Contributor, Benzinga
November 30, 2022

Green bonds are an excellent funding source for issuers looking to finance or refinance a green project or environmentally friendly initiatives. Since first issued by the European Investment Bank in 2007, green bonds have witnessed explosive growth in the global capital market as investors become increasingly aware of the inherent risk of climate change. In the five years before 2021, it enjoyed a 49% growth rate and has already topped the $1 trillion mark in cumulative annual issuance, according to Climate Bond

Climate change threatens global communities and economies, posing risks for agriculture, food and water supplies. Human activities relating to energy consumption are the core driver of this change, as established by the Intergovernmental Panel on Climate Change (IPCC). Connecting environmental projects to the capital market or channeling capital toward sustainable development can help mitigate some of the dire consequences of climate change — and green bonds are an excellent way to make such a connection. 

Investing in green bonds translates to real-life activism for better green practices. Therefore, suppose you're looking to contribute to the green effort globally and earn substantially while at it. In that case, green bonds offer practical opportunities, especially as these debt instruments also come with tax incentives. Benzinga spotlights green bonds, providing insights into how you can leverage the green instruments to reap returns while championing environmental sustainability.

What Are Green Bonds?

Green bonds are fixed-income debt instruments whereby an issuer (usually a mega-corporation, government, or well-established financial institution) borrows significant capital from investors,, which they use for sustainability-focused projects. The bond issuer typically raises a predetermined amount of money from investors over a set period (maturity), returning the capital (principal) when the bond matures and paying an agreed amount of interest (coupons) along the way.

Because green bonds are typically connected to assets and guaranteed by the issuer's balance sheet, they have the same type of credit rating as the issuer's other debt obligations. Green bonds provide tax benefits such as exemptions and credits, making them more attractive investments than conventional taxable bonds. These tax breaks offer a financial incentive to address pressing socio-economic challenges such as climate change and the transition to renewable energy sources. 

Although green bonds are typically available to institutional investors, individual investors can gain indirect exposure by investing in green bond exchange-traded funds (ETFs) and mutual funds. The Calvert Green Bond Fund (NASDAQ: CGAFX) is an example. Green bonds do not differ much from traditional bonds, except the funds are strictly for energy-efficient or renewable energy investments or for financing other projects that meet core sustainability requirements typically formalized in a framework developed by the issuer. Green bonds often involve at least one third-party firm to underwrite, certify and monitor the bond issuance.

What Do Green Bonds Fund?

Green bonds fund new or existing projects that deliver environmental benefits and a sustainable economy. Green projects encompass initiatives that promote energy efficiency, clean transportation, conservation, sustainable resource use and climate change adaptation. 

Other aims include sustainable agriculture, pollution prevention, clean transportation, aquatic and terrestrial ecosystem protection, clean water and sustainable water management. A  portfolio-wide installation of efficient building technologies also falls among these categories. These projects are usually large and ambitious in scope.

Historically, green bonds have been issued by multilateral lenders such as the World Bank, the African Development Bank (ADV), the International Monetary Fund (IMF) and the European Investment Bank (EIB). However, mega-corporations and government bodies now issue green bonds as a part of their ESG initiatives. 

How Do Green Bonds Work?

Green bonds work essentially like any other government or corporate bonds. However, unlike traditional bonds, green bond issuers publicly state how the proceeds will fund sustainable investments, thereby ensuring the bond is marketed to investors as green. Although there are no existing universal rules guiding the issuance of green bonds, the guidelines provided in Green Bond Principles (GBPs) and Climate Bonds Standard (CBS) regarding appropriate fund usage, project selection processes and reportage are popularly adopted. 

Typically the pre-issuance report describes the project or investment considered for a green bond, detailing how such investments will achieve the issuer's desired impact. This report can be prepared by an external party and involves four levels:

  • Opinion from a second party regarding the bond's overall alignment with GBP guidelines
  • Verification against defined environmental or corporate criteria, such as objectives based on science 
  • Certification following a third-party standard, like CBS
  • A rating based on an external methodology 

Issuers can develop a framework that meets their sustainability or environmental goals and use it to issue multiple green bonds. Since there's no governing body, they can self-label and perform internal impact verification on such bonds. Once the bond has been sold to raise capital, the issuer oversees the usage of the proceeds to meet the bond's objectives. 

Project funding can be direct, with the issuer purchasing equipment or hiring contractors for execution. Furthermore, the issuer can use the proceeds to finance service agreements like Energy Service Agreements (ESAs) in coordination with energy service companies. Issuers regularly release or distribute post-issuance reports to investors. This practice accounts for the use of the proceeds and progress toward the bond's goal realization.

