A GROWING number of investors worldwide want their savings to contribute to a better world, supporting the environment and promoting human welfare. One way to do this is to invest in green and sustainable bonds, the market for which has soared in recent years.

Green bonds finance environmental projects, such as wind farms and solar power parks. Governments also issue green bonds as a source of financing large scale green infrastructure projects – the UK issued its inaugural green gilt in 2021 to fund renewable energy investment, clean transport, and climate change adaptation.

The market for green bonds doubled in 2021 to more than half a trillion US dollars. But in 2022, it contracted for the first time, by 7%. This was due in part to Russia’s invasion of Ukraine triggering an energy crisis that caused global economic turmoil, rather than a reduced commitment on climate change.

As markets recover and investors return to bonds, however, we expect to see a return to growth in green bond markets in 2023.

The energy crisis has only highlighted how essential it is that we develop alternative, renewable sources of energy and become more energy efficient, while regulation, environmental targets and investors will all continue to drive demand for green bonds.

But does it follow that a green bond will be a good investment?

Our investment approach is consistent to all bonds – just because a bond is green doesn’t mean it’s a good investment. We manage sustainable fixed income funds and investors might assume our portfolios are full of green bonds. However, for us, the unique structure of green bonds can be a cause for concern.

Although the proceeds are used for green projects, the debt is serviced by the issuing firm. EDF, for example, has several green bonds outstanding, with proceeds allocated to renewable energy projects complying with ICMA principles. EDF, however, also has considerable exposure to nuclear and coal energy elsewhere.

As the market for green bonds has proliferated, so too have accusations that some issuers are engaged in ‘greenwashing’ – the practice of overstating or misleading investors about the environmental credentials of a company or financial product, such as an investment fund.

In response to concerns around greenwashing, the UK’s Financial Conduct Authority is currently consulting on a system for classifying sustainable investment funds – the Sustainability Disclosure Requirements and labelling regime (SDR). This aims to clamp down on greenwashing by introducing three mutually exclusive classifications for sustainable funds.

  • Sustainable improvers: must improve sustainability over time with pre-determined measurable improvements in sustainability profile.
  • Sustainable focus: at least 70% of assets must meet with a specified standard or be exposed to specific sustainability themes.
  • Sustainable impact: must have pre-determined measurable real world (positive) impact.

In February this year, European regulators also reached a provisional agreement that would set high-quality standards for green bonds – the EU Green Bond Standard (EUGBS). Under the EUGBS, firms issuing green bonds would have to ensure that a minimum of 85% of the cash raised is allocated to projects that meet the green standards laid down in the EU Taxonomy (such as Technical Screening Criteria, Do No Significant Harm and Minimum social safeguards).

There are voluntary best practice guidelines to which issuers of green bonds can adhere to – these include the Green Bond Principles published by the International Capital Market Association (ICMA) in 2014, and the Climate Bond Standard of 2010. The former sets guidelines around environmental objectives that bonds should meet while the Standard sets eligibility criteria by sector and covers performance metrics for each category.

It is key for investors considering green or sustainable bonds to think about the following when choosing where to put their money:

  • Use of proceeds – these should be designated for green projects.
  • Process for project evaluation and selection – issuers should provide transparency of the project’s sustainability objectives and process.
  • Management of proceeds – this should be held in a distinct sub-account and tracked throughout the life of the project, with a high level of transparency for investors.
  • Reporting – should be kept up to date and readily available, describing the amounts allocated to the projects and the expected environmental impact.

Ultimately, a good bond for investors will be measured by the interest they receive (the coupon) and the capital repayments, all of which are dependent on the financial health of the issuing firm. This is why when making a decision about whether to invest in a green bond, we use the same process as we apply for non-green bonds.

And from a credit investor’s standpoint, there is no difference between green and conventional bonds: the green classification does not change the risk profile as this is driven by the underlying credit quality of the issuer.

Another option for investors to consider is sustainability-linked bonds (SLBs). With SLBs, issuance proceeds are not ring-fenced to green or sustainable purposes (unlike ‘use of proceeds’ green or sustainable bonds) but may also be used for general corporate purposes. They are guided by the sustainability-linked bond principles. While these are voluntary and only constitute best practice – similar to green bond principles – they are designed to promote integrity and transparency in the sustainable finance sector.

With SLBs, issuing firms commit to making improvements in sustainable outcomes within a set period. If they fail, then the coupon paid to investors typically steps up 25 basis points as a penalty. As examples, retailers such as Tesco, H&M and Ahold have all issued SLBs with targets such as reducing carbon intensity, increased recycling of textile materials and cutting food waste.

As the drive to tackle climate change and move towards a sustainable future becomes more urgent, the need for investment to finance this also grows. Green and sustainable bonds have a key role to play in this, provided investors do their homework first.

Kenny Watson is a fixed income investment manager in the sustainable team at Liontrust