It has become fashionable for governments to issue “green” bonds to fund the transition to sustainability. However, sovereign green bonds as currently designed have next to no real effects. Redesigning financial instruments is no substitute for actions that directly promote sustainability, writes Daniel C. Hardy based on his recent research.
Many governments have started issuing securities that are meant to promote environmental and social sustainability, and in particular to tackle climate change. Most commonly, governments issue “sovereign green bonds” (SGBs), the proceeds from which are assigned to particular sustainability-promoting uses (e.g., expenditure on the construction of zero-carbon renewable energy plants). The total stock of SGBs outstanding at the end of 2021 (the latest according to the Climate Bonds Initiative) was $211 billion, out of $1,890 billion in total green bonds outstanding. Large issuers include France, the UK, Germany, and Italy, but also emerging market countries such as Mexico and (most recently) India. Chile and Uruguay have recently issued an alternative, namely, “sovereign sustainability-linked bonds” (SSLBs), where the payoff is adjusted depending on over- or under-achievement relative to certain sustainability-related targets (e.g., the reduction of national greenhouse gas (GHG) emissions by a certain test date).
The question addressed here is whether these new instruments serve any useful public purpose, or whether they are a fad or a charade. Governments give high visibility to their sustainability bond programs and claim that they will help achieve many objectives by contributing to the government’s overall “green” agenda; getting better financing conditions; meeting investor demand; developing the sustainable finance sector; improving coordination within government; and raising public appreciation of government policy action in this area. Can a modification in bond terms and conditions have so much effect?
Sovereign Green Bonds
The defining characteristic of SGBs is that the receipts from their sale are exclusively applied to finance or re-finance eligible green projects. Otherwise, they are just like ordinary “plain vanilla” bonds. Plus, the government commits to provide verified information on the progress of the associated green projects and the allocation of proceeds.
However, the allocation to specific projects or even spending categories is purely notional, at least for a government with a medium-to-high credit rating. In the jargon of economists, money is fungible, that is, particular inflows are not linked to particular outflows in any meaningful way. The notional status of the allocation and lack of impact is most clear in the case where SGB proceeds are allocated to expenditures that have already taken place, a possibility that most issuing countries allow: the project is already implemented before the bond is announced, let alone sold. Moreover, most government projects are planned well in advance of execution, that is, before the associated SGB is issued.
It follows that SGBs do not meet the underlying needs of investors. One class of investors may feel a moral imperative to invest in something that promotes a sustainable environment. SGBs, whose issuance has no physical impact, do not achieve this objective. Another class of investors may be concerned to hedge climate change-related and other environmental risks. These risks include transition risks (e.g., from the effects of related policies and technology change) and physical risk (e.g., from increased probability of prolonged drought). SGBs provide no such hedging because their payoff is identical to that of conventional bonds. However, by fiat, SGBs do allow financial institutions to meet mandates imposed by regulators or retail investors to hold what counts as official “green” assets.
Not surprisingly, the pricing of SGBs is very close to that of conventional government bonds, especially for the advanced economies. For example, the yield at issue on German SGBs has been around 2 basis points (bps.) below that on comparable conventional bonds. Hence, if Germany issues €10,000 million in SGBs, the gross savings are about €2 million per year—a trivial amount for a large economy. Moreover, this so-called “greenium” is offset by the higher operational costs of tracking expenditures and reporting on projects. SGBs do seem to attract some new, dedicated “green” investors, but this expansion of the investor base is not of great importance to larger sovereign issuers.
Governments often assert that SGBs support the development of the overall market for green finance by providing a “safe” liquid asset. Green bonds issued by corporates and banks carry significant credit risk, and issuance is more irregular and in smaller sizes. Hence, they tend to be relatively illiquid. However, it turns out that, except for in the case of the very largest countries, eligible green expenditures are not enough to allow the regular issue of green benchmark bonds. SGBs are likely to remain niche products.
More emphasis has been placed in recent years on the role of SGBs in promoting inter-departmental cooperation and in enhancing public awareness of those policies. Governments need to understand the projects to which SGB proceeds are to be allocated in order to ascertain eligibility and determine the timing of the allocation. The regular reports on supported projects provides the public with unusually detailed information on a range of activities and their impact.
