition, transmission and distribution infrastructure, smart electric meters and battery storage technology have also been financed by bonds in GRNB.
Green building development and retrofits is also an extremely important piece of achieving global climate goals, considering that 40% of annual global CO2 emissions are generated by buildings.2 Several U.S. REITs including Alexandria Real Estate Equities, Boston Properties, and Vornado have all issued green bonds financing certified green commercial, retail and residential properties, including the iconic Salesforce Tower in San Francisco.
Similarly, transport will continue to be an area of focus in the fight against climate change, as it currently accounts for approximately 24% of global emissions and is growing at a rate that is faster than any other sector.3 With automobiles as the largest contributor to emissions within the transport category, green bonds such as those issued by Toyota Auto Receivables, Kia Motors and Hyundai Capital Services to finance purchases of electric vehicles may become increasingly common in the industry. Mass transport projects such as those constructed and operated by the Metropolitan Transit Authority in New York City and the MTR in Hong Kong, which have both issued green bonds held by GRNB, will continue to play a major role in reducing emissions in urban areas, contributing to more livable and sustainable cities globally.
Other project categories remain a much smaller recipient of green investment, but we believe these may see greater investment in coming years. Although most focus and investment tends to go to projects that may stop or slow global warming, adapting to the existing impacts of climate change also requires significant investment. And although global warming is generally at the top of the list of investor concerns, an increasing focus on the catastrophic impact of the loss of biodiversity may also lead to greater investment in land and aquatic conservation efforts, which will require funding. Climate change adaptation and terrestrial/aquatic biodiversity conservation efforts both received less than 1% of green bond proceeds among bonds in GRNB’s portfolio.4
Q: How is environmental impact measured?
A: Green bonds can be particularly attractive to impact investors, because of the transparency and reporting provided on the use of proceeds. In most cases, issuers can identify the projects that were financed by a particular bond, allowing investors to know not only how the proceeds were allocated but also the specific details of the project, such as location and expected environmental impact. For example, the largest U.S. green bond issuer, Fannie Mae5, provides CUSIP-level impact data for each of the green bonds it has issued as well as an annual impact report on its overall green bond program. Metrics including estimated annual energy, water and emissions reductions are provided, which are typical metrics reported by other green bond issuers as well. In addition, Fannie Mae provides estimates of various social and economic impact indicators, including the number of jobs created or supported by its investment and the average utility cost savings for homeowners.
Impact data such as Fannie Mae’s allows us to estimate the environmental impact an investment in green bonds may have. For example, by aggregating all available data for the bonds in GRNB, we find the following impact for every $1 million invested6:
|Impact:||Metric (per $1 million invested):||Equivalent to7:|
|Energy savings from efficiency upgrades||244 megawatt hours||Approximately $34,000 in savings, or the annual electric bill of 25 average U.S. households|
|Renewable electricity generation||989 megawatt hours||Enough electricity for 92 U.S. households annually|
|Greenhouse gas emissions reduced or avoided||807 metric tons||175 cars removed from roadways each year|
|Land protected||13 hectares||18 soccer fields|
Unfortunately, not all issuers provide the same level of data as Fannie Mae, although the number of issuers providing post-issuance reporting has increased over time and has also increased in quality. Almost 90% provide information on how bond proceeds are allocated, and 77% of issuers provide estimates of environmental impact.8 However, issuers reporting impact metrics may not always apply the same assumptions on calculations, and currently issuers are able to report on the metrics they choose and are not mandated to report specific measures of impact. Over time we expect increased standardization (either due to regulatory or market-based demands) of both metrics reported and calculation assumptions, which will allow for a greater ability to compare green bonds and aggregate portfolio level data.
At the same time, although certain projects lend themselves to measureable environmental impact calculations, other green projects may have impacts that are harder to quantify. For example, in 2020 NXP Semiconductors was one of the first semiconductor companies to issue a green bond, raising $1 billion for eligible green projects.9 The majority of proceeds were invested into various research and development activities, including increasing energy efficiency in power adaptors, extending the range of electric and hybrid cars through better battery control and energy management, and reducing the power consumption of 5G networks. All of these technological innovations could potentially drive positive environmental outcomes, but are difficult to quantify until commercialization. In addition, allocation data and impact estimates are typically not provided by green bond issuers until a year after a green bond is issued, so data may not yet exist for many green bonds given the growth of the market this past year.
Q: What role can green bonds play in a portfolio?
