According to the International Energy Agency, we can expect global warming of 6 to 7 degrees Celsius (10.8 to 12.6 degrees Fahrenheit) over this century. Yet if paleontological records of past peaks in greenhouse gases are any indication, “global frying” might be a more apt phrase. The IEA does say, however, that we have a good chance of avoiding the worst of this if we can make a rapid transition to a low-carbon economy. This would involve some $36 trillion of global investments beyond business as usual through 2050.
The clock, however, is ticking fast. There are massive, productive investments to be made in green projects. At the same time, there is an oversupply of risk-taking capital at very low yields.
Green bonds have evolved as one way to bridge the supply-demand gap between debt capital markets and targeted green investment projects. In 2014 the asset class trebled impressively, reaching $34 billion. Put in context, if we look at absolute size rather than growth rates, the green bond market is dwarfed by an average issuance of $100 billion per week in investment-grade bonds alone. Verizon Communications raised $49 billion in funds — more than the amount outstanding in the total labeled green bonds market — in one short day last year to help fund the acquisition of Vodafone’s 45 percent stake in Verizon Wireless. Why could we not harness such market power into investments dedicated to growing a low-carbon economy?
If you accept the impact that climate change will have on the world’s economies, it is perplexing to see large investment houses dedicating often minuscule fractions of their assets under management to investments aligned with climate change mitigation and adaptation, such as dedicated green bond funds. A 2 percent allocation to such dedicated funds draws attention to the issue, but what we actually need to see is large chunks of mainstream portfolios allocated to the task. The risk, however, is that dedicated green bond funds could, over time, prove detrimental to that allocation to green bonds in mainstream portfolios. Let us explain.
First, natural switches in bond funds, which are sources of trading profits, may be restricted owing to the relatively small size and limited diversity of green bonds. If you trade supranational bonds in a venue like the World Bank, at which there are many bonds outstanding on the yield curve, selling a nongreen bond to buy a green is generally a much easier decision than buying a new green bond outright. Such natural switching opportunities are not available for a wide range of bonds, however, which might lack a green bond equivalent.
Second, one of the first lessons you learn as a trader in that environment is to avoid being a forced buyer or seller of anything. Funds in the green bond space that set quantitative targets on how much they need to buy make themselves so-called axed buyers, that is, they make their preferences obvious. It’s natural for banks and other market participants to reverse engineer such knowledge and offer worse pricing. As in poker, showing your cards clearly runs the risk of underperforming. On top of that, when it comes to primary-market issuance, issuers and banks can target forced buyers to make prices uncomfortably high. In turn, that puts off market-driven investors from joining green bond syndications, further dampening demand and slowing green bond market growth.
Finally, suppose a large bond fund decides to make that 2 percent allocation into green bonds, which would still be considered a fairly large number in today’s marketplace. Is it likely that the best portfolio managers will be dedicated to such a small subfund? There is a chance that such green bond funds will be managed by more junior managers, who are likely to have smaller risk mandates than do more senior managers. These mandates tend to be more restrictive in terms of alpha potential.
Overall, the conclusion is that constraining green bond investments to only a small fraction of larger portfolios is likely to induce underperformance of the asset class, which again, if it occurs over long periods, will deter investors from including green bonds in their core funds. From a trader’s perspective, you are better incentivized to trade green bonds if you are not constrained to the format of dedicated green bond funds.
Besides performance issues, it is worth understanding the difference between direct and indirect impacts from green bond investors on finance in the real economy. Direct impact occurs at one point only: when the bond gets issued in the primary market. Something classified as a green bond portfolio, with 100 percent of capital invested in the asset, may have directly contributed zero percent cash to green projects or refinancings, if the bonds were bought on the secondary market. The purchase of green bonds in the secondary market could have an indirect impact on green financing, however, if the seller of the green bond reinvests the money from the trade into green bonds from the primary market.
Investors wanting to maximize their direct impact on green financing should aim to maximize their investment in green bonds in the primary markets. To do that, they must roll over their green bond portfolio at a faster rate. For example, there is a tenfold difference between the direct environmental impact of a portfolio that rolls its holdings over twice a year, versus one that rolls them over every five years. End investors should be aware of this feature if they want to have a more tangible impact on the real economy.
So, suppose green bonds make a quantum leap, become a playground for everyday bond managers, and the potential for inflows grows into the trillions. What will the challenges be then?
If anything, there might be a lack of projects to fund. There is a gradual shift among issuers of corporates to thinking pro-actively around this, but we believe policymakers and financial intermediaries can help too. We know there are plenty of potential green projects that may not hit internal rate of return targets, which may be set quite high to bring enough return to stakeholders. An environmental project that looks to produce an IRR of 10 percent versus a required 15 percent might get binned, although from a broader societal standpoint, accounting for environmental positive externalities, it might still be profitable.
We’re going to need policymakers to utilize equity and mezzanine financing as an effective way for constrained government budgets to get more environmental projects going. If the public sector takes this role, bond markets will be there to provide the senior part of the capital structure.
Embrace and leverage that willingness. Our economies need it.
Ulf Erlandsson is a senior portfolio manager of credit, global macro trading, at the Fourth Swedish National Pension Fund in Stockholm, and Sean Kidney is the CEO and co-founder of the Climate Bonds Initiative in London.
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