Episode 01: Understanding Green and Sustainable Bonds

TRANSCRIPT:

Dan Krieter: So, in a lot of ways, the sustainability bond market reminds me of where green bonds was 4 years ago. There are still more questions around what exactly a sustainability bond is. What types of projects qualify for the proceeds of a sustainability bond? The same questions that the green bond market dealt with, those questions remain outstanding in the sustainability-bond market, but we are seeing impressive growth in both markets.

Michael Torrance: Welcome to “Sustainability Leaders.” I’m Michael Torrance, Chief Sustainability Officer with BMO Financial Group. On this show, we will talk with leading sustainability practitioners from the corporate, investor, academic and NGO communities to explore how this rapidly evolving field of sustainability is impacting global investment, business practices and our world.

Legal disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries.

Michael Torrance: Today, we’ll be talking to Dan Krieter, BMO green bond specialist, about his green bond outlook for 2019 and a roundup of what we saw in the market for 2018. Dan is based in Chicago. Our interview in early January gave insights into the year that was for green bonds and what trends to look out for in 2019 including growth of the nascent sustainability bond market. To kick things off, Dan explained what a green bond is and how a sustainability bond differs from the traditional green bond.

Dan Krieter: Well starting just very high level, a green bond is, perhaps not surprisingly, a bond issued whose proceeds go to benefit the environment in some way, generally reducing greenhouse gas emissions, so a very easy example would just be a project … Say a corporation has a project to install solar panels to provide electricity to all their buildings. They would be able to issue a bond and use the proceeds of that bond issued to support the solar panel project, so because the proceeds go to support that type of environmentally beneficial project, they could issue a green bond.

Michael Torrance: And I’m aware of different kinds of related products like sustainable bonds. Can you just describe what those are?

Dan Krieter: Sure. So, a sustainable bond is the same concept or spirit of a green bond, but it broadens the market out to more sustainability factors as a whole. So, if we look at sustainability, a common-use acronym is ESG, which stands for environmental, social or governance, so green bonds only get at the E in ESG. A sustainability bond tries to get at the S and the G as well, so take, for example, a bond that is issued and the proceeds go to support some initiative that’s going to try to enhance gender equality or provide educational opportunities to people in poverty-stricken countries. These types of projects are not beneficial for the environment, so you couldn’t, say, issue a green bond to support those projects, but they are “do good” projects that get at the ESG in whole, and those projects would be supported by a sustainability bond or a sustainable bond rather than a green bond.

Michael Torrance: With a new year and a new podcast, I thought it would be good to take a step back and learn a little bit about Dan’s background and how he got into this field.

Dan Krieter: At BMO I work in the fixed-income strategy group, which is primarily responsible for creating sell-side research on interest rates. I have a special focus on what we consider the spread market, so, you know, everything from US agencies all the way down to investment-grade corporate, also focusing on swap spreads and the interest rate derivative market.

Michael Torrance: And I think you’ve got also a specialty in green bonds. Can you tell us a little bit about that?

Dan Krieter: I do have a focus on green bonds. It came to be that one of the main areas of interest in my markets is what’s called the super national community or the development banks who are considered, kind of, the fathers of the green bond market for lack of a better word. They invented the product going on 10 years ago and were the major catalysts behind pushing it from a small, little-known market to what it is today, and having that focus on super nationals in my day-to-day work led me to an interest in green bonds. So, I’ve been writing monthly green bond research for 4 years now and have gotten quite familiar with the market through my focus on super nationals. Now they’re also at the forefront of pushing into sustainability bonds, social bonds and things of that nature, so my interest in the ESG bond market comes directly from my experience with working with the development banks.

Michael Torrance: Are other investors interested in these products now?

Dan Krieter: Oh, absolutely. Even just looking at last year, despite being the inventors and, kind of, leaders of the market, super national or development bank issuance in the green bond market represented just 10 percent of the entire market. Now we have engagement from corporations, sovereigns, municipal borrowers. The market has spread far past the super national community. That said, they still are considered, kind of, the leaders there. Even if their borrowing programs don’t allow them to be the biggest issuers, they still are at the forefront of developing things like standards or new types of issues coming out of the ESG space.

