In late September the UK government launched its first green gilt, raising £10bn from institutional investors in the process. This was a watershed move by the UK government and there is plenty of evidence that green bonds – bonds that differ from conventional bonds in that the money they raise is used in specific projects relating to supporting climate transition – are growing in popularity. Green bond issuance is predicted to pass £367bn this year, according to The Climate Bonds Initiative and potentially could reach £734bn in 2023.
TwentyFour Asset Management partner, chairman and portfolio manager Graeme Anderson
says green bonds could help pension schemes meet their sustainability goals.
“Green bonds that help transition from countries and/or corporates to a more environmentally sustainable future must have a role for a pension fund, because essentially they’re all interested in what goes on in the long run,” he says.
“It’s a way to help them meet their ESG obligations. If they’ve got a net zero target, for example, it’s a way for them to meet that, there’s no question about that.”
Green bonds are being viewed with interest by some of the biggest pension managers in the country and Legal & General Investment Management (LGIM) was one of the organisations to take part in the UK government’s inaugural green gilt issuance.
Mission statement
“Our investment teams are viewing it from different angles – obviously it’s another instrument, so it just goes into the asset allocation toolkit,” says LGIM head of DC investment solutions Veronica Humble.
“Different pension funds will view it in different lights – it is very much driven by mission statements, and the approach to asset allocation that the schemes are taking.”
However, she adds the use of green bonds may be less straightforward for other mandates.
“These funds are explicitly more ESG-focused, so for them, it aligns with explicit strategies and objectives, and so their inclusion is great,” says Humble. “If the objectives don’t include ESG in more explicit ways, it remains to be seen how those schemes approach this new type of asset.”
The advantages of green bonds can extend beyond simply meeting ESG goals. Cardano portfolio manager Carl Jones says investing in green bonds could reduce the overall risk of a portfolio.
Pricing climate risk
“One of the reasons we favour green bonds is that we believe that climate change is an under-priced systemic risk in financial markets,” he says.
“By increasing our allocations to green and sustainable assets – both in bonds and equities – which in turn support companies’ and governments’ transition to low and no carbon economies, we better manage the systemic risks associated with climate change. For our portfolios, which are global and multi-sector in nature, this in turn reduces the overall risk.”
Both DB and DC schemes have ESG obligations to meet as set by TPR. But green bonds may be attractive to each for different reasons. LGIM’s Humble suggests green bonds are naturally more allied with DC schemes because of investor demand.
“I think [green bonds] are probably more naturally aligned with DC. They’re still an instrument for DB, but in DB, your primary objective is to meet the liabilities of the scheme, whereas in DC you don’t have liabilities, but you have sometimes more explicit climate-focused goals,” she says.
“We’re seeing interest from our DC clients because members care about ESG, and particularly the climate change component.”
Cardano’s Jones points out that the youngest members of a DC scheme may be more than 50 years away from retirement, and keen to address the systemic risks caused by climate change, for both themselves and for future family members who could live into the next century.
With that said, he adds that for many DB schemes looking to de-risk, “high quality” green bonds could be attractive, both in helping the portfolio de-risk and to meet a scheme’s sustainability goals.
Potential drawbacks
The so-called ‘greenium’ that comes from green bonds is one of the product’s main drawbacks. Significant demand for the product means interested investors are willing to pay a premium for it, meaning they tend to carry a lower yield than their neighbouring conventional bonds. As a result, holding these bonds to maturity would lock in a lower yield for the end investor.
The UK’s recently launched green gilt demonstrates the ferocity of investor demand. It attracted more than £100bn worth of investor bids – 10 times the money it planned to raise.
TwentyFour’s Anderson says it is crucial investors know about and understand the greenium, and are aware of issues in the market that have come about because of quick investor demand.
“Normally, a new market must take time to establish what investors want, and so it has to come cheap to justify its place in a portfolio. With green bonds it’s happened the other way around.
“In a way that’s a good thing – it shows a lot of people want to support transition and want to do it through green bonds, but in a way the market has been a victim of its own success, and there has been quite a lot of problems with proceeds not being tied down to what they’re supposed to be used for.”
Non-sustainable ends
The risk of green bonds’ proceeds being diverted to non-sustainable goals, either mistakenly or on purpose, is real. In November 2017, energy company Repsol issued a green bond that made claims it would save 1.2 metric tonnes a year of carbon dioxide by improving the efficiency of its operations. However, the company faced criticism because, while the bond was not directly investing in increasing fossil fuel output, proceeds from the bond made the firm’s refineries more efficient, likely extending plant operating lifetimes, and therefore indirectly increasing emissions over time.
“We look to avoid the risks of allocating to those issuers who are less green than they may say by firstly underwriting the ESG credentials of the issuer, which is approved by our internal credit committee,” explains Cardano’s Jones. “We then only allocate to bond where there are strong processes in place around the management of the proceeds, project selection and impact reporting.”
The speed at which the green bond market is growing, with new issuances every day, is part of the problem. Not only is greenwashing made easier to hide, but this rate of growth can encourage prices further upwards.
“The speed at which the market fixes these issues is slower in the green bond sector because demand is so high,” Anderson continues. “[The market] doesn’t have to challenge itself quite so hard. As you’d expect, we’re seeing improvements in the use of proceeds, it’s just happening slower because demand is so great.”
Greenium turn-off
For some, this greenium is now enough to put them off the product altogether. Henry Tapper, CEO of AgeWage and Pension Playpen, argues: “I think green bonds are a con. Pension funds are paying a greenium for knowing they are providing debt for sustainable projects. This assumes the research that justifies the greenium should be paid for by bond holders. I don’t think they should.
“Certainly, in the case of government bonds, all bonds should be guaranteed green. What business has government in requiring funds for environmentally unsustainable, anti-social and poorly governed work?”