Beyond the greenium: Assessing the additionality of green bonds

This year green bonds are celebrating their 15^th anniversary. The introduction of principles structuring issuance of bonds earmarked to finance green projects (Green Bond Principles) by International Capital Markets Association in 2014 helped to stimulate their issuance. In more recent years, green bonds have seen a rapid growth, with global issuance exceeding US$ 2 trillion dollars in 2022, though still representing only about 2% of the global bond market. In 2019, Sustainability-Linked Bonds (SLBs) were introduced, aiming to provide investors with measurable environmental objectives and penalties in case of the issuer’s failure to meet its commitments. They have attracted considerable attention and exceeded US$ 200 billion of global issuance just in two years. Despite this startling market growth, debate around additionality of both green and sustainability-linked bonds (GSLBs thereafter) and their contribution to net-zero objectives is still there.

As the term suggests, ‘additionality’ refers to an additional effect that GSLBs provide, either by enabling capital to flow to green assets and projects that would not otherwise get financed (financial additionality) or by enabling environmental impact of investments that would not otherwise been achieved (development additionality according to the OECD).

The ambition behind green bonds is to enable a large (systemic) shift of capital to green projects and a tangible impact on transition to a low-carbon economy. Their potential lies, particularly, in their visibility to investors and provision of global understanding what green investments are and what they seek to achieve. Financial additionality of green bonds is thus reflected in providing ‘green’ issuers with lower financial performance or higher credit risk with access to capital at a more affordable rate than otherwise would  be possible; while issuers already with access to markets and with good financial strength are positioned to obtain cheaper funding by issuing green bonds.

In developed countries green bonds are mostly issued by companies that already have access to capital markets and experience no funding shortage. The effect could, in theory, be larger in developing markets as access to capital is more limited both for firms and countries, however, evidence of such an impact is scarce.

Green bonds with external verification or issued by companies with established environmental credentials tend to enjoy tighter spreads.

Do green bonds provide cheaper funding? It depends. Several studies show that green bonds trade at tighter spreads relative to conventional bonds of the same risk profile, the so-called ‘greenium’[1]. The differential is on average rather limited, albeit with wide variations across sectors, countries, and issuer types. Greenium has shown to be particularly associated with a bond’s credibility, as a legitimately ‘green’ investment. That is, those green bonds with external verification or issued by companies with established environmental credentials tend to enjoy tighter spreads. Green bonds of developing countries appear not to benefit from greenium, potentially due to lower credibility and higher financial risk. A big challenge with assessing greenium is to pair green bonds with conventional bonds of the same risk profile (the same issuer, maturity, bond type). This is not an easy task for developed countries, and even more so for developing countries as number of both green and conventional bonds are limited.

Do green bonds enable positive environmental impact through green projects, such as reduction in carbon emissions? Overall, issuance of green bonds seems to be associated with improved environmental performance of issuers, notably, for green bonds that are more credible and that are issued for new projects and not for refinancing old projects. However, the impact cannot be attributed specifically to green bonds as their share in total funding of these issuers remains too small. Both the issuance of green bonds and improved environmental performance largely reflect companies’ general commitment to sustainability.

SLBs which were created to foster environmental impact have also shown only limited contribution to achieving environmental objectives, as most issuers set up targets lacking ambition, and most SLBs have low probability of hitting a penalty coupon step-up. For example, recent research finds that some SLBs obtain greenium larger than potential penalty of the bond thus limiting issuers’ incentives to respect the objectives. Demand-chasing-supply can also partially explain the greenium for GSLBs.

For borrowers, issuance of green bonds can lead to better organised and stronger sustainability processes and reporting within a company.

If judged by definitions of development finance, green bonds show overall limited financial and development additionality. However, according to surveys of issuers and investors, they have been significantly contributing to the discussion of sustainability both within a company and in the market and throught their introduction in companies’ and markets’ culture and practices. For borrowers, issuance of green bonds can lead to better organised and stronger sustainability processes and reporting within a company, as well as extending their investor base to bond investors focused on sustainability themes. In sum, these investors are learning how to invest sustainably, assess companies’ commitments and environmental impact of green projects.

Up to now, the marketing of GSLBs has succeeded in drawing investors’ interest in green projects; however, it is time for GSLBs to realise their potential to bring capital flows to green projects with real environmental impact if they are to foster transition to a low-carbon economy. For this, a number of obstacles needs to be overcome. Transparency, data availability, comparability and standardisation of GSLBs are essential to make these bonds more attractive and efficient. Thus, it is key to strengthen green bond standards with a clear definition of a green project, (ideally mandatory) standardised reporting and audited certification.[2] To close the gap between project-level financing by green bonds and issuers overall sustainability performance, it is essential for companies to show how issuance of green bonds contributes to their sustainability and transition objectives. Even more importantly, environmental objectives need to be aligned with financial performance and risk constraints.

This last point is more difficult to address as it concerns provision of capital to the public and corporate sectors in developing countries and also to riskier and overindebted firms in developed countries that still are to undergo  transition. For many investors financing of these issuers is inconsistent with their mandates as they primarily invest in low-risk investment grade bonds. The small size of the green projects is often mentioned as another obstacle. A potential solution could include green securitization and blended finance with involvement of public agencies and international organisations. But this naturally requires larger involvement and coordination among public authorities, regulators, and market participants.