Green bonds are taking off as the financial instrument of choice for the private and public sectors to finance projects with social and environmental benefits, such as clean power, low-carbon transport,energy efficient buildings, waste management.
But what are exactly green bonds and how they could be used by corporation to gain access to capital and put in place their projects for the transition towards sustainability?
Green bonds function in the same way as any other bonds as they are a type of debt securities issued by public or private institutions to finance themselves.
This type of financial instrument can be issue by any organization with bonding authority, from private companies, financial institutions up to municipal government: unlike other credit instruments, the proceeds from this fixed income issuance are allocated solely to financing new or existing projects, so as to pursue environmental, sustainable and social purposes.
To grasp the potential of this market, one can compare the 2015 year-end cumulative green issuance, equal to $104 billion, with the 2021 year-end cumulative volume of $1.5 trillion worldwide.
Moreover, it is worth mentioning how the Next Generation EU program will be partially financed through green bonds, for a quota up to 30% of the total package before 2026: the EU Commission made the first issuance on October 2021 and the demand was 11 times higher than the offer, remarking the high potential of such instrument.
Corporate green bonds have become increasingly popular in recent years and the relative market is growing YoY at an interesting pace, gaining trust from both side of the instrument, issuers on one hand, and investors on the other.
While the use of corporate green bonds has increased, little is known about the effectiveness of this financial innovation, both in terms of financial and environmental performance, and the implications for firm-level outcomes. In particular, do corporate green bonds deliver on their promise and yield improvements in companies’ environmental footprint? Also, do companies benefit from issuing green bonds?
A first focus area is represented by the implications that the environmentally-sustainable finance has on the issuing firms value. Green bond issuance represents a positive signal in terms of company commitment and, mostly, transparency, and firms’ value may benefit in the long-run from a reduced level of information asymmetry, given the higher operating disclosure.
Moreover, issuances of ESG bonds are generally more expensive than those of conventional securities, due to external and independent reviewer cost to certificate that the use of proceeds is aligned with the ESG criteria. As a consequence, green bond may turn to be a convenient source of funding, with the topic of a negative premium on ESG debt securities, informally called greenium, which refers to the possibility of a lower yield accrued on these bonds because of the higher costs of issuance and the return on sustainability.
One of the key features of green bond issuance is the standards and criteria included within the contract. Criteria established by the Green Bond Principles, are the following:
Use of proceeds: the cornerstone of a green bond is the utilisation of the proceeds of the bond for eligible green projects, which should be appropriately described in the legal documentation of the security. All designated eligible green projects should provide clear environmental benefits, which will be assessed and, where feasible, quantified by the issuer.
Process for Project Evaluation and Selection: the issuer of a green bond should clearly communicate to investors; the environmental sustainability objectives of the eligible green projects, the process by which the issuer determines how the projects fit within the eligible green projects categories; and complementary information on processes by which the issuer identifies and manages perceived social and environmental risks associated with the relevant project(s).
Management of Proceeds: the net proceeds of the green bond, or an amount equal to these net proceeds, should be credited to a sub-account, moved to a sub-portfolio or otherwise tracked by the issuer in an appropriate manner, and attested to by the issuer in a formal internal process linked to the issuer’s lending and investment operations for eligible green projects.
Reporting: issuers should make, and keep, readily available up to date information on the use of proceeds to be renewed annually until full allocation, and on a timely basis in case of material developments.
The above described is a rather restrictive framework that in the past has worked well in reducing the phenomenon of greenwashing (fraudulent behavior aimed at pursuing a purely fictitious environmentalism) but which has obviously reduced the potential audience of issuers.
Nonetheless, green bond issuers will possibly achieve multiple advantages, for instance related to the reputational benefits, give as marketing activities can highlight issuer’s green credentials and support for green investment or other social activities, but also enhance the commitment of the firm towards a sustainability strategy, making them pioneer in these fields.
At last, the issuance of green bonds may prove to foster dialogue with investors and give access to a diversification of the capital providers, reducing capital concentrations and the exposure towards a market fluctuation.
One of the infrequently cited benefits of the green bond issuance framework is that tracking the use of proceeds and reporting lead to improved internal governance structures, communication towards the external shareholders and knowledge in sharing project and financial information effectively.
As mentioned, there are some disadvantages with respect conventional debt issuance, mainly relate to transaction costs, and to the possibility of a “green default” whether the sustainable objectives are not achieved. Investors may seek instrument anchored to key sustainability indicators (KPIs), e.g. the amount of CO2 emitted or the minimisation of toxic production waste.
The potential of green bond issuance is permeating different sectors and entities, with a remarkable implementation of such instruments from private SMEs seeking funds for their innovative and sustainable projects. For example, that is the case of the green Mini-bond issuance an italian company specialized in the field of automatic systems for measuring the quality of products and industrial processes, subscribed by a primary italian bank in 2020 for €5 million. This was the first “sustainable” minibond, with green and social purposes, issued in Italy by an industrial company (source: Osservatorio Minibond, Politecnico di Milano).
More in detail, in order to issue the “sustainable” minibond, the italian company has identified some green and social projects on which to focus investments: e.g. the “Leaf Community project”, the eco-sustainable micro-grid that includes italian company laboratories, some residential homes with zero CO2 emissions, the production and accumulation of renewable energy from the sun, water and land, with the management and optimization of energy flows.
ESG bonds are bound to be a key financial instrument to channel financial resources into green, sustainable and social projects. The adoption of such instruments by the corporate and government sectors has rapidly increased in the last five years, with a dramatic expansion of the volumes issued and of the number of issuers.
Sources: GBP, Banca d’Italia, Climate Bonds Initiatives, Osservatorio Minibond Politecnico di Milano, OECD
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