Michael Torrance: Dan publishes a regular green bond market update that focuses on the green social and sustainability bond markets. It’s geared towards both issuers and investors, so using this year-end update that Dan prepared as a guide, I asked Dan about how the green and sustainability and social-bond markets did in 2018 and some projections for this year.

Dan Krieter: The green bond market last year total issuance came in at about 170 billion, so a record year for green bonds. That said, 2017 issuance was 135 billion, so 2018 was considered a mild disappointment for green bonds. A lot of estimates from other market participants had green bonds breaching $200 billion in issuance this year. The highest I saw was $400 billion in issuance. That was always a little optimistic, but I guess the bottom line is people were expecting, maybe, more growth this year than we had in green bonds, but still, you know, I think a good year on the whole. Regarding the sustainability bond market, still it’s much smaller than the green bond market. We had issuance of 15 billion, but that’s a record year for sustainability bonds and also a rapid growth. If, you know, we look at 4 years ago, green bonds … Maybe they were issuing $15 billion or so. Now they’re at 170. Sustainability bond at 15 billion, 4 years ago there were zero.

Michael Torrance: And you said that there was a little bit of a disappointment in the growth year over year for the green bonds. What do you attribute that to?

Dan Krieter: In my most recent piece, I tried to take, what I hope, an interesting look at the green bond market. I took an economic theory that pertains to the adoption of innovations typically applied in economics to a new type of technology or a new product that innovates in some way and look at the economic theory behind how that product is adopted by the general public. And if we consider green bonds an innovation of the financial market, which I think is fair to say, we can apply that same economic theory to the adoption of green bonds as a whole in the financial markets. And without getting too deep into the weeds, the innovation adoption theory states that there are five main groups of people in the population, and it begins with what they consider innovators. Innovators are the first stage of the adoption process, and then they’re followed by early adopters, and then we go early majority, late majority and then what’s called laggers. Now without having the benefit of looking at a chart on the podcast, it’s your general bell-shaped curve where the innovators represent only a very small percentage of the market and then early adopters a little more, and you don’t really see a massive growth until you get into the majorities. See early majority and late majority, which represents 75 percent of the market as a whole. If we use that model and apply it to green bond market today, we’re still in the phase of

growth where it’s innovators and now some early adopters who are actively issuing green bonds. And the part that I found most interesting with this innovation adoption economic theory is that around this time when you’re transitioning from the innovators and the early adopters to most of the financial market, they have what’s called a chasm. It’s referred to as the chasm because it’s the point of innovation adaption where innovations tend to find the most difficulty. You already have innovators and early adopters who have engaged the market or the new product, but the majority still remain skeptical, and I think that that’s a fair way of comparing to the green bond market today. Been many, many investors and issuers alike that have engaged the market meaningfully, but I’d say that the majority of investors remain a little skeptical of the market, remain on the sidelines waiting to see if it becomes a full-blown market phenomenon and all issuers are issuing green bonds and ESG ratings become part of the mainstream instead of just, you know, more of a niche market like it is today. And if you buy this theory that innovation adoption can apply to the green bond market, I would argue that maybe we’re at this chasm perspective or this chasm point in the development of the market where we’re just having a little bit of a struggle getting from the innovators and early adopters of green bonds and transitioning it to the majority or the mainstream of the market. And this theory is sort of supported by the issuance patterns we saw last year in 2017 which was the largest year of growth just from an absolute growth-of-issuance year. We saw 90 new different borrowers into the green bond market over 2016. 2018 brought only 44 more over 2017 level, so we saw a slowing in the growth of new market entrance, and issuance was more dependent upon repeat borrowers, borrowers that have already issued green bonds coming again into the market. So, we’re seeing less and less evidence of new issuers coming into the market at this point. Now I don’t want to say that I think that that’s going to continue. I just think that we’re at a particular stage of growth in the green bond market where we haven’t yet got the majority to really focus on the market. I think that is going to happen, but it didn’t happen in 2018, and I think 2019 might even be a little optimistic. Basically, according to the innovation adoption theory, to cross the chasm you need to have marketing efforts designed at getting the mainstream more interested in a market, and I think that those marketing efforts are well underway. We just haven’t finished them yet, and so to that end, maybe green bonds remain a bit of a niche market, a bit of a special interest market until most of financial market participants really engage in the market, and we just haven’t quite gotten there yet.

