Investors and bond issuers must improve communication in order to meet each other’s needs as the green-bond market expands rapidly.
Green bonds have the potential to enhance transparency, mitigate risk, and stimulate the market toward reaching a low-carbon economy. The green-bond market is estimated to total $150 billion in 2017. This is an 85 percent increase above 2016, according to data from Climate Bonds Initiative.
Despite this growth, the green-bond market is fraught with ambiguity and miscommunication between bond issuers and investors. A recent article in Stanford Social Innovation Review outlined the many challenges bond issuers face in matching their products to meet investors’ needs and vice versa.
“The major challenge to further growth lies in identifying a sufficient flow of projects that are attractive to private investors,” the article said.
Appealing to investors is crucial to tap into the $100-trillion bond market to finance environmentally beneficial projects. Plus, if investors are willing to pay a premium for green bonds, interest rates would drop, enabling bond issuers to enjoy a lower cost of capital for projects.
What are investors seeking? How can both investors and bond issuers better communicate and clarify their expectations for green bonds?
To find out, Conservation Finance Network spoke with Eric Glass and Robert Fernandez, two investors working on environmental, social and governance (ESG) investing strategies.
Glass is a senior portfolio manager at Alliance Bernstein, an international investment management and research firm that manages $480 billion in assets. He is also a member of the firm’s Responsible Investment Committee.
Fernandez is a vice president and director of ESG research at Breckinridge Capital, a Boston-based investment advisory firm that manages $27 billion in total assets.
Their insights illuminate three key dimensions of green-bond financing that influence how investors identify “attractive” bonds: long-term vs. short-term thinking, balance of ESG criteria, and traceability of impact.
Thinking in the Long Term
Investors are motivated to generate returns on their investments. But Glass and Fernandez said that when it comes to financing green bonds, profitability in general is less prohibitive than investors’ tendency to think about profit in the short-term.
This short-term view is pervasive in finance. In a recent report, McKinsey Global Institute summarized key findings from research conducted by FCLT Global: 87 percent of surveyed executives and directors felt pressure to perform well financially within two years or less. 65 percent indicated that short-term pressure has increased in the last five years.
Short-term goal setting can push investors away from investments in green bonds that fund municipal infrastructure projects that could span decades.
“We need to turn away from a short-term perspective,” Glass said. “It shouldn’t be about earnings from quarter to quarter. It should be about big vision and strategy and how we create a more sustainable world.”
Both Glass and Fernandez indicated that the long-term investment views of their firms enable them to integrate environmental and social considerations into their strategies. They said that smart, sustainable investments enhance resiliency to climate change and may prevent costly damage in the future.
Glass said, “The decisions that we are making from an infrastructure perspective today will have consequences for 40-50 years into the future. We are going to be feeling the impact of climate change…We will be well on that path.”
Balancing ESG Criteria
Both Alliance Bernstein and Breckinridge Capital finance green bonds as part of their ESG investment strategies. Therefore, to better understand how investors identify attractive bonds, it is important to realize that many investors consider green bonds within the broader ESG framework.
Glass works on impact investing for municipal bond portfolios. He explained that when he looks at a particular bond, he considers all three aspects of ESG – environment, social and governance criteria.
“Having a green bond for us is just fine, it’s great. But it’s not the whole picture… it’s one leg of the three-legged stool,” Glass said.
To get the “whole picture,” Glass and his firm launched a municipal impact strategy that measures key performance indicators and ESG criteria. For example, the scores for a sewage or public power project will be more heavily weighted for environmental criteria like water conservation or waste management.
Apart from environmental considerations, social values are also important for Glass when evaluating the attractiveness of an investment. He said, “We are trying to promote investment in underserved and low-income communities.”
These social considerations can determine which green bonds Glass chooses to finance. If presented with two municipal green bonds funding similar projects, one in an affluent area and one in a low-income community, he would finance the bond with the project in the low-income community for the greater impact it would generate. In this way, environmental considerations are just one piece of the puzzle when identifying attractive ESG investments.
Breckinridge also scores municipal bond issuers based on ESG criteria. The scorecards weigh different factors depending on the type of issuer, such as water and sewer utilities and school districts. With water and sewer utilities, for example, 15-20 percent of the score has to do with drought-related risks.
In addition to ESG criteria, diversification is particularly important at Breckinridge. “For our municipal bond clients, one of our primary objectives is to build a diversified portfolio,” Fernandez explained. He aims to construct portfolios with certain percentages of different sectors like school districts or water and sewer utilities.
Green bonds’ place within the greater ESG investment landscape means that they are often just one piece in a larger, more complex puzzle in which investors consider a variety of factors to assess which investments are most attractive for their portfolios.
Though positive environmental and social benefits are the reasons for including green bonds in impact investment portfolios, investors often struggle to measure the impact these bonds actually generate.
As many articles and reports on green bonds have noted, mistrust between issuers and investors has historically been a barrier for large-scale adoption of green bonds in the conventional bond marketplace.
“Quality accuracy and willingness to disclose data is key… For us, transparency is paramount,” Glass explained.
Though investors rely mostly on information provided by bond issuers, they do not take the ‘green’ label at face value.
“Part of my due diligence is digging into ‘what do you mean by green?’ It’s up to me to find that out,” Glass said.
Investors will typically supplement the information provided in the bond report with their own research pulled from big data sources. Breckinridge, for example, uses county health rankings and United States census data to evaluate ESG risks in a city or county.
Reporting on impacts is significant to investors for two main reasons. First, concrete information can help generate more internal support for ESG investments. Second, clients who are interested in sustainable strategies want to know in greater detail what their money is funding so that their investments feel worthwhile.
Use of proceeds and impact reporting are powerful ways to rally support for green bonds and attract more capital. Yet reporting in this area is lacking.
Bond issuers are increasingly choosing to pursue third-party verification from groups like Sustainalytics or certification from the Climate Bonds Initiative to enhance transparency, highlight their commitment to disclosure, and confirm that the bond is in fact green.
Although third party verification for green bonds can “offer a stamp of approval,” Fernandez said, third party verification is not necessary if investors already know and trust the issuer.
Glass said he agreed. “We want to partner with issuers that we think are doing good things – that are accomplishing their missions and serving their communities in a positive way.”
In this sense, the credibility of the bond issuer itself is perhaps more significant to investors than the particular project a green bond is financing.
With all of these insights in mind, bond issuers and investors can improve communication and adapt their processes to increase green bond issuance.
Below are recommendations for how issuers and investors can address long-term vs. short-term debates, balance ESG criteria, and improve the traceability of impact.
What Issuers Can Do
- Highlight the long-term benefits of projects in bond reports.
- Situate green bonds within the ESG landscape and articulate the sorts of environmental, social and governance criteria the projects will fulfill.
- Improve disclosure and follow through on reporting impacts to investors.
What Investors Can Do
- Cultivate an institutional culture that values long-term sustainability.
- Communicate transparently to issuers regarding ESG scoring processes. Expand green bond financing outside of ESG strategies.
- Communicate values and criteria so that bond issuers know what information is pertinent to disclose.
Glass shared his vision for the issuer-investor relationship that could enable green bond growth in the future. “I want to partner with issuers and I’d like issuers to partner with investors. Having a symbiotic relationship is very important going forward.”