How to Grow the Green Bond Market–A Modest Proposal

Once again, the Climate Bonds Initiative has pulled off an interesting conference. There were lots of good panels, Sean Kidney was in fine form, and I was asked to monitor a round table on Green Bond pricing, which people seemed to think went pretty well. The group was pretty knowledgeable, with a majority of the panel from various Capital Markets departments–a group that, if there really were anything weird going on with Green Bond pricing, they would have noticed it. The verdict is still open–while there seems to be agreement that it’s difficult to see any consistent effects at primary issuance, there is still insufficient data to generalize pretty much anything at present. Ditto for secondary markets, with one notable exception–the US municipal bond market, where Green Bonds seem to outperform non-Green bonds in certain contexts (see the excellent work by Candace Partridge.) The US muni bond market has its own oddities, however, which may limit the extent to which generalizations about the broader bond market will be meaningful. All interesting and potentially important stuff.

More broadly, once again I left the conference with the feeling that there was still an extraordinary amount of work to be done, and not enough time to do it. On the one hand, as usual, the attendees and organizers–the entire Green Bond community, most likely–must be pleased by the robust growth of a bond category that practically no one knew even existed six years ago, into something that now exists in pretty much every financial market. On the other hand, we all know that it’s not even close to being enough. We’re raising billions, true. But we need to raise trillions, and we need to do it soon. And, as usual, there was a fair amount of discussion around this point. Some of this we think is a bit misdirected, frankly–there was lots of “How will Investors Drive the Transition to a Low Carbon Economy,” for example, not just a specific panel, but as a running thread. Which I think slightly misses the point, as Felipe Gordillo of BNP pointed out–what will drive the transition will be policy makers, and we need to be putting pressure on them to do just that. As investors, we will certainly play a major role in financing this–but we are also in a position to pressure policy makers to pick up the pace, and we should indeed be doing just that.

Some of the discussion dealt with developing new products–there was a panel on Green CLOs, for example. There were more specialized discussions on the potential growth of a Green Bond market in Africa. The entire conference, in fact, appeared to be a confirmation of the notion that if we just kept developing the right products, this would somehow solve the funding shortage problem–it’s really an issue of supply, rather than demand. In, fact, I see this comment about supply not keeping up with demand quite a lot. But I rarely, if ever, see any numbers to support this. In the corporate market, at least, thanks to Caroline Harrison’s excellent work at CBI, dedicated Green investors only make up about half of corporate Green Bond purchases in 2017 and 2018 ($ and € benchmark deals only), and this varies widely by deal. And it certainly wasn’t half back in 2014 and 2015. In short, even with dedicated Green buyers accounting for half of corporate Green Bond purchases, it’s bond buyers in general who continue to carry the Corporate Green Bond market, as they have for a number of years now. We may reach the point where the dedicated Green community is big enough to carry the market, but we’re not there yet.

So we need to grow the market, and quickly. One way to do this, I think, might be to follow the example of the US municipal bond market. The US municipal bond market is probably unique in several respects. First, it’s how the US funds most of its infrastructure. The US has by far the largest municipal bond market in the world in part because the US is unique in funding so much of its public works through such regional and local borrowings. These borrowings are usually secured, either by project revenues (Revenue bonds) or the ability of governments to raise taxes to fund such projects (General Obligation bonds.) States use this market to issue bonds to fund large capital projects such as bridges, or whatever. But it also drives down to the local township level–small bonds in small cities and towns issue these bonds all the time, nearly always for infrastructure needs. When I was on the School Board of the little town I lived in in New Jersey, we explored and eventually issued a $1 million bond to finance upgrading the school buildings. This happens all the time in America, and practically every level of government–from states down to counties down to small towns issue bonds of this sort. Which is why the muni bond market is nearly US$4 trillion in size.

There is little that resembles the US municipal market elsewhere, for several reasons. First, most infrastructure financing in the US takes place at the local or state level, not necessarily at the federal level, unlike most other countries. Second, as mentioned above, income from municipal bonds is not considered taxable income by federal and most state laws. In the UK, for example, there is no tax benefit from buying the Transport for London green bond—in the US, there likely would be. In general, coupons are generally lower on municipal bonds than on corporate bonds to reflect this tax advantage. As a result, most US portfolio managers do not comingle municipal bonds with corporate bonds in the same portfolio, but rather create separate funds for municipal issues–corporate bond managers do not want to include the lower yield of a muni bond in their portfolio. This is generally not an issue outside of the US, where such issuance is considerably lower, and such issues tend to be taxable, as most corporate issuers are.

So why not make the Green Bond market like the US municipal bond market? Specifically, create a global tax system where the interest income from Green Bonds is not taxable income. Conceptually it’s straightforward, but the real-world logistics are prodigious. It would involve national governments agreeing to a similar tax treatment of all Green Bonds. Watching the flailing around that’s characterizing attempts to limit tax avoidance and tax havens in general does not inspire confidence in this regard, admittedly. It would also require a universal, international standardization of “Green.” Again, the level of discourse surrounding this particular issue the past several years has not been encouraging. Watching the EU trying to come to agreement on the meaning of “Sustainable Finance” has been painful. We recognize that none of this will be easy. Still, let’s consider some of the advantages.

First, remember that the US municipal bond market is large–nearly $4 trillion. It’s only 4% of the global bond market, but still, that’s a pretty meaningful market in its own right. The Green Bond market should be so lucky to have that scale. Also remember that the majority of issuance in the US municipal bond market is related to infrastructure. Well, so is the Green Bond market–a whole lot of Green Bond proceeds go to infrastructural improvements to reduce GHG generation, or other adaptation and mitigation efforts. There’s a natural overlap between the two categories.