Michael Torrance: Following our discussion about general trends in the marketplace, Dan and I spoke about some specific topics that he expects to play out in 2019, including the growth of green covered bonds.

Dan Krieter: To answer that question, we must start by talking about what exactly a covered bond is in case anyone is not familiar. So, a covered bond is different from a traditional-type bond because it has really two sources of support for an investor. So normally, a traditional bond is issued by some borrower that promises to pay back the bond. That’s how a bond typically works. A covered bond has that same promise on the issuer, but to may investors feel more secure they will also have a basket of collaterally. Typically, we consider … Covered bonds are issued primarily in Europe, and they’re backed by mortgages, so someone who buys a covered bond has both the promise of the issuer to repay, but if that issuer goes bankrupt or, you know, something happens, they have recourse to a dedicated explicit group of mortgages that “cover” that bond. So, a covered bond is just one that has a specific pool of collateral or assets backing that bond issue, so now looking at what a green covered bond is, that would be very similar to a traditional covered bond, but the cover policy would have assets that are eligible for green bond proceeds in them. So, if an issuer has a portfolio of, say, solar panel projects or green buildings, they would put that into a separate off-balance-sheet trust, and those projects would just support the green covered bond that was issued in conjunction with the cover pool. So covered bonds, like I said, are very, very popular in Europe, and Europe is also the leading geographical area in green bonds, so it makes sense for there to be more green covered bond issuance, and to that point, a very interesting development that happened toward the end of 2018 was that European Covered Bond Council had a task force that was designed, or set up, to define what they call energy-efficient mortgages. Basically, it’s a set of criteria that if a mortgage history certain goals, then that would be considered a “energy-efficient” mortgage, and what that means is then a bank that has a lot of energy-efficient mortgages could put them into a cover pool and issue green covered bonds based off those energy-efficient mortgages. So, we’re going to see a lot more production of energy-efficient mortgages out of Europe going forward now that those standards have been clarified, and it would just follow that we would also see more green covered bond issuance as energy-efficient mortgages rose in popularity.

Michael Torrance: Another area of focus for my team and for BMO is the sustainable development goals. We’re doing a lot of work about trying to align what we currently do with the goals but also using the goals to help define our strategy, and you mention sustainable bonds. Can you talk a little bit about where sustainable bonds are going and how they’re going to be part of strategies aligned to the SDGs?

Dan Krieter: Absolutely. Sustainability goals … Or sustainability bonds, I’m sorry, I should say, are another area of growth that we’re expecting in 2019, and this, you know, spawns very directly with the super national community who invented green bonds. An interesting thing about the super national community is they were seeing a lot of interest in their green bonds, and there was perhaps a bit of confusion on the investor side over the sustainability of all development bank debt. So really any bond issued by a development bank goes toward some sustainable goal, not just their green bonds, all their bonds. But there was some concern that that message was being lost, so some development banks have taken the step of trying to promote the sustainability of all of their bonds rather than just their green bonds, and the next step that has come from that is they’ve begun issuing bonds directly linked to individual sustainability development goals. Not just broad green bonds or broad sustainability bonds, they issue bonds that will directly support one of the sustainability goals. And one type of issue that we at BMO are very proud to have been involved with was a World Bank issue in the Canadian dollar market that was specifically designed to support gender equality, which is one of the sustainability development goals, and we expect them to continue issuing, you know, more SDG-linked bonds. And as the development banks who are, you know, as we talked about earlier, who are the leaders in the sustainability bond market, as they issue more SDG-linked bonds and investor knowledge of awareness, interest in SDG-linked bonds continues to grow, we would expect other types of borrowers, corporates, sovereigns … The same types of borrowers that followed the development banks into the green bond market, we would expect those types of borrowers to follow the development banks into the SDG-linked bond market as well. I don’t know if that’s going to happen in 2019, but I do think we’ll see more issuance particularly from the development banks directly supporting individual SDGs, and then in the years ahead, 2020, 2021, maybe we’ll start to see other types of borrowers in the SDG-linked market as well. It’s a very exciting market to be in.

