Going Green with Bonds

The Paris Agreement and the Sustainable Development Goals set ambitious targets for transitioning to a low carbon global economy, including keeping the rise in the global temperature to well below two degrees Celsius. The International Finance Corporation (IFC) estimates that South Africa, which is a signatory to the Paris Agreement, requires more than US$588bn between 2016 –2030 in climate-smart investment to meet its Paris Agreement policy commitments, making the development of a green financial system, and green financing solutions increasingly pertinent. Green bonds are likely to be an important instrument to facilitate climate-smart investment.

What is a green bond?

A green bond refers to any type of bond instrument where the proceeds will be applied exclusively to finance or refinance, in part or in full, new or existing eligible green projects. Green bonds are intended to fund projects or capital expenditure that will have positive environmental or climate benefits. The specialised use of the proceeds is one of the key differentiators between a green bond and a conventional bond. The green label does not fundamentally change the bond’s risk profile which, as with a conventional bond, depends on the underlying credit quality of the issuer. 

There are four types of green bonds: standard green use of proceeds bonds; green revenue bonds; green project bonds; and green securitised bonds. In the South African context, listed green bonds that have been issued have been limited to standard green use of proceeds bonds where, like a conventional bond, recourse is to the issuer’s balance sheet and the use of funds is specifically restricted to the identified low carbon project.  

Globally, the Green Bond Principles (GBP), published by the International Capital Markets Association, are a widely-used guideline for green bond issuers around the use of proceeds, project evaluation and selection, as well as management of proceeds and reporting. In addition, the GBP recommend that issuers make use of an external review to confirm the alignment of their bonds with the GBP guidelines. External review includes review by a consultant or institution with expertise in environmental sustainability, independent verification by a qualified party, certification against an external green assessment standard or obtaining a rating by a qualified third party such as a rating agency. External review is also important in maintaining the integrity of the process and avoids potential ‘greenwashing’ where green bond proceeds are allocated to assets with little environmental value which can be damaging for the development of the green bond market. 

The international green bond market

The first green bond was issued in 2007 by the supranational European Investment Bank and today the global green bond market is estimated at $369bn outstanding. The green bond market has seen tremendous growth over the past five years with an average annual issuance volume of $67bn. During 2017, a staggering $155bn of green bonds were issued, with 34% of that number being issued in the United States and 33% of the total proceeds raised being invested into renewable energy. Government entities (local government, multi-lateral banks and state-owned entities), which account for over 50% of the total green bonds outstanding, are an obvious fit for green bonds, given their large infrastructure spending budgets. However, corporates and banks are becoming increasingly active in this space. Toyota Financial Services, one of the largest corporate green bond issuers, has issued over $5bn of green bonds to finance loan and lease contracts related to its low carbon vehicles. Bank of America has also been active in the green bond market, raising $4.35bn which is being used to fund renewable energy projects. Moody’s expects global green bond issuance during 2018 to exceed $250bn, driven by buoyant investor demand seeking to integrate sustainability within their asset allocation and risk management practices. As markets evolve, specialised forms of green bonds are also likely to become more prominent, such as green securitisations and green sukuk bonds.  (See Figure 1.)

Fig 1 - Global Growth in Green Bonds Source: Climate Bonds Initiative

Growth of green bonds in South Africa 

In the South African context, green bonds are still a nascent asset class with only a handful of listed bonds in existence, issued by the IFC (R1bn), City of Johannesburg (R1.5bn), City of Cape Town (R1bn) and Growthpoint (R1.1bn). In 2017, the Johannesburg Stock Exchange (JSE) joined the growing list of stock exchanges with a dedicated Green Bond segment which provides a platform for issuers to raise funding to be applied towards low-carbon initiatives. The platform is also intended to satisfy investors’ environmental social governance (ESG) mandates and address climate risks as a part of their portfolio construction. 

A bond issuer wishing to have an instrument listed on the Green Bond segment is required to comply with the Green Segment provisions of the JSE Debt Listings Requirements. At a high level, this includes an external review by an independent advisor confirming that the instrument meets the green standards, being either GBP or any other standard accepted by the JSE as well as a requirement to annually confirm that the instrument continues to comply with the green standards. 

Investor demand for green instruments has been somewhat muted in the past, with only a handful of asset managers having specific green mandates. The exponential growth of the global green bond market, coupled with increasing public interest and commitment towards managing climate change, are likely to be catalysts for the development of the South African green bond market.  We have observed increased appetite for green bonds on the recent issuances being more than three times oversubscribed. 

Green bond considerations

The appeal of green bonds is predominantly around the positive messaging and profiling that the transaction creates around the issuer’s commitment to environmental sustainability. In addition, investor diversification may be achieved with the introduction of investors who have specific green mandates. 

The lack of a pricing benefit, coupled with the additional reporting costs and complexity, have been suggested as the major factors holding back a more rapid expansion of the green bond market. However, recent reports suggest that there may in fact be a pricing benefit for green bonds (known as a ‘greenium’) citing better spread compression post-issuance and tighter new issuance premiums compared to conventional bonds. 

Case Study – City of Cape Town Green Bond

What appears to be widely acknowledged is that green bonds attract a higher number and a broader range of investors resulting in higher oversubscription and as such, a lower cost of funding. Although it is difficult to reach a conclusion on this for purposes of the South African green bond market given the limited available data points, the order books for both the City of Cape Town and Growthpoint’s green bonds seem to corroborate this view. Both transactions received interest from non-standard corporate bond investors including offshore asset managers with specific green funds, which assisted in driving up the subscription levels. The City of Cape Town, in particular, was able to achieve a pricing benefit of 42bps compared to a conventional municipal bond issued by a comparable credit less than one week earlier – the City of Cape Town’s green classification is believed to have been a driver of investor demand, resulting in an order book that was almost five times over-subscribed which assisted in compressing the final issue spread.  

Case Study – Growthpoint Green Bonds

The future for green financing in South Africa

As a signatory to the Paris Agreement, South Africa has committed to addressing climate change. The South African government has already issued draft legislation relating to carbon reporting, carbon tax and climate change in general. One of the key challenges identified is around catalysing the financing of and investment in the transition to a low carbon and climate resilient economy. The implementation of these regulations, coupled with growing awareness of climate risks, is likely to add much needed impetus to the development of South Africa’s own green finance market where green bonds are expected to play a prominent role.