Green bonds: ESG investing meets the fixed-income market

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Can fixed-income assets help the environment?

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Interested in funding a renewable-energy project and getting paid for it? You’re not alone. Green bonds—fixed-income securities on environmentally sustainable projects—have become popular investment vehicles in the climate change fight. Green bonds also fit into the larger scope of sustainable or environmental, social, and governance (ESG) investing.

But let the buyer beware: When it comes to this investment vehicle, you need to know what green bonds are and, more critically, what they aren’t. When green bonds were first launched, some turned out to be linked to not-so-green initiatives. As with any investment, do your due diligence to avoid getting greenwashed.

Green financing has been around for years, such as when municipalities issue bonds for environmental reasons like improving water-treatment plants. What makes green bonds different is that the green bond market structure makes it easier for investors to track the environmental part of a particular bond’s proceeds of use.

To specifically address climate change, the World Bank launched a strategic framework for development and climate change in 2008 to encourage and coordinate public and private sector investment. The European Investment Bank issued the first green bonds starting in 2007: AAA investment-grade bonds from multilateral institutions.

Green bonds work like any other fixed-income security. An entity, usually a government or a corporation, wants to raise money and does so by issuing bonds. Bond buyers loan the entity money, and in return, the buyers are eventually paid back the face value of the loan, plus periodic interest payments. As with all bonds, prices fluctuate inversely with interest rates, and investors should know the credit rating of the entity issuing the bond to understand the default risk.

It’s the next step that makes green bonds different from regular bonds: Issuers create a “framework” that details the bond’s environmental and sustainability objectives, and establishes how the issuer will track the money spent from the initial sale. Common green bond projects include:

When green bonds come to the primary market, the Climate Bonds Initiative, a global nonprofit focused on using debt markets for climate solutions, reviews the bond. It uses a taxonomy based on climate science and research from the Intergovernmental Panel on Climate Change, the International Energy Agency, and other experts.

The Climate Bonds Initiative identifies projects that are needed to deliver a low-carbon economy and are consistent with the 1.5 degrees Celsius warming limit in the 2015 Paris Agreement. It uses a traffic-light system to indicate eligible assets and projects:

The CBI also keeps tabs on the number of green bonds issued annually; for 2023, the organization forecasted the green bond market would be $85 billion. That figure is growing, but it’s a fraction of the $119 trillion global bond market.

The group labels three types of green bonds:

To receive the Climate-Bond Certified designation, an issuer must:

Beyond the typical credit analysis for any fixed-income product, buyers should also look deeper into the issuer’s proceeds of use, overall ESG strategy, its track record of issuing bonds, and the verifier’s track record.

Green bonds that align with CBI’s green definition follow the organization’s standards, but the issuer isn’t paying for certification and verification.

Green bonds not aligned with the CBI’s definition may still follow the “Green Bond Principles,” which is a voluntary best-practices guide overseen by the International Capital Markets Association (ICMA), a trade group for capital markets participants. Those principles recommend transparency and disclosure of proceeds use, and “green” can be quantified by the issuer.

CBI’s standards can give investors confidence that a green bond mitigates climate change. This helps investors avoid greenwashing—that is, investments that claim to be environmentally friendly but don’t actually cut carbon emissions. An oft-cited example happened in 2017, when Spanish energy company Repsol (REPYY) issued green bonds to make its oil refineries more energy efficient.

Green bonds are considered part of ESG investing, particularly because they focus on the “E” part. Many investors like green bonds because it’s easy to identify how the money is spent.

Although CBI labels types of green bonds, investors need to beware because there are no global standards defining them. Any entity can come up with its own framework for how it mitigates climate change.

In the past, the People’s Bank of China and Chinese regulatory guidance allowed green bonds for “clean coal” plants—standards that don’t align with other countries’ frameworks to reduce greenhouse gases. Additionally, some green bond projects financed nuclear power plants and large hydropower dams, two types of low-to-no carbon-emitting power sources that are controversial in some environmental circles.

Buyers should also understand that green bonds are different from other ESG investments in that companies that issue green bonds may have lower social or governance scores. For example, a fossil-fuel company may issue a green bond for a bona fide green project, such as a solar plant. This is another reason for investors to understand what they are buying.

Green bonds can be a solid component of a diversified portfolio. However, these vehicles are often in high demand when they come on the market, especially the CBI certified bonds. When demand is strong for a bond, its price can rise beyond what’s reasonable relative to other bonds. And because a bond’s yield moves inversely to its price, your return may be lower than you’d like.

Another option for the retail bond investor is a green bond exchange-traded fund (ETF). Many of the top fund companies run green bond ETFs; two popular ones are the iShares USD Green Bond ETF (BGRN) and the VanEck Green Bond ETF (GRNB). And again, before investing, take a look at the fund’s prospectus to understand how the fund selects securities.

Green bonds are a small but growing part of the bond market, and if you’re an ESG-minded investor, they offer a way to add fixed income to your portfolio. However, as with any sustainable investment, it requires extra due diligence beyond the typical research you might do for a traditional fund.

Be sure to understand the track record of the entity issuing the bond and how it uses the proceeds to avoid getting greenwashed.

Specific companies and funds are mentioned in this article for educational purposes only and not as an endorsement.