Dissecting greenium: Germany’s pioneering role in green securities

Germany has emerged as a significant player in the European green bond market, having issued the first green federal securities through syndication in 2020. Capitalising on its influential role in debt capital markets, the German federal government aims to promote the market for green financial products and establish itself as a benchmark issuer in this asset class, potentially earning an additional benchmark premium. The traits of the Bund investor base, including risk aversion, a preference for liquidity, and low sensitivity to yield, align well with green bonds. To accommodate market demand, the government offers a wide range of maturities (currently five, ten, and 30 years), with the prospect of future expansion.

Green federal securities have a unique characteristic as ‘twin bonds.’ They are closely linked to corresponding conventional bonds of the same maturity and coupon. The Bundesrepublik Deutschland – Finanzagentur GmbH, acting as a fiscal agent, enables trading through combined transactions and promotes liquidity through debt-neutral sale-and-purchase (switch) transactions, in addition to standard secondary market operations. Consequently, the liquidity premium for green bonds can be mitigated by leveraging the market liquidity of their conventional counterparts. Green federal securities adhere to the standard green ‘use of proceeds’ bond type as defined by the ICMA’s Green Bond Principles, and prospectively, the EU green bond standard. The funds raised are intended for allocation across multiple green sectors: transportation, international cooperation, research and innovation, energy, industry, agriculture, forestry, and biodiversity conservation. Nonetheless, the same issuer–same risk principle applies: The green bonds carry the same extremely low risk premium as their conventional twins since both are issued and supported by the German government. Their debt service payments reflect German sovereign risk and are not dependent on or limited by the revenue generated from specific environmental projects.

According to the German government, green federal securities serve to indirectly contribute to climate protection by signalling the existence of a ‘greenium’ in the market. This term, an artificial combination of ‘green’ and ‘premium,’ refers to the yield difference between a green bond and its conventional counterpart. The basic premise of the greenium concept is that investors are willing to accept lower returns to support non-financial investment objectives and derive personal satisfaction, such as advancing ethical goals or expressing moral sentiment. The emergence and size of this market are influenced by regulatory preferences and the commencement and discontinuation of the Eurosystem’s public sector asset purchase programmes. The funding cost advantage should encourage other issuers to issue similar bonds, thereby facilitating the financing and expansion of green investments.

One might question why green bonds do not directly contribute to climate protection. To understand this concept, it is important to recognise that the funding structure does not affect the environmental implications, nor does it impact the return on investment, as established by Modigliani and Miller’s irrelevance theorems. The distinction lies in the allocation of proceeds, which can be designated as ‘green,’ rather than the source of funding itself. It is well known that creditor governance is limited, especially when dealing with sovereign debtors. The parliament is, in general, not obligated to allocate funds raised for specific purposes, due to the constitutional principle of non-affectation. In reality, when green bonds are issued, they primarily earmark existing green projects. It does not inherently imply the creation of new, additional green investments.

In a perfect market scenario, the division of bonds into green and grey tranches should not impact the total funding costs. However, this concept is qualified by market imperfections that create an opportunity for issuers to take advantage of the information deficit and potentially exploit the investors’ irrational behaviour. The green bondholders may either be uninformed or filter out the fact that the mix of green and conventional bonds does not determine the overall environmental impact of the investment. Thus, they willingly pay a greenium, harbouring the hopeful, albeit optimistic, expectation that this particular financial arrangement will prompt the sovereign debtor to enhance investments in eco-friendly endeavours.

Moreover, the concept of a ‘pollution premium’ as a form of ‘negative greenium’ appears to be an under-recognised narrative. The pollution premium should compensate conventional bondholders for the increasing lack of the issuer’s ‘unencumbered’ green assets caused by the issuance of green bonds. Considering the bond segmentation as a zero-sum game, the yield reduction (greenium) on the green bonds should ideally be offset by a yield increase (pollution premium) on the outstanding conventional bonds. However, this is not the case. Indeed, conventional bondholders, possibly due to their limited environmental consciousness, either remain unaware or indifferent to their deteriorating position in the creditor hierarchy of eco-friendliness and thus miss out on the pollution premium. Consequently, purchasers of both green and conventional bonds will face compromised returns.

Upon reflection, the sell side may realise that green financing effectively lowers the total cost of capital, without imposing penalty rates for failing to meet pre-defined green key performance indicators, as seen in sustainability-linked bonds—one might consider achieving the Paris climate goal for the federal issuer. From a buy-side perspective, however, an investor who balances ethical considerations and risk diversification in his or her portfolio might choose to allocate equal amounts to green bonds and their conventional twins. As a result, he or she might experience a dip in returns, which could have been avoided without pre-segmenting the bonds. In conclusion, both the greenium and the retained pollution premium provide market-based subsidies to public finance, creating a voluntary form of taxation to promote the public good.[1]