Michael Torrance: One of the other things I get asked a lot is, what’s in it for the issuer or the holder of a green bond? Like, are there any premiums or enhanced value attached to green bonds? What’s your views on that in terms of the actual data, and where do you see that question of premium pricing going in 2019?

Dan Krieter: Well, the question surrounding premium pricing of green bonds is one that’s very, very important to the market, and I’ll just start by back up a little bit and saying … defining exactly what we mean by premium pricing. So, by premium pricing we mean that an investor is willing to pay up or in some ways accept less yield in order to own a green bond or a sustainability bond, and an argument could be made that the investors benefit from doing so even though you’re optically getting less financial return to own a green bond at a lower spread than a traditional bond. There have been numerous studies in the market that over the long term, issuers with better ESG scores or ESG ratings outperform borrowers with low ESG ratings, so they’ll perform better, more chance of an upgrade or stronger chance of performance of their financial securities. We also have the benefit of being able to market for an investor, say a money manager who manages money in a green bond fund. You could use the disclosure reports from an issuer and say, okay. The financial return, which is just the direct yield of our bonds, came in at, say, 2 percent, just pulling numbers, but then we’ve been able to measure the environmental impact of our investments, and our investments into green bonds, which, you know, we can try to monetize how valuable green bond investments are. Like, carbon has a price. Carbon is traded in some markets around the world, and so if a money manager is able to say,

“Our investments went to save 500,000 tons of greenhouse gas emissions last year,” we can price that. We can say that’s worth another 50 basis points, so while your financial return was only 2 percent, our environmental return was another 50 basis points, so we have “total return” of our green investments at 2.5 percent whereas maybe non-green bonds yielded 2.3 percent. So, you have a lower spread for green bonds, but when you take into account the environmental benefit of the environmental investment, you actually outperform. And the reason I talk about this, why investors maybe would consider accepting lower spread for green bonds, is that it’s important to the long-term viability of the market that a premium does develop for green bonds, and that’s because issuers of green bonds take on additional costs when they issue a green bond. They have to first hire environmental experts who are going to measure the environmental benefit of each project supported by a green bond. Issuers are also expected to produce at least annually, sometimes more than annually, ongoing disclosures to their investors insuring the investors that our green bond proceeds are going to environmentally beneficial projects, and these are the statistics. This is how much environmental benefit our green bonds are creating, so the ongoing costs of those disclosures, having people work on them, hiring environmental experts to do them, it increases the cost of borrowing to an issuer, and if it’s more expensive to issue a green bond than a regular bond, maybe down the line the issuer might just say, “You know what? I’m just going to issue a regular bond because I don’t want to take on the additional cost of a green bond.” So, you know, looking forward, for the green bond market to really reach its full potential, I think a premium for green bonds does have to develop in the long-term. Now where are we now? We do see some evidence of a premium, mostly in European markets, but it’s on a one-off basis. You can’t say for sure that there is green bonds trade two or five basis points to traditional bonds. There is no consistently observable and reliable premium for green bonds in any market yet to date, and we continue to monitor this in hopes that one will develop, but we have not gotten that yet.

Michael Torrance: And so, you know, we’ve talked a lot about the supply side, but what’s driving the demand side? I mean, I’m always blown away by some of the statistics. The Principles for Responsible Investment report, they’ve got signatories that hold assets under management in excess of $70 trillion, so it seems to be there’s a tremendous demand for voluntary good practice in sustainability reasons, but what are you seeing that’s really driving the demand?