A: Green bonds can fit well into a core bond allocation, allowing investors to build a more sustainable fixed income portfolio with little impact to risk or return. As mentioned previously, a green bond is like any other bond except that the use of proceeds is clearly disclosed. From a risk and return perspective, the fundamental drivers are identical, all else equal. At an aggregate level, the green bond market is similar to core bonds in that they are multi-sector, high credit quality and have a yield and duration that is not significantly different from the overall core bond benchmark.10 Investors who allocate to green bonds can also achieve added diversification, as green bonds tend to be more oriented to corporates and less to government issuers (to date, the U.S. Treasury has not issued any green bonds). Nevertheless, as shown below, these broad similarities allow investors to allocate a portion of a core bond portfolio to green bonds without significantly impacting risk and return, based on traditional portfolio characteristics such as yield and duration.
|US Aggregate Bonds (100%)||USD Green Bonds (100%)||US Aggregate Bonds (80%) and|
USD Green Bonds (20%)
|Modified Duration (Yrs)||6.86||6.01||6.69|
Source: S&P Dow Jones Indices and ICE Data Indices, as of 9/30/2021. Green Bonds are represented by the S&P Green Bond U.S. Dollar Select Index. US Aggregate Bonds are represented by the ICE BofA US Broad Market Index. Investment Grade includes unrated bonds issued by U.S. government sponsored enterprises. Actual results will vary. See important disclosures and index descriptions below.
From another perspective, green bonds may be considered a risk management tool for fixed income investors seeking to construct a more climate resilient portfolio. Considering that green bonds are only issued to finance environmentally friendly projects, it is natural to conclude that issuers who are proactively managing and addressing environmental risks tend to be issuers of green bonds. As mentioned, the overall yield levels of green bonds tend to be similar to non-green bonds, indicating that the market may not be putting a high price on climate risk, although there have been several idiosyncratic examples where this risk was reflected. To the extent that these risks begin to be priced in by the market more systematically in the future, green bonds, and perhaps other bonds issued by the same issuer, may be more resilient while bonds of issuers with greater climate risk may experience a loss of value.
Q: How do green bonds differ from other types of labelled sustainable fixed income securities?
A: There is a growing market for other innovative financing structures in the bond market which are similar but distinct from green bonds. Several other “use of proceeds” bonds have emerged that leverage the structure of green bonds for social investments and come with a variety of different names. “Social bonds,” for example, are issued only to finance projects with positive social outcomes, such as providing access to basic infrastructure, affordable housing, food security or socioeconomic advancement and empowerment. In early 2020, there was a surge of social bond issuance as many issuers shifted priorities to healthcare and pandemic related spending. “Sustainability bonds” have also been issued to allow issuers to finance either green or social projects. These various labels allow investors to achieve both green or social objectives in their portfolio, and to tailor their exposure based on their own objectives. Green bonds are targeted to investors seeking positive environmental outcomes.
“Sustainability-linked bonds” are a newer structure that does not restrict how the proceeds may be used, but links interest payments to pre-defined key performance indicators that the issuer establishes at the time of issuance. For example, a sustainability-linked bond may provide lower (higher) coupons over time if an issuer’s environmental or other sustainability rating, as provided by a specified data provider, increases (decreases) over the life of the bond. These structures can provide more flexibility to issuers and can be attractive to issuers who do not have a robust green project pipeline, or those involved in more “brown” businesses that are trying to transition to green. Valid questions around alignment of incentives, defining and measuring KPIs and whether higher coupons are sufficiently punitive deserve more attention, we believe, before this market can mature. However, the structure appears promising and could serve as another useful tool in the overall sustainable financing ecosystem.
GRNB’s index does not explicitly consider whether something is referred to as a green or sustainable bond, but does require use of proceeds to be clearly reported and will only include a bond if 95% of proceeds go towards environmental projects aligned with the CBI taxonomy. Sustainability-linked bonds are therefore not eligible because of the lack of transparency on the use of proceeds. The index may exclude “sustainability bonds” that disclose significant allocations to social-related investments such as schools or hospitals. So-called “blue bonds” are issued only to support healthy oceans, and would be eligible for GRNB’s index if the projects are aligned with the CBI’s project taxonomy, which includes several marine related projects, such as natural ecosystem protection and restoration projects. Further, because green bonds assessed against the CBI taxonomy disclose their use of proceeds and are aligned with the Paris Agreement, as opposed to “transition” projects, we believe they can be attractive for investors seeking to build a “darker green” impact portfolio.
Originally published by VanEck on December 2, 2021.
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1 Source: Climate Bonds Initiative.
2 Source: UN Environment Programme.
3 Source: World Resources Institute.
4 Source: VanEck and issuer reporting as of 9/30/2021.
5 Source: Climate Bonds Initiative.
6 Source for environmental impact and project data: VanEck and issuer reporting. Based on the most recent reporting from bond issuers on individual green bonds or an issuer’s green bond program. No assumptions were made for green bonds where no environmental impact reporting has been provided.
7 Energy savings based on average annual U.S. household energy price per kilowatt-hour per the U.S. Energy Information Administration; electric generation based on the annual U.S. household average energy consumption per the U.S. Energy Information Administration; greenhouse gas emissions based on average passenger vehicle emissions per the U.S. Environmental Protection Agency; land protected based on the average size of a soccer field.
8 Source: Climate Bonds Initiative.
9 Source: NXP Semiconductors.
10 Based on comparison of the S&P Green Bond U.S. Dollar Select Index for green bonds and the ICE BofA US Broad Market Index for core bonds.
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