Monday 31 May 2021

European Green Bonds and mechanisms for long-term policy commitment

Green sovereign bonds—government borrowing tied to expenditure commitments to climate action—are becoming more common. Notably, the European Union has decided to issue green bonds to finance its coronavirus response program. But how effective will official-sector green bonds be in delivering on climate goals, and could we do better?

This blog reports on a seminar in the Political Economy of European Climate Action series, hosted by the European Studies Centre of St. Antony’s College Oxford, on May 24, 2021, which examined green sovereign bonds. Daniel Hardy (EuPEP, St. Antony’s College, Oxford) dissected their likely efficacy, and proposed an alternative approach; Fatos Koc (OECD), and Martin Ellison (Nuffield College, Oxford) reacted; and Charles Enoch (EuPEP) chaired the session. Click here for the podcast of this session.

Hardy started by documenting the recent proliferation of government green bonds (issues by Germany, UK, Italy, Hungary, Poland, France, Belgium, etc., etc.) but reminded the audience how small this financing still is: government green bonds make up much less than half a percent of world debt; the planned €250 billion issue of Next Generation EU bonds would more than double their stock.

He then examined governments’ motivations for choosing green bonds (instead of plain untied borrowing) and—spoiler alert—found that official green bonds have significant shortcomings in delivering on these objectives.

  • Governments say their primary motivation is to promote their green investment. However—as governments and investors well know—it is meaningless to link specific funds to specific activities in a government budget, since money is fungible and all funding usually flows into and out of a unified treasury account. It is the decision to spend on green investment that pursues the green goal, not how that spending gets financed. In practice, governments decide their projects within the budget preparation process, and their debt managers then look for items that can be tagged as green and attached to green bonds. The rationale for green EU bonds is slightly stronger than for a national government: green bonds can support green investment if: (i) they are allocated to activities that wouldn’t happen otherwise—e.g., the share of NextGeneration EU funding that will be given as grants; or (ii) if they generate funding more cheaply than via plain-vanilla bonds (create a ‘greenium’)—it’s possible the European Commission will be able to borrow more cheaply than the average EU country, though not at a lower rate than, say, Germany or the Netherlands.
  • Other government goals are to cut the cost of funding and widen their investor base. However, so far investors seem willing to accept only a very slightly lower return on green bonds, and this idealism is unlikely to continue to apply to much larger bond issues. Moreover, green bonds are inherently more expensive than plain vanilla bonds, because they incorporate an additional cost—of verifying that the promised green activity gets carried out. A study of German green bonds (Climate Bond Initