The Smart Bet on Green Bonds

by Zach Stein, Co-founder of Carbon Collective

Aug 28, 2024

If you’re like us, you spend a lot of time thinking about the climate capital stack.

According to the IEA, the world needs to be investing $4 trillion per year in clean energy by 2030 to be on track for a new zero-energy system by 2050.

Where’s that capital going to come from?

As MCJ readers, you probably have a natural assumption that it’ll be some private investments with government incentives and backing that will fill that gap.

But do you know what private investments need to thrive? Public markets.

For the amount of capital and investors that we need to get in at the beginning and middle of these companies and projects to hit our climate goals, we need a very active public market ready to acquire that debt or equity at the end. Without a plausible exit, earlier stage private investment dries up.

From a returns perspective, green bonds are a strong alternative to traditional bonds. For individual investors, they provide a transparent way to track the emissions avoided through their investments, like a retirement fund. And from a collective-impact perspective, we’ll be unlikely to hit our global climate investment goals without them.

What’s a Green Bond?

Green bonds are securitized debt instruments issued by governments and corporations with a specific mandate to invest only in green projects like renewable energy, new green buildings, or energy retrofits for old buildings. These bonds not only provide audited sustainability reports (like this one from Avangrid) but also offer diversification and potentially lower risks for investors.

For the issuer, the bond structure has proven to be a cheaper source of capital than bank loans in these times of high interest rates. When a company issues a $500m bond, individual institutional investors will ask for allocations in $5 - $10m chunks. Because each investor is only taking on a small part of the bond, the risk to the investor is lower than if a bank issued a loan for $500m. The impact of default on the bank would be much higher than a given individual bond investor, meaning that green bonds have given profitable, investment-grade companies some (small) relief in this high interest rate environment.

Here’s how Bloomberg NEF analyst, Atin Jain put it in a recent article from the team at Heatmap:

“Where possible, if you’re a creditworthy issuer and you’re more financially stable and have the ability to make regular interest payments, you have been viewed attractively by the bond market,” Jain told me. Bond issuance by utilities and renewable developers has more than doubled since before the pandemic, according to BNEF data. “That’s how people are navigating this environment: cutting loan tenors, doubling down on bonds. Everyone is hoping that though they have to tap more expensive debt now they’ll be able to refinance those loans.”

Second, for investors, the liquid nature of these bonds enables them to package any given green bond with a series of others further to reduce the impact of any specific issuer defaulting on the debt.

50 Shades of Green (Bonds)…

But like any part of the climate-capital stack, the risk of greenwashing in green bonds is very real.

In general, there are 4 categories of green bonds. Two of them have a clear quantifiable impact, while the others are less clear.

One of the more popular forms of green bonds sounds impactful in principle but rarely seems to play out that way in practice (at least so far). Sustainability-Linked Bonds (SLBs) are generic corporate bonds (meaning a company can use the cash raised for any purpose) that will pay out a higher yield if the company fails to meet predetermined emissions reductions.

Again, that sounds great in theory. The perfect market-driven way for a company to price in its failure to decarbonize. But to work it requires companies to make failing to hit their goal extremely painful. And that hasn’t happened. Most SLBs only start counting emissions reductions in the final 1-2 years of the bond and the price of failure is relatively minor, something like a 0.25% bump in coupon. So, on a $1b bond, failing to hit their target could cost the company up to $5m in additional interest payments. That might sound like a lot to you and me, but for investment-grade corporates, that’s a rounding error and not a major motivator to stretch further on decarbonization.

The Important Role of Green Bonds in Solving Climate Change

Fortunately, the use of SLBs has been declining while use-of-proceeds green bonds that disclose how each dollar in the bond was actually allocated (this is the kind we like) has been growing significantly, with over $4 trillion of green bonds having been issued in the last 5 years (not including 2024).

That’s awesome. Because climate finance is like a supply chain, and public securities are almost like the end consumer. When more public securities are looking to acquire green projects and companies, a signal gets sent down to the rest of the capital stack to tee up more supply.

The inverse is also true. If we see demand for publicly traded green bonds shrink, we would similarly expect to see a dampening effect on the entire capital stack as earlier-stage investors lose confidence that they will be able to exit.

In 2023, the globe issued about $500 billion of green bonds. That’s a lot, but it’s still well short of where we need to be for our energy transition goals.

The Unique Financial Upside of Green Bonds

So as an investor, should you invest in publicly traded green bonds?

On the surface, green bonds are fairly attractive. In the US, you can generally get the same yield on a green bond as the same corporation's generic debt. And, at least according to this report from LSEG, the default rate in green bonds has been “significantly below the average default rate of the broader market.”

So the same reward for potentially lower risk and a quantifiable impact as compared to the generic bond alternative?

I’m listening.

But there’s a world where it gets even better. How? Ask your local central banker.

The Federal Reserve in the US and Central Banks around the world have a dual mandate: keep inflation low and employment high. We’re seeing the impacts of them working on the former right now with elevated interest rates around the globe.

Central banks really don’t like inflation.

So what are they going to do about climate change?

It’s not (yet) getting the attention in market commentary that it should but be ready to start hearing the link between climate-driven shortages of key staples and inflation (aka “ClimateFlation”) a lot more in stock market commentary.

In 2024 alone we’ve seen:

Unprecedented drought in Panama led to weeks of delays in global shipping.
Extreme Sahara winds and drought in Western Africa led Cocoa prices to hit all time-highs.
Rice, arguably the most important food staple in the world, jumped to the highest prices since 2008 after El Nino conditions impacted outputs.

The question is not if, but when climate change is brought up regularly by the Fed and central banks. As we all know: it’s here. It’s getting worse. And it’s wreaking havoc on supply chains.

So what can central banks do about it?

They have tools. They can incentivize financial vehicles that specifically build projects that reduce emissions and harden supply chains. They can give subsidized credit rates to banks to increase their green lending. They can enable banks to operate with more leverage if they keep more green bonds on their books. And they can even push for fiscal policy changes, like making green bonds qualify for a similar tax status to municipal bonds or US Treasury bonds (no state tax).

Should any major central bank undertake any of the above actions, it could result in an overnight increase in value for outstanding green bonds.

Green bonds not only match the yields of traditional bonds but also present unique financial upsides. Central banks could further enhance their attractiveness through policy measures like subsidized credit rates or favorable tax statuses, making them a valuable addition to any investment portfolio.

In the fight against climate change, green bonds are not just a financial instrument—they are a beacon of hope, guiding us toward a sustainable and resilient future. As investors, we have the power to accelerate this transition by embracing the green bond market.

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