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The Emperor Has No (Green) Clothes

How does one recognize a legitimate green bond?

A shiny new object is popping up in impact investment portfolios everywhere – behold, the green bond. A corporate or municipal fixed income instrument offering both market returns AND positive environmental impact, green bonds have emerged over the past six months as a significant area of new issuance. Corporations are issuing carve-out bonds whose proceeds go to infrastructure retrofits, while munis are hopping on the green bandwagon with bonds targeting a wide range of applications, from “clean and green” to affordable housing and school construction.

The first problem: We are beginning to see a lot of greenwashing. Savvy issuers have recognized that branding a bond issue as being green opens it up to a new group of purchasers (impact investors) that may otherwise not give these bonds a second look. This made us wonder: how does one differentiate a legitimate green bond from one that’s been greenwashed? For guidance, we turned to two municipal fixed income managers: Wasmer, Schroeder and SNW Asset Management.

The answer, according to PM’s at both firms, lies in the use of proceeds. Bonds that list specific, environmentally beneficial uses of proceeds in their offering documents are likely to be green, whereas bonds listing vague uses of proceeds or which say that proceeds “may” fund environmental improvements are likely greenwashed. Wasmer initially evaluates potential green bonds for credit worthiness, and then focuses on the use of proceeds to determine if the bonds are actually green. SNW applies a retroactive filtering system managed by HIP Investor to support security selection. Bonds that lack specific uses related to environmentally solid purposes don’t make the cut at either firm. Curiously, we have found that few investors use proceed utilization as a selection screen.

The second problem: Regulations don’t govern what can and can’t be labeled a green bond. The International Capital Markets Association (ICMA) has created voluntary Green Bond Principles, but financial institutions are using watered down standards to meet green paper demand. Further, the ICMA obliges issuers to comply with long-term requirements on reporting, which includes use of proceeds, but muni issuers have a longer lag time for the filing of financials compared to issuers of equities or corporate bonds. A cynic might conclude that this (significant) reporting lag represents a marketing opportunity.

Greenwashing aside, we embrace legitimate green bonds as an excellent source of capital for beneficial projects which might not otherwise receive funding, and recognize that Original issuance is one of the few instances where impact investors can connect directly to projects via public markets. Nevertheless, we approach the broad sector with a healthy dose of caveat emptor due to the current market dynamics.

This gentle skepticism leads us to believe that some impact scoring methodologies could be refined so that investors can more easily differentiate the relative impact of green bonds. For example, one impact scoring system rates Bank of America Merrill Lynch (BAML) green bonds at 61 (out of a relative scale of 100) but rates regular BAML corporates at 58. We are surprised that the delta between these two bonds isn’t higher.

Caveat emptor would also argue for acknowledging that, in our broader view of the impact universe, we believe publicly traded securities inherently produce a lower level of impact than can be achieved through direct investing. That said, liquidity and steady yield are key components of a robust portfolio, and these needs are nicely satisfied by legitimate green bonds.

In the spirit of the perfect not being the enemy of the good, we are encouraged to see green bond issuers coming to market with the clear purpose of creating environmental benefits or efficiencies. Unfortunately, the proliferation of greenwashing seems poised to rise. To that extent, we encourage caveat emptor among investors: read the use of proceeds, and know what you are buying. To paraphrase a favorite fable: a naked emperor is better than one with green clothes.

TAGS: Fixed Income
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