Second, it would likely expand the Green Buyer base. The Muni bond market is different from the corporate bond market in another important respect–the size of the issues. You will never see a corporate bond for $1 million, but you see it all the time in the municipal market. So much so that about 40% of the US muni market is made up of individual investors. Size matters in this case. Potential corporate Green Bond issuers need to have a sufficient inventory of projects to warrant a benchmark size (say, US$500 million, or €500 million.) But the US municipal market finances projects of all sizes–from large projects such as bridges, to small projects such as school refurbishments. So there is a very broad range of municipal bond sizes that is not matched in the corporate market. Some readers may remember my venting about the lack of green product for individual green investors. A Smaller Green bond size that accommodates smaller green projects has the potential to vastly improve the retail buyer base for Green Bonds–and therefore the potential demand for more product.

Thirdly, as a corollary, it would expand the range of projects that would be funded, simply by expanding the pool of investors to fund them. Muni projects come in all shapes and sizes, and many don’t occur in a timely manner because issuance has to take account of the usual stuff–market conditions, recent issuance elsewhere, the sorts of things that are characteristic of bond issuance. But if you expand the range of potential investors, particularly at the retail level, you’re creating a situation where green bond demand will drive supply. I return to my comment above about corporate Green Bond demand exceeding supply–but if only half (at best of issuance) of Green bonds are being bought by dedicated Green buyers, then this argument loses some of its justification. But in the US muni market, we know that demand does help drive supply, and that muni buyers are just that–dedicated muni buyers. Why not create an analogous supply/demand mismatch in the Green Bond market where the buyers of Green bonds are dedicated Green buyers? I was at a conference once where the World Bank representative commented that The World Bank could easily find $1 trillion worth of infrastructure projects to fund–annually. A Green Bond equivalent to the US muni market might make it easier to find funding for those projects.

Finally, it would accelerate the apparently never-ending and tedious discussion of Green Bond standards. We fully admit that there needs to be a set of green standards. If green bonds are going to qualify for a particular tax status in various tax jurisdictions, there needs to be some solid, universal set of criteria to allow the appropriate authority–central banks, national regulators, exchanges, whoever it turns out to be–to determine whether something is a Green Bond or not, and therefore eligible for this special treatment. We’re comfortable with the Green Bond Principles at a target, but this might prove insufficient for some market participants. But the discussions over this point–at the level of the EU, or among investors, or regulators, or space aliens–has become interminable. It needs to be accelerated and resolved.

These are clear benefits for the potential growth of the Green Bond market. So what are the disadvantages? Assuming that the above are not insurmountable obstacles, we see several further, and potentially complicating, issues. First, governments would lose potential tax revenues if interest income from Green Bonds, currently taxable in most jurisdictions, were to become non-taxable. I have seen no estimates of this, but I imagine it could be meaningful (it sounds like a fine project for an enterprising graduate student, in fact.) So taxing jurisdictions where interest income is taxed would face a dilemma over whether to choose to forego that potential revenue. On the one hand, governments might not appreciate the potentially lost tax revenues. On the other hand, the bonds would fund infrastructure or other adaptation and mitigation investments that would reduce future adaptation and mitigation costs. There is clearly a potential trade-off here that I’m perfectly happy to let economists debate. But I suspect it’s an issue that will need to be considered.

A further potential concern would be cross-border investment. If Green Bonds are to become a global market, there will need to be some agreement among national tax authorities that the non-taxability of interest income is valid across tax jurisdictions. But we already have a global financial system that, inefficient as it sometimes is, seems able to accommodate this sort of problem. Tax authorities across the world are always setting up mechanisms to allow individuals to deal with different taxation systems. The number of individuals affected might vary considerably by country. Large funds, on the other hand, would simply set up separate Gereen funds for non-taxable Green bonds.

Thirdly, for all everyone’s good intentions, it’s unlikely that such a system would be created and implemented on an international scale all at once. This would take years, obviously. But that wouldn’t necessarily preclude individual countries, or regions like the EU, from pursuing this approach unilaterally. In the US individual states have their own approach to the potential taxation of municipal bonds, and the system accommodates these differences. There’s no reason why this sort of approach couldn’t work in individual countries (Germany would make an interesting test case, given the political importance of its states.) Even more important, if this approach were adopted by multi-state entities such as the EU, this would expedite the process. We could see pan-Asian or pan-American entities evolving for this purpose. Again, we are trying not to underestimate the political difficulties that would be generated by moving in this direction.

Finally, consider the poor fund manager. US managers are already experienced at dealing with this issue–just create separate funds for muni issues, and let buyers decide what they want. Both corporates and muni bonds are already out there, and have been for some time, so managing their separation is straightforward. But for Green Bonds it would start out complicated, simply because there are a number of taxable Green Bonds already out there, included in funds with other corporates. The transition period would be a bit messy, to say the least. Hopefully, the growth of the non-taxable Green Bond market would be robust enough to offset the headaches this transition would generate, but it’s an empirical issue, and we won’t know unless it’s attempted.

I’m sure there are other objections that I have not yet thought of, and I imagine people will not be shy about sharing them. Good. Still, I think the idea has some appeal. The range of projects that needs to be funded in the next ten years is prodigious–“monumental” does not appear to be an inappropriate term for what must be done. But if it isn’t done, the consequences will be severe, as we all know. So let’s start discussing financial triage here–what needs to be addressed immediately in the global financial system that would contribute to the work that needs to be done? The approach outlined here probably isn’t perfect. But we need to think of something. Time is short and the river is rising, as they say.

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