Focus on Fixed Income: Actively managing today’s green bond opportunities
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In this article we examine the process for green bond labelling and certification and its implication for index investors. Passive (index-tracking) green bond funds are bound by eligibility rules and each index has its own labelling requirements.
We strongly believe that a well-balanced green bond portfolio should have a wider remit, to include issuance from companies that are actively contributing to the growth of a low-carbon economy, even if their debt is not labelled green. From an investment point of view, there are significant opportunities in this space.
What defines a green bond?
Green bonds first appeared in 2008 with an issue from the World Bank. Since then, environmental, social and governance (ESG) mandates, as well as issuance to finance climate-related expenditures, have gained prominence as concerns over greenhouse gas (GHG) emissions and climate change have grown. Green bonds are a key tool in efforts to decarbonise the global economy and are set to see rapid growth.
Given the absence of a legally binding system, the definition of a green bond is complex. The International Capital Markets Association (ICMA) maintains a classification framework, originally established in 2014, referred to as the Green Bond Principles (GBP). Although adherence is voluntary, it is worth looking at the key components in order to understand what is seen as green financing:
● Use of proceeds (UOP): this needs to be adequately defined in the bond prospectus. In standard bonds, the UOP is often simply ‘General Corporate Purposes’. To be considered as green, at a minimum, the UOP should clearly indicate the projects to be financed or refinanced by the proceeds, why these projects are environmentally beneficial and their effectiveness in meeting the issuer’s decarbonisation goals.
● Process for project evaluation: this includes a description of the issuer’s sustainability objectives, its process for determining the eligibility of a project as green and the process for managing environmental and social risks.
● Management of proceeds: proceeds from green issuance need to be virtually (but not legally) segregated and linked to the green projects in a credible way.
● Reporting: the issuer should regularly provide up-to-date information on the progress of the projects detailed in the UOP. This can be an internally or externally certified process and allows the formal labelling of an instrument as a green bond.
The Climate Bond Initiative (CBI), an international non-profit agency, has introduced an independent Climate Bond Standard certification scheme to help reduce due diligence requirements for investors. This is also a voluntary scheme.
The GBP and the CBI certification system were originally designed to provide a framework for companies that were not in the business of climate mitigation, but which could demonstrate to investors that certain issuance was for green investments.
Bonds from ‘green pure-plays’ – companies whose revenues are entirely from green activities – were almost non-existent at the time, something that has now changed significantly.
Examples of green pure-plays include companies producing solar panels, wind turbines or electric vehicle charging infrastructure. Such companies are part of the drive towards a decarbonised future and in our view their debt should be considered as being aligned with environmentally sustainable investment goals, even if they do not seek a formal label.
Crucially, only a third of the climate-aligned bonds identified by the CBI are labelled as green bonds.1 In addition, some companies may have projects that meet GBP criteria, are certified and index-compliant, but these businesses may still be in industries that are often avoided by ESG investors – such as oil and gas, industry, and mining. As green investors, we need to be mindful that the mechanics of the supply chain mean that most emissions occur upstream – so there is a requirement to extend the conversation to cover these industries.
Indices, and by extension passive green bond funds, are bound by eligibility rules. Each index has its own labelling requirement, either through strict or broad alignment with the GBP or CBI criteria. We believe that active management can add value in such a relatively new field as it can tap into opportunities around unlabelled company debt.
Beyond the green label (or lack of one), an active manager will primarily consider the fundamental credit profile of the issuer (using a bottom-up approach), ensuring that the manager picks companies that are fundamentally creditworthy.
In our view, the analysis should not stop there. A thorough review of the environmental sustainability of that company’s business model, its performance on key environmental performance indicators and the governance arrangement in place – at the company and also surrounding its ‘green’ commitments – should also be carried out to ensure that the green projects will meet their goals.
Academic research2 has demonstrated that there is a positive, statistically significant link between a company’s environmental events and its valuation, with recent studies based on companies within the S&P 500 supporting the theory that there is a positive relationship between environmental performance and valuation. Other, broader studies have also backed the theory that stronger governance and shareholder engagement are linked to higher valuations.
A holistic approach to green bonds
In our opinion, there are merits in continuously benchmarking each green bond against its peers and moving into issues that offer greater relative value, as opposed to following an index or holding bonds to maturity.
Franklin Templeton’s European fixed income research team looks at green bonds holistically; we establish a baseline level of environmental impact reporting for all issuers held in a portfolio, regardless of whether any particular bond is labelled green. As a major global fixed income investor, we are also well-positioned to engage with the management of companies on an ongoing basis, both around their ESG commitments and the underlying credibility of their business plans. The research team then assesses issuers based on the extent to which:
● The issuer can pay the interest and coupon on the bond as it falls due;
● It supports the transition to a low-carbon future;
● It has an appropriate governance structure; and
● The operational processes and practices that make up the company’s environmental management systems are adequate.
Our active approach to investing in green bonds allows our portfolio managers to apply discretion while still investing in bonds that provide environmental benefits. We believe this approach can also deliver superior risk-adjusted returns for investors in an area of the market which is still in its infancy.