UK hops on the sovereign green bond bandwagon, at last

On November 9, Chancellor of the Exchequer Rishi Sunak announced that the UK would issue its first sovereign green bond in 2021, subject to market conditions. The announcement was part of a broader plan for the future of financial services in the UK, which will include mandatory climate disclosure for all companies.

The new stance of the British government on Green Gilts marks a sharp U-turn: they had so far resisted the trend, saying such instruments could end up being costlier than conventional bonds.

The quest for a Greenium

In January 2020, Sir Robert Stheeman, head of the DMO since 2003, indicated bluntly in an FT interview that issuing sovereign green bonds would be a purely “symbolic” step and might well cost money to the British taxpayer. His underlying argument is that one-off bonds of small size tend to exhibit a liquidity premium. According to him liquidity represents a risk bigger than the benefits of establishing a new framework for green debt.

The article also reported that investors did not seem willing to pay more for this new instrument, although they were advocating for its introduction. This feeds into the broader debate around “Greenium”, defined as the yield differential between green and conventional securities. Financial incentives are crucial to catalyze the environmental transition, and cheaper funding for green expenditures is certainly one of them. This may however contradict asset managers fiduciary duties, which require the maximization of investment returns. Additionally, ESG-focused investors make up only a rather small part of global liquidity pools, which may limit their influence on pricing mechanisms.

It is useful to examine this debate in the light of recent events in the sovereign space:

• Germany presented its sovereign green bond framework in September, based on an innovative “twin bond” concept whereby each green security is issued together with a conventional bond with the same financial characteristics. The DMO acts as a counterpart for exchanges between the green security and its conventional twin, keeping a share of the latter in its books to ensure demand is always met. The mechanism was designed to ensure the liquidity of green bonds and resulted in a small Greenium of around 2bps for the inaugural bond.
• Egypt was the first MENA country to issue a hard currency green bond at the end of September and was able to upsize the transaction from USD 500m to 750m on the back of a strong orderbook (5 times oversubscribed). It priced with a 12.5bps negative new issue premium and the bond traded some 20bps below the curve on the days following issuance. On top of the “greenness” of the bond, the strong appetite from emerging market investors may also have been influenced by other factors, such as this being the inaugural issuance in the region, or a wider surge in demand driven by search for yield.

Signalling political commitment to the transition

Besides reaching new liquidity pockets, sovereign green bond issuances enable governments to underpin their broader environmental strategy and affirm their political commitment to combat climate change. Recent issuance of such instruments was well received by the media and the investor community. In his announcement, Rishi Sunak indeed insisted on the UK’s national strategy and climate-neutrality goal, while Boris Johnson followed by unveiling his plan for a green recovery.

This positive trend in sustainable finance is an important opportunity to attract market participants and bolster domestic financial centers. Such is the case for the City, battling to retain its role as the leading European financial center in the wake of Brexit. In this sense, the British government presented its Green Finance Strategy in the summer of 2019, which explicitly aims to position the UK as the leading sustainable finance hub as a source of attractivity.

It was therefore critical for the government to lead by the example and align itself with its peers such as France, the Netherlands and more recently Germany and Luxembourg which have all issued sovereign green bonds.

Caving-in to the demands of investors, academics and issuers

Pressure had been building up on the UK government for several months, and culminated on October 7 with the call on the government by the LSE Grantham Research Institute on Climate Change and the Environment to issue an instrument named “Green+ Gilts”. This call was backed by several academic institutions as well as by a group of investors that collectively manages USD 10tn in assets. (1)

The proposal involved a specific instrument which would share most of the features of a conventional green bond, with a focus on rebuilding the economy after the COVID-19 crisis. The advocates of the initiative stressed how the sovereign issuance will be key in providing a green bond benchmark for sub-sovereigns and corporate issuers.

Such push by investors however comes with increased scrutiny, as they become more wary of greenwashing issues and the associated reputational risk. An example of this trend is the recent decision by NN Investment Partners to divest from the Polish government green bond, due to the absence of a national coal phasing-out policy.

Another example is the second German green bond issuance, which was met with considerably less investor appetite than the inaugural one, reaching a bid-to-cover ratio of only 1.3 compared to a ratio of 5 for the first September issuance. Part of the reason is due to global market conditions, which pushed Bund yields at a low amid the US election uncertainty, but as reported by Bloomberg some investors criticized the government choice to use the funds to finance green expenditures from previous budgets. (2)

Green bond issuances should thus be considered carefully by sovereigns, and need to be underpinned by a credible environmental strategy as well as a robust framework. Otherwise, in a time of low yields across the board, investors might argue that green bonds are irrelevant if they finance already planned expenditures which would have been funded by conventional debt instruments anyway.

Notes

(1) Investors surveyed for the proposal interestingly recommended the government not to aim for a Greenium at issuance “which it was feared would result in demand from niche investors only.”

(2) Many governments are not allowed to earmark bond proceeds for specific expenditures. The solution to issue a green bond is then to “scan” the previously voted budget for green expenditures and to issue up to an equivalent amount of green debt.