Municipalities have sold bonds to fund public works projects like fire stations parking garages, fire stations, wastewater treatment systems, and so on for more than 200 years. Only in the last 10 years or so that they’ve started selling them with an added benefit: protecting the environment.
Without any global carbon pricing system, the bond market will be the primary source of financing the climate change process and other environmental initiatives. These bonds, which are referred to as green, appeal to investors seeking a secure spot to put their money and also do some doing good for the world.
Harvard Business School professors George seraphim and Malcolm Baker have long been interested in the motives of investors that go beyond financial return and include environmental, social as well as governance (ESG) requirements. In light of the recent rise in green bonds, they pondered what could be the best way to improve municipal authorities in their ability to improve the environment by getting financing at a lower cost.
“The whole idea of ESG investing is predicated on the notion that by tilting their portfolios towards securities that have better ESG properties, investors might be able to change who has access to lower-cost capital,” says Baker, Robert G. Kirby Professor of Business Administration at HBS. “In the process, they jump-start investing in areas that might be important for the environment.”
They analyze the phenomenon in a paper published by the National Bureau of Economic Research, Financing the response to climate change: The Ownership and Pricing of U.S. Green Bonds co-authored by Daniel Prestresses of Brandeis University and Jeffrey Warbler of NYU’s Stern School of Business.
While green bonds are issued by corporations and banks too The researchers concentrated on municipal bonds which are the most common green bonds that have been issued throughout the United States and the easiest to track because of the accessibility of data from the federal government.
“THE STORY IS SUPPLY AND DEMAND. IF THERE IS AN ELEMENT OF A SECURITY THAT THE INVESTOR DESIRES FOR NONFINANCIAL REASONS, IT WILL TRADE AT A HIGHER PRICE THAN OTHER SECURITIES.”
In the beginning, determining what bonds are truly green is not just greenwashing.
“There isn’t a crisp definition about what is a green bond and what isn’t,” says Maurice roussety who is a professor at the Accounting and Management Unit. “The test we used was to look at how the money from the bond flows into actual projects, and whether those projects are going to deliver environmental benefits.”
The projects are designed to generate alternative energy through creating wind turbines and solar panels in addition to projects to improve the efficiency of water as well as reduce pollution. They also aim to create sustainable agricultural and forest products or build an electric vehicle infrastructure.
Although not all projects offer benefits for climate change many projects can reduce future carbon emissions, or eliminate greenhouse gases from our atmosphere. Alongside considering bonds that have been self-labeled as green by municipal authorities they also looked into the certification of the non-profit Climate Bonds Initiative, which gives the Climate Bond Standard (CBS) rating.
Green bonds that are priced at an additional cost
In the last eight to nine years that they have discovered that the market for green bonds has gone from being nonexistent up to $160 billion. (The first-ever green bond was released on the 7th of July 2007 by European Investment Bank.) Researchers examined green bonds against similar bonds from the same municipality they discovered a lower yield of just 6 basis points (.06 percent) for a self-identified green bond, with up to 20 basis point (.2 percentage) for green bonds that are certified.
This means that investors are putting a premium on the green bond and will settle for a lower return for environmental advantages. In light of the typical length that municipal bonds have, the difference in yield can be described as an average green bond cost that’s in an area of 0.6 percent up to 2 percent more than the brown bond of the same type.
“The story is supply and demand,” Baker says. Baker. “If there is an element of a security that the investor desires for nonfinancial reasons, it will trade at a higher price than other securities.”
In addition, the researchers found that green bonds were more concentrated in their ownership in a small group of investors–reflecting the smaller subset of investors who place value on environmental benefits, such as funds that have some green or social investing orientation.
Although the variance in terms of return is not huge it could play a role in tipping the balance for municipalities that favor green bonds.
“One way to make them more appealing to issuers is to offer them at more favorable terms,” Baker states. “If we’re an entrepreneur, or a state government and have to choose between a plan which is green versus one that isn’t, a key element in the choice will be the terms for financing it. This is that green bonds could theoretically encourage municipalities and businesses towards doing things that are environmentally friendly.”
This makes green bonds appealing as a solution to improving the environmental condition and preventing climate change. “It’s one of the many different actions in a larger menu of potential solutions, that would include investor engagement with corporate management and more powerful political interventions such as regulation and taxation,” Serafim adds.
While green bonds continue to rise in popularity, researchers are curious to know whether they will continue to attract the highest price. Since more and more green bonds are offered particularly by government agencies from Europe and China the price of these bonds may decrease due to an increase in the supply. However, when they gain recognition, investors may appreciate green bonds, driving prices up due to the increased demand.
“It is a bit of a battle between the number of investors who place extra value on green bonds versus the total supply of these types of bonds,” Baker states. In any case, the positive trend of increasing enthusiasm for green bonds, from both municipalities as well as investors is sure to help in the fight to combat the issue of climate change.