Sunday 15 November 2020 2:51 pm

Explainer: What are green bonds? And how will the UK’s first green gilts work?

Chancellor Rishi Sunak announced yesterday that Britain will issue its first green government bond next year, in a bid to capitalise on growing investor demand for assets that fund environmentally-friendly projects. 

The market for investments with an environment, social, or governance (ESG) focus has increased exponentially in recent years. Around $250bn (£189bn) of green bonds were sold last year, amounting to around 3.5 per cent of bond issuance globally. 

But how do green government bonds differ from typical gilts? And how will the environmental credentials of the government’s new bonds actually be determined? City A.M. spoke to Saxo Bank fixed income strategist Althea Spinozzi to find out how the bonds are expected to work. 

How are green bonds different from typical government bonds? 

“The funds that are going to be raised through green bonds have to be directed to renewable energy or clean energy projects,” Spinozzi explains. 

“The government will not be able to use the funds to finance any policies they want, like employment or health, these will be just directed to renewable and clean energy.”

“The UK coming to the market is going to set an example to other governments on issuing green bonds, because at this moment in time – when there are lockdowns and dire economic circumstances – governments can secure quite cheap funding,” she continues.

“They would rather do it now that rates are at historic lows, so they can get green funding cheaper now than at any other time. I think we will see more of this coming.”

But how are the green credentials of these investments measured? Who decides what counts as environmentally friendly?

“This is quite a controversial issue. At this point, it is just the trust in the government. The government will need to impose a supervision of these funds and where they will flow,” says Spinozzi. 

Sunak yesterday spoke of plans to create a framework for the investments, she continued, with the government planning to establish rules on what counts as a green investment. Such a system is likely to be based on EU rules, with some possible adjustments for the UK. 

Why do green bonds trade at a premium? 

“There is no mystery behind it, it’s a simple matter of supply and demand. At the moment, there have been very few governments that have issued green bonds, although we have seen more corporates issuing them.”

However on the buy side, Spinozzi continues, asset managers and pension funds have increasingly large mandates to purchase green bonds and ESG assets. “So there has been great demand and very low supply.”

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There had also been expectations of a spike in green bond issuance this year, but the coronavirus pandemic has been very disruptive to markets, meaning the anticipated dramatic increase has not occurred. 

“The reality is that governments and to a certain extent also corporates can issue green bonds cheaper,” she says, “just because there is much more demand than supply.”

Why do investors opt for green gilts over regular sovereign bonds?

Although environmental concerns or ESG mandates may be a factor, the main reason investors will buy green bonds is a belief that demand for them will be sustained, says Spinozzi. 

The UK government’s green gilts will be issued in sterling, she continues. Data from Bloomberg shows there are currently 42 issuances of green bonds in sterling – mainly corporate bonds – with a total value of around £11bn, making it a very small market. 

“People should look at these assets because they know in the midterm that demand will continue to be sustained, because there is not enough supply, especially in sterling,” Spinozzi says. 

The environmental aspect of these gilts is also a key attraction for some investors, especially institutional investors such as asset managers and pension funds.

“Institutional investors will have a mandate to invest in these type of assets,” Spinozzi continues. “They will buy them to invest in ESG and green energy.”.

“But retail investors might buy these securities just because of economic reasons. They see there is upside, and they see the potential for capital appreciation.”

Should investors be concerned about the risk of ‘greenwashing’ – marketing products as more environmentally-friendly than they actually are – with green bonds?

“This market is at an early stage,” says Spinozzi. “I would not be surprised if later down the line there are some cases that emerge that conflict with green bonds’ policies, but at this point in time investors just have to trust the issuer.”