Green bonds don’t make a bond fund ‘green’

ESG bond funds’ sustainability levels can’t be measured by ‘green bond’ share. They require a more thorough comparison of the investors’ sustainability theory of change against the fund’s ESG policies & implementation investments.

• An analysis of the ESG bond market has found a surprisingly small proportion of assets were invested in green bonds in most funds
• Some ‘dark green’ funds had limited green bond exposure, but that may not be as indicative of the fund’s ‘green-ness’ as appears on first glance
• The green bond market isn’t representative of the bond market as a whole, and it isn’t lacking investor interest, which opens up other ways for funds to achieve their ‘green’ objectives for the real economy besides investing in green bonds

It may come as a surprise but a minority of the bonds held by most ESG bond funds are ‘green bonds’. Research conducted by ABN AMRO of European Article 8 (‘light green’) and Article 9 (‘dark green’) bond funds has found that only 8% of light green bond funds held more than 15% of their assets in green bonds. The number was higher among dark green bond funds, which are focused on achieving environmental and social objectives. However, even among dark green bond funds, almost half (41%) of the funds had green bond share that accounted for less than 15% of their total assets.

Although it would seem to be a contradiction for investment funds labeled as ‘ESG’ to include such a low proportion of assets that are labeled ‘green’, the Climate Bonds Initiative (CBI) pegs the green bond share of the GSS+ market at 49% of all outstanding green, social and sustainability (GSS) bonds. The dominance of green bonds means the ABN AMRO analysis isn’t overlooking the large pool of social and sustainability bonds included in these funds that aren’t being counted.

If the most natural bonds for the objectives of these labeled funds are not accounting for the bulk of their investment assets, there are a few competing explanations. The funds could be overstating their ‘green’ or ESG credentials, and putting themselves in the position of risking sanction as regulatory scrutiny of SFDR disclosures ramps up. Alternatively, not all ‘green’ bonds may be issued with a ‘green’ label if there is consensus that they are funding green assets, such as solar or wind project bonds.

Although each explanation seems reasonable on its own, it doesn’t provide an explanation for the scale of the gap between ESG fixed income funds’ holdings of green bonds and what might have been expected. There may be a subset of unlabelled green bonds, and there are probably some fund managers letting their marketing get ahead of their investments.

One possible answer might be limitations within the green or GSS+ bond market itself, which is not deep enough for all of the investments that are currently labelled as sustainable. According to the Climate Bonds Initiative’s most recent analysis of the primary market for green bond issuance for the second half of 2021, the ‘greenium’, or new issue premium for green bonds, was seen in half of the new issues they studied. Across those bonds, two-thirds of the investor base was composed of dedicated ‘green’ investors.

The CBI’s analysis suggested that investors did gain from paying a new issue premium for green bonds in terms of tighter secondary markets compared to similar vanilla bonds, but there is a common concern with green bonds that there is too much demand chasing too few assets. This would explain why many fund managers with sustainable funds might look for other eligible assets, even if they weren’t explicitly labelled bonds. Another reason driven by the market conditions might be the need for more diversification than the green bond market can provide across different investors’ mandates.

The CBI’s Global State of the Market for the Sustainable Debt report 2021 found that the use of proceeds identified by the issuers was largely confined to energy, buildings and transportation, which together account for about 80% of global issuance. Among investors in China, a survey from CBI found investor preference for green bonds strongly focused on renewable energy and transportation.

The contours of the green bond market are not aligned with the international bond market as a whole. Much more of the market is concentrated within a few sectors. For some investors, that’s what they see as most aligned with their expectations for ESG fixed income. If their theory of change is that by increasing their fixed income investments’ concentration in projects that can demonstrate alignment with the low-carbon economy, they will lower the cost of capital for more investment in these sectors, so it makes sense to measure alignment with the proportion of fixed income assets that are invested into green bonds.

However, that is likely to be a view that many investors may not agree with, or may not be able to implement across the bulk of their fixed income investments. They may be constrained (formally or in practice) to some amount of deviation from a broad fixed income benchmark that doesn’t enable them to approach green bonds as more than a thematic element within their fixed income allocation.

And beyond the investor perspectives, there is a broader question about whether progress towards an objective of a low-carbon economy is best measured by increasing the share of investments labelled as ‘green’. This argument is particularly relevant in respect of emerging markets, where the portfolio targeting approach of measuring progress by the share of green assets or bonds, compounded by a shortage of green assets available in many emerging markets, will limit funding towards a low-carbon economy just at the point when it is needed most.

This links up to the article we shared last week about the challenges of asset managers with disclosures of EU Taxonomy alignment. Whether the metric used to evaluate asset managers is their share of green bonds (on the fixed income side) or EU Taxonomy alignment (for either equity or fixed income), it is likely to have weak explanatory power about the effectiveness of the investments to make an impact in the real economy.

It may be perfectly logical for asset owners to exclude some assets as incompatible with their beneficiaries’ interests, or for asset managers to exclude some assets as incompatible with their assessment of ESG-related risks (such as stranded asset risks). However, the logic behind these restrictions isn’t the most relevant to evaluate the progress of the asset management sector as a whole in supporting progress towards a low-carbon economy.

Even if the objective is narrowly defined in terms of focusing only on climate change, there isn’t a single portfolio metric, especially one as simplistic as share of assets in green bonds, that will neatly divide the funds that are helping the real economy align with Paris or Net Zero pathways from those that are capitalizing on the popularity of ESG but not working within a clear theory of change to achieve the desired result.

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