Green Bonds are Giving SRI a BLACK EYE


This article marks my website's first commentary on the fastest growing trend not only in social investing but ALL of investing.  No, I'm not talking about Enhanced Exchange Traded Funds.  In just the last five years, the emerging asset class of Green Bonds has come from nowhere, growing to $36.6bn (2014) outstanding.

A "Green Garage" courtesy of The Wall Street Journal

Climate Bonds Initiative (a leading London-based research organization in this area) thinks the market will more than double in 2015, to nearly $100bn after tripling in 2014 (see graph).  Total issuance reached $24.5bn year-to-date as of August 2015, so it appears that forecast is untenable. The total addressable market amounts to over $0.5 trillion.

Source: Climate Bonds Initiative, Barclays.



What is a Green Bond?
Green Bonds (aka Climate Bonds) are fixed-income instruments whose proceeds go towards a benefit to the environment.

Types
Green bonds are similar to other bonds. The main types are "Use of Proceeds", Project Bonds and Securitized Bonds. Use of Proceeds use either dedicated revenue streams as collateral backing the bonds, or are standard bonds which are backed by all of the issuer's cash flows. Project Bonds, as the name implies, are backed only by specific projects and not the issuer.  Securitized Bonds are asset backed vehicles that are specially-structured and designed

History
The evolution of Green Bonds is similar to what has been seen for early stage industries. The modern Green Bond "movement" began in 2007 when supranationals, mostly highly-rated banks (e.g., European Investment Bank) issued their first bond. Years later the market broadened to public finance/municipal entities and corporates. During 2014, a corporate name issued the first high-yield bond.  That year, 2014, was a key catalyst for Green Bonds as the market grew deeper and broader. It is very important for the Green Bond market to have corporates in the same manner that the junk-bond market propelled corporate financings during the 1980s (we'll leave Michael Milken out of this one!)

Proceeds by Issuer Type (source: Climate Bonds Initiative)





The U.S. Green Bond market
The U.S. took a back-seat during the Green Bond market's early years.  The Europeans have taken the lead due to their socialist nature (see chart below from Climate Bonds Initiative). Several European asset owners and investment managers have signed on to the United Nations Principles for Responsible Investment (PRI) initiative.  Furthermore, European governments have encouraged (via subsidies) socially responsible investing and green projects such as solar power, wind, etc.  Though recently, large liberal States (and cities) of California and Massachusetts have issued municipal Green Bonds.  Given the overall SRI movement in the U.S. and the influence of large pension finds (i.e., TIAA-CREF) corporate issuers are expected to become a larger contributor to the overall Green Bond market.


At this time, the only investment vehicle that focuses in Green Bonds is a mutual fund called Calvert Green Bond (CGAFX). The fund has underperformed, partially due to its high front load (3.7%) though it has underperformed other funds too. It invests 90% of its assets in the U.S. and has an effective duration (maturity) of 5 years.

Recently, Ameriprise Financial subsidiary (Columbia Threadneedle) opened a new muni fund called Columbia U.S. Social Bond Fund which utilizes ESG criteria.

Where do we go from here
The Green Bond market was born in Europe, broadened in the U.S. but it will reach escape velocity in Asia.  During 1Q'14, Toyota Motor Corp. issued the market's first ABS, backed by auto leases. The proceeds were earmarked towards electric vehicles.  Despite its $1.8bn size, the Japanese market will pale in comparison to the tidal-wave of Green Bonds emerging in China, according to a study conducted by The Intl. Institute for Sustainable Development.