Where to Buy Bonds

Types of Green Bonds

Although green bonds typically fund environmentally friendly projects, specific debt instruments may differ based on proceeds usage, issuer and collateral (in case of liquidation). Some typical green bond types you may come across in the market are:

Use of Proceeds Bond

A use of proceeds bond is a green bond that solely finances green projects. The proceeds from the bond sales are typically channeled into promising green projects. Lenders have the legal right to demand compensation or payment from the bond issuers in the event of liquidation. The issuer's other assets can serve as collateral in fulfilling these legal debt obligations. This type of bond carries the same credit rating as the issuer's other bonds. Examples include the EIB's Climate Awareness Bond and the Barclays Green Bond.

Use of Proceeds Revenue Bond or Asset-Backed Securities (ABS)

Asset-backed securities are green bond types used to finance or refinance green projects. For collateral, this debt leverages revenue streams accrued from alternative sources, such as those collected by the issuers via taxation or fees. Municipal bonds (muni bonds), often issued by states or local governments, use this structure.

Project Bond

Project bonds are green bonds created or earmarked for a specific underlying green project or a group of interrelated green projects. The implication is that these bond types are limited in scope. Investors only have recourse to the balance sheet and assets related to the project. A typical example is Invenergy Wind Farm (backed by assets including the Invenergy Campo Palomas wind farm).

Securitization Bonds

Securitization bonds are debt instruments that target financing or refinancing of debt portfolios. A debt portfolio typically contains a group of green projects systematically gathered together for optimal exposure, such as solar leases and green mortgages. The bond portfolio's total inventory of projects serves as collateral against liquidation. Examples include Tesla Energy (backed by residential solar leases) and Obvion (backed by green mortgages).

Covered Bonds

This debt investment funds a group of green projects referred to as the covered pool. The covered pool is basically a portfolio of eligible green projects earmarked by the bond issuers based on preset criteria. Investors have recourse to the issuer in this instance. However, if the issuer can't fulfill the debt payments during liquidation, bondholders have recourse to the covered pool. Berlin Hyp green Pfandbrief and Sparebank 1 Boligkreditt green covered bonds are typical examples of covered bonds.

Loan

Green loan finance eligible green projects or back qualified green assets. Financing for these green projects may be secured (backed by collateral) or unsecured. For unsecured green loans, the issuer's other assets serve as collateral in the event of liquidation. For secured loans, lenders have full recourse to the predetermined collateral — and, in some cases, limited recourse to the issuer's assets. Examples of some top green loan bonds include MEP Werke, Ivanhoé Cambridge, Natixis Assurances (DUO) and OVG.

Other Debt Instruments

These offerings include other debt instruments that directly or indirectly finance green projects but do not fall under the above classifications. Convertible bonds or notes, Schuldschein,  commercial paper, Sukuk and debentures all fall under this category.

Benefits of Green Bonds

Unlike conventional bonds, green bonds offer various benefits to investors and issuers. Some of these benefits are:

Tax Advantages

Green bonds provide tax advantages such as tax exemption and tax credits to incentivize potential investors and help investors to earn non-taxed income on their interest.

Diversification

Investing in green bonds is an excellent way to diversify your portfolio to reduce overall risk exposure. Green bonds are typically low-risk investments. Their standard debt collateral framework ensures lending investors are exposed to the lowest possible risk.

Encourages Socially Responsible Investing

Green bonds can help socially conscious investors put their money where their values are. As a core part of a much larger trend that is environmental, social and governance (ESG) investing, green bonds have a mission built into the investment itself. Investing in green bonds translates to real-life efforts to make the world a better place.

Cost-Efficient and Scalable Capital 

The issuer generates significant funds at a considerably low rate by selling green bonds. Such substantial sums are especially helpful in funding capital-intensive projects or smaller investment portfolios.

Full Control

Green bonds offer issuers more discretion regarding proceed usage. Issuers have the flexibility to set repayment as desirable. This aspect enables them to support diverse projects with extensive payback periods.

Additional Costs Associated With Green Bonds

Although beneficial, green bonds are associated with additional costs, potentially making them more expensive than conventional bonds. Some of these extra costs are:

Administrative Costs

Administrative costs entail the upfront and ongoing transaction costs required to demonstrate the environmental impact of underlying green projects to prove the bond's green integrity. The administrative fee also encompasses the cost of investor management.

Certification and Verification Costs

Bond issuers are susceptible to reputational risk if a bond's green credentials are challenged. Green bonds must therefore undergo certification following popular standards like CBS and verification against established criteria. Both processes cost money and are often included in the administrative cost.

Monitoring and Reporting Costs

These costs are related to monitoring underlying green projects to ensure their green integrity and the expenses incurred in the annual reporting of the project progress.

Frequently Asked Questions

Q

How do you choose green bonds?

A

Your choice of green bonds will depend mainly on your socio-economic preferences (the sectors you wish to impact positively) and the bond’s credit potential.

Q

What are the key features of green bonds?

A

Green bonds’ core feature lies in their usage in funding projects that strictly deliver extensive environmental benefits, a more sustainable economy and a favorable climate impact.