If such an improvement in coordination and policy transparency, broadly defined, is so desirable, it might be achievable without the extra trouble of issuing bonds. Action in other important public policy areas is undertaken and publicized without the benefit of issuing dedicated bonds.
At a higher level, the issue of SGBs, whose revenues are notionally tied to particular spending categories, is inimical to accepted principles for good fiscal policy governance. The putative tying of receipts to expenditures is, at best, non-transparent. At worst, “tied” revenues lead to a misallocation of resources.
Moreover, advertising projects that receive SGB allocations may distract from other policies that reduce sustainability. Non-eligible expenditures (e.g., to promote lignite mining) may be so detrimental to sustainability objectives that they far outweigh any positive contribution from the narrow class of eligible expenditures that are associated with SGBs. Some investment managers have already divested from the SGBs of certain countries whose overall policies were judged to be insufficiently green.
Sovereign Sustainability-linked Bonds
Sovereign sustainability-linked bonds offer an attractive alternative for investors concerned about climate change and its risks. The defining feature of SSLBs is that the payoff adjusts depending on the performance of the country as a whole relative to certain key performance indicators (KPIs) at defined test dates. For example, one trigger for adjusting the coupon on the Chile SSLB relates to ceilings on GHG emissions in 2030 and also cumulative emissions between 2020 and 2030, derived from Chile’s Nationally Defined Contributions under the 2015 UN Paris Climate Accords. The other target is the achievement of 60% of electric power generation from “on-conventional renewable energy” sources by 2032. If one of these targets is not satisfied, the coupon step-up will be 12.5 (25) bps., accrued over eight years.
SSLBs therefore reinforce the government’s incentives to implement sustainability policies, and also provide a hedge for investors against some climate change-related risks. On the one hand, a real effect can be attributed to this “commitment mechanism,” which penalizes under-performance and, under some designs, rewards over-performance. On the other hand, investors get some compensation if the government fails to meet its own goals.
SSLBs have additional attractive features. They link funding costs to the achievement of national objectives, which is the express responsibility of the government. That responsibility can be fulfilled using a full range of policies, such as regulation and compensation for the burden of a carbon tax, which go beyond what counts as an expenditure eligible for the allocation of SGB proceeds. Even a smaller issuer can establish a regular schedule of SSLB issues and build up benchmark issues, which should promote market liquidity and price discovery.
However, assessing the probability of a country meeting distant KPI targets is extraordinarily difficult, a fact that is likely to discourage many investors unless the performance-linked adjustment in returns is negligibly small. In addition to economic risks, the future path of KPIs is subject to technological and political risks, which are very hard to quantify in the context of an unprecedented structural transformation. Moreover, SSLBs do not embed a strong “natural” hedge: the conditions under which the coupon rate is raised (lowered) are not necessarily the conditions under which the fiscal position is especially strong (weak). The government therefore has a motive to renege (expressly or discretely) in case of a bad outcome. It might also be suspected of manipulating measurement of KPI outcomes to meet the conditions for a lower coupon. The motivation for manipulation is strongest if the adjustment is large. Hence, the greater is the “materiality” of the contingency mechanism, the harder is pricing and the higher is the risk premium likely to be demanded by investors.
The issue of SGBs by many governments has been well-meaning and not costly, but they do not seem to contribute importantly to legitimate public policy purposes. They may have been given prominence as a cheap way to advertise good environmental intentions. SSLBs seem to be superior in most respects, but designing them in a way that builds in a strong “commitment mechanism” while achieving market acceptance is challenging.
Given these concerns, it may be best even from a narrow debt management perspective to concentrate efforts on policies that directly help mitigate or adapt to climate change and achieve other sustainability goals. Markets are beginning to demand a premium for heightened sovereign vulnerability to climate change risks; the risk premia may increase with rising awareness of the fiscal costs of threats such as persistent drought and “stranded” carbon-intensive industries. A government that maintains long-sighted, comprehensive policies to mitigate and adapt to climate change, and to promote sustainability more widely, is likely to be regarded favorably by bond market investors. The country that is “green” and is seen to be “green” should eventually enjoy lower borrowing costs and a wider investor base, whether or not it introduces special funding instruments.
The views expressed in this article belong solely to the author and do not necessarily represent those of any affiliated institutions or the University of Chicago, the Booth School of Business, or its faculty.