Anyone that has ever visited China or ran the Beijing Marathon could see for themselves that pollution is a BIG problem.  Some observers say environmental costs may be as high as 10% of GDP.  Consequently, the Chinese State Council announced plans to grow a corporate Green Bonds market as part of its Five-Year Plan. There are several drivers that are expected to quicken this pace including:
  • High levels of household savings
  • the movement away from Shadow-Banking towards transparent markets
  • limited financing for small and medium-sized businesses
  • Urbanization and its affect on public health
  • High foreign investor demand
  • Large infrastructure programs that are Green Bond friendly (see below)
Transport, primarily rail, will be a dominant way of reducing emissions in China, according to the IEA. Despite declining rates of rail investments here in the U.S., China recently added 6,000 km of high-speed rail track - which is double the ROW.
Beijing Marathon'14 (Reuters)
Green Standards Need to be Refined Yet Again
There are several standards that define what exactly (or not so exactly) a Green Bond is. The most popular are the Green Bond Principles and Climate Bonds Standard.  There are also Green Bonds indices in which investors can determine if a particular bond is an index component. Both sets of standards are evolving and voluntary. The Climate Bonds Standard was developed by the Climate Bonds Initiative. It is very focused on Green Bonds from solar and wind companies and needs to be broadened to other industries such as transport, water, agriculture, etc.  The Green Bonds Principles were developed by the ICMA and represents over 50 large financial institutions. It is a set of Best Practices for determining what is a Green Bond as well as the process of issuance, management of proceeds and reporting. The Green Bonds Principles were updated on March 27, 2015.  I read them and thought I had mistakenly read the executive summary as they were too general in scope.

When Green Bonds go Bad
There are several ways a Green Bond could turn ugly.  For example, bond proceeds may be diverted from their original noble cause towards activities that are not green. Green-proceeds may also be loosely-tracked and mixed with an issuer's other bond proceeds.  Reporting may not be transparent enough and assurances may not be objective or from a reputable third-party.  While the above risks are valid, I believe they could be lessened over time. But there is an even greater overarching issue...

Is Green Bond investing really Socially Responsible Investing?
The short answer is a resounding No!

Socially Responsible Investors seek to purchase those companies that are practicing ESG (Environment Social Governance).  These are companies that are striving to reduce their carbon-footprint, treat their employees (and community) well, and become more transparent. Few companies attain five-stars in all three letters, so investors emphasize certain areas.  But overall, SRI asset managers tend to judge the whole company.  The website Socially Responsible Investing, for example, focuses on how companies treat their employees because I believe if you don't treat your own well you will never treat society well either. Others focus on companies with a mixed track-record that are progressing towards social responsibility. Apple under Tim Cook is a good example of this.  Again, these asset managers are focusing on the merits of the whole company.

The overriding problem with Green Bond investing is that any company (or municipal) could issue such a bond so long that its proceeds go towards benefiting (i.e., less harm) the environment.  With this type of definition, I cannot see a case that a borrower can not issue a Green Bond. So if oil company BP Plc wants to issue a Green Bond to make a new efficient LEED-class building (something it may have been planning anyway) socially responsible asset managers would be allowed to purchase those bonds. (In fairness to the Calvert Green Bond fund, I had conversations with its lead portfolio manager and Chief Investment Officer Fixed Income (Catherine Roy) who understood my issues, but stated that Calvert has experience in SRI and would ensure that it was buying bonds of companies that are socially responsible overall.)

However, the Barclays MSCI Green Bonds Index does address the issue of whether or not the whole company is green-bond worthy in its 90% Rule.  This rule says that a general obligation bond is Green if 90% of its revenues fall under one of its five eligible economic categories.  While I give kudos to Barclays for both addressing the whole issuer and for listing specific economic categories and subcategories, they are too lenient determining whether a whole issuer is Green. For example, using its subcategories, a company is Green if it sells superconductors or building-insulation.

The Case of the Green Parking Garage
In March'15, the WSJ highlighted green bonds sold by Massachusetts (Salem State University) whose proceeds would be used to build a garage with electric-car charging stations. Officials said the garage would reduce pollution by cutting down students' circling the parking lot looking for spots. However, environmental advocates noted that having a parking garage still encourages people to drive and create greenhouse gases.

Conclusion
Green Bond investing properly executed will continue helping the broader investment world adopt SRI.  However, investors should fully understand the issuer's core business. Otherwise, these bonds will just be Greenwashing the issuer's dirty laundry.






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