Dan Krieter: Yeah, the estimates are certainly staggering behind how much demand is supposed to be out there, and we have seen a lot of demand, but the demand so far has come, I’d say, primarily through institutional accounts, and by institutional I mean, you know, large individual investors rather than, say, smaller investors, say, mutual funds or something like that where small investors pool their money and then buy investments. We haven’t seen a large proliferation of mutual funds or hedge funds that invest in green bonds yet. Rather, the observable growth in demand has really come from the institutional space, large banks. Say, for example, Barclays earlier this year announced that they were going to increase their investments in green bonds from 2 billion up to 4 billion. We see similar large borrowers like, you know, development banks, investment portfolios, large banks, some pension funds. Insurance companies are large borrowers that have committed to buying multiple billions of dollars worth of green bonds. This is where we’ve seen most of demand or growth in demand for green bonds so far. There have been some efforts for more mutual funds. New mutual funds have been launched, and money managers, asset managers are increasing the options of green investments out there, but still the assets under management at green or so-called ESG bond funds in particular still are not as large as, maybe, we would expect them to be given the size of estimates for ESG-themed investments.

Michael Torrance: I’m just going to change gears a bit and ask you about one of the more interesting developments from 2018 that my team has also been keeping a close eye on, which was the workout of the European Union and the High Level Expert Group that conducted its own studies and released a report recommending new regulatory approaches to promoting sustainable finance, and we’ve seen, actually, that many of their recommendations have led to the implementation of regulation in the EU. Can you give us some background about that work and how you think that will affect the market?

Dan Krieter: I think the work being done in Europe in the green bond space is probably the most important thing for the market today and the most exciting, and we talked earlier about how Europe has really been a leader in the green bond market. That’s both from an issuance perspective but also from the perspective of putting in standards and regulations that are going to encourage green bond investment and green bond issuance going forward. So, there have been really four initiatives. So, there was the High-Level Expert Group or HLEG as they’ve said, and they issued their report in Q1 of last year. Then European rule makers took that a step further and took the HLEG recommendations and have implemented some of them into law. Really there were four initiatives that have been proposed to be put into law. One is the development of a green bond label. It was very interesting. So far, there have been a few efforts. China created their own green bond standard, and there are many in the private sector, but no sovereign country outside of China has actually built a green bond standard, and this is what Europe is embarking upon, and we’re expecting to get a report from their working group on the European green bond label in the first quarter of this year that, I think, will have very important ramifications for the market. Outside of the construction of a European green bond label, they’ve also put forth a few other initiatives designed to more explicitly link investment with sustainability, so things such as creating a new category of benchmarks for environmentally or sustainable investments, also more explicitly linking investment so investors will have to, potentially must, disclose their environmental and social governance considerations going forward. And, say in the example of an asset manager, when they have a new client, they must ask them questions about, how important is ESG investing to you, all kind of designed at encouraging investment into ESG types of investments. If there is more of an explicit link between end-investor interests and ESG factors or if asset managers are required to disclose their ESG initiatives each quarter, it could incentivize asset managers of all different types and sizes to increase their investment in the ESG space. So, if you see other countries start to implement these types of initiatives as well, it could really be a big boost for the green bond market and sustainability bond market as a whole.

Michael Torrance: You mention taxonomies before, and I think that was one of the concepts that the EU has been looking at. Can you just explain more what a taxonomy is? What kind of work is happening around taxonomies and what the implication of that work will be for the market as it develops?

