Getting to net zero will require big investments from public and private sources. Green bonds give fixed income investors a way to contribute. Find out what these bonds are financing.
Climate change continues to be a primary focus for ESG investors. The 2022 report from the Intergovernmental Panel on Climate Change (IPCC) concludes that if the global effort to cut carbon emissions fails to accelerate, the negative impacts of climate change—rising sea levels, drought, and famine, to name a few—will rise faster than we can adapt to mitigate them. A January report from global consultancy McKinsey & Company estimates it could cost up to $275 trillion, or $9.2 trillion per year on average, to invest in the physical assets needed to reduce global emissions to net zero by 2050. The necessary investment in renewable energy, efficient transportation, and carbon capture and storage technology will require a significant amount of both public and private financing.
Investors can play a key role in transitioning to a carbon-neutral economy by allocating capital to funds and investments with positive environmental purposes. The incredible global rise in green and sustainable bond issuance signals growing interest from both issuers and investors in aligning investments with these larger environmental goals. Let’s take a look at how this rise is playing out in the municipal and corporate bond markets.
What are green bonds?
Sustainable bonds—bonds with a sustainability, green, or social label, either self-declared by the issuer or verified by a third party—passed the $1 trillion mark in annual global issuance for the first time in 2021, and more than $500 billion of that issuance was labeled green. Green bonds are issued to fund projects with both measurable and positive environmental impact. According to the Green Bond Principles (GBP), enacted in June 2021 by the International Capital Market Association (ICMA), issuance of these bonds should provide “transparent green credentials alongside an investment opportunity.” The principles seek to support the financing of projects that will aid the transition to a net-zero economy.
Green bonds in the corporate credit market
In the US corporate credit market, total issuance of sustainable bonds grew to $123 billion in 2021, a 126% year-over-year increase. Green bonds made up more than half the year’s total ESG-labeled corporate bond issuance, at $67 billion. Banks are frequent issuers of green bonds aimed at financing loans to clients for green projects, such as the construction of Leadership in Energy and Environmental Design (LEED)–certified buildings or renewable energy development. A large US bank recently updated its Green Bond Framework, which includes a list of eligible projects for green bond issuance:
- Development, construction, and maintenance costs for new or existing commercial or residential green buildings
- Development, transmission, and maintenance costs relating to onshore wind energy, solar energy, small-scale hydropower generation, and geothermal energy
Telecom companies are also large issuers of green-labeled bonds. One telecom company issued a $1 billion green bond in February 2022, planning to invest the proceeds into moving the company’s operations toward its goal of net-zero emissions by 2035. The company fully allocated the bond’s net proceeds to renewable energy purchase agreements (REPAs), which are power purchase agreements for an aggregate of approximately 910 megawatts (MW) of new solar- and wind-power-generating capacity across seven states.
The municipal bond market saw another record year for sustainable bonds in 2021, with $46 billion in issuance across the three categories of green, sustainability, and social bonds. This was an increase over the $27 billion in ESG-labeled issuance in 2020. Based on current growth projections for labeled bonds in the municipal bond market, issuance could grow to $60 billion this year. To put these numbers in perspective, sustainable-labeled issuance in the municipal market totaled 9.7% of overall municipal bond issuance in 2021, up from a 5.5% share in 2020. This could increase to about 13% of total projected annual issuance for 2022.
Sustainable Debt Share of Municipal Issuance
Source: S&P Global Ratings Research, 2/10/2022. For illustrative purposes only. Not a recommendation to buy or sell any security.
Green bonds continue to make up the largest share of sustainable municipal bond issuance, with 47% of that total sustainable-labeled issuance at $21.7 billion for 2021. The green bond category covers a range of issuers and sectors that continues to expand, including sustainable building projects, wastewater management, renewable energy, climate-adaptive infrastructure, and clean mass transit. There are a growing number of issuers in the health care and education sectors, issuing green bonds for LEED-certified building projects and solar panels on school buildings. Green buildings and water-related improvements represented the two largest shares of green muni bond issuance in 2021, each at 33%, followed by public transportation at 20%.
Recent examples of projects funded with green bond issuance in the municipal market include:
- The Peninsula Corridor Electrification Project, which involves electrification of the rail corridor from San Francisco to San Jose, including the construction of electric train infrastructure and the purchase of approximately 133 new electric-powered rail cars.
- A 102 MW wind-powered electric-generating facility in Utah, consisting of 68 wind turbines that generate 1.5 MW each.
- A materials recovery program in a California municipal district, designed to update aging infrastructure to process construction and demolition waste while meeting state mandates for recycling.
Additionally, the passage of the Bipartisan Infrastructure Law in November 2021 could spur issuance of more green bonds through the muni market. This legislation included $550 billion in total spending for environmental initiatives that could be financed this way, such as water system upgrades, energy-efficiency improvements to buildings, clean energy generation, climate-resilient infrastructure, and mass transit funding.
The bottom line
As investor interest in ESG grows and issuers move to meet their demand, there will be an increasing share of sustainable and climate-aligned bonds on the market. The impactful nature of these projects will continue to attract sustainability-focused bond funds and strategies outside of the traditional fixed income client base. This became clear in the first quarter of 2022, when sustainability- and ESG-focused funds saw net positive inflows of $5 billion, while traditional non-ESG fixed income funds saw net outflows of $85 billion. As the world moves to solve the critical problem of climate change, fixed income investors will play a pivotal role in allocating capital toward viable solutions.