Dan Krieter: Yeah, absolutely. So, when we say the word taxonomy, what we really are trying to describe is just, like, a set of guidelines more than anything else that encapsulates what a green bond is or more accurately the type of project a green bond should be used to support. So, an example would be any project that falls into a category, call it solar panels or green buildings or, you know, water management. A project supported by green bond proceeds should be of a specific type. It should have a quantifiable impact on the environment. For example, it should save XX tons of greenhouse gases. Those savings should be measurable and things of that nature. So, with taxonomies, there are many in the green bond market. There’s the green bond principals, which is kind of the most widely recognized and most widely used, but there are many others. There’s climate bond certification. There are also … Like I said, China has its own green bond taxonomy. There are a few different taxonomies out there that are provided by insurance, I’m sorry, assurance providers, institutions like Cicero or OCOM that certify the greenness of an issuers green bond program. They have their own taxonomies, and the taxonomies aren’t always the same. They’re not always directly comparable to each other, so what’s considered a green bond under one standard might not be considered as green on another standard, or some green bond standards might, or taxonomies might, require a certain level of disclosure that others don’t, and there really hasn’t been one taxonomy that’s emerged as, kind of, the most preferred option. Like I said, the green bond principles are the most widely used, but there are others that go into more depth and things of that nature, and there hasn’t been one that’s really, “Okay, this is the taxonomy we’re going to use,” and that’s what Europe is trying to rectify in embarking on building their own European green bond label. When they first began construction on the label, they described the process as trying to create a Rosetta Stone for all existing green bond taxonomies, It will make them all relatable and comparable to each other and kind of become the master taxonomy that all issuers, regardless of type or geographical location, can use and communicate with investors in a way that we can all understand what we mean when describing an individual green bond or a green bond framework. So that’s why there’s a lot of excitement over Europe’s initiative that this could hopefully be, you know, emerge as maybe a new standard in the green bond market that everybody looks to and everyone can use as one template to communicate to each other, which should just help the green bond market to continue to grow.

Michael Torrance: Well, that’s interesting. Yeah, there’s also an expert working group on sustainable finance in Canada that’s advising the government of Canada, and I know that taxonomies and that sort of thing are being looked at closely whether Canada needs its own taxonomy or how our own economy can fit into some of these global taxonomies that are being developed. So just as a concluding thought then, Dan, is there anything that you would suggest to our listeners to keep on their radar for 2019?

Dan Krieter: Well, yeah, and I think the big one is what we just talked about, is the product of Europe’s work into a taxonomy, and I think it’s very important for the reasons we described earlier, but I think what you just mentioned about Canada’s sustainability council is another indication for why what Europe is going to announce this year is so important. There’s a thought out there that there are some issuers or investors that want to get into the green bond market, but they haven’t done so yet, and they’re awaiting the results of Europe’s work to decide, okay, if I’m going to issue a green bond, maybe I don’t want to issue one right now because there’s still this uncertainty over, maybe, what exactly is green or going forward, you know, if there going to be some minute threshold for environmental benefit that’s going to be considered green, and maybe I don’t want to issue a green bond if there’s still a bit of uncertainty there. What Europe’s standard will hopefully achieve is become a, you know, the master taxonomy that everybody can use, and everyone can feel certain that if their green bond conforms to that standard that it will be well received by investors. It will receive good publicity, and it will stand the test of time but will remain, you know, a “good” green bond into the future. So, you have potentially a large amount of market participants waiting in Europe’s announcement before they engage the market. So, I think the results of Europe’s working group is going to be the, probably the single most important storyline of 2019, and, like, I said, we expect their report out in the first quarter of the new year, so hopefully we won’t have to wait too long, but that’s really … If I’m going to focus on one thing this year, that would be what I would be focused on.

Michael Torrance: Fantastic. Thanks so much for your time, Dan.

Dan Krieter: Oh, my pleasure.

Michael Torrance: Thanks for listening to “Sustainability Leaders.” This podcast is presented by BMO Financial Group. To access all the resources, we discussed in today’s episode and to see our other podcasts, visit us at bmo.com/sustainability leaders. You can listen and subscribe free to our show on Apply Podcasts or your favorite podcast provider, and we’ll greatly appreciate a rating and review and any feedback that you might have. Our show and resources are produced with support from BMO’s marketing team and Puddle Creative. Until next time, I’m Michael Torrance. Have a great week.

Legal disclaimer: The views expressed here are those of the participants and not those of Bank of Montreal, its affiliates or subsidiaries. This is not intended to serve as a complete analysis of every material fact regarding any company, industry, strategy or security. This presentation may contain forward-looking statements. Investors are cautioned not to place undue reliance on such statements as actual results could vary. This presentation is for general information purposes only and does not constitute investment, legal or tax advice and is not intended as an endorsement of any specific investment product or service. Individual investors should consult with an investment, tax and/or legal professional about their personal situation. Past performance is not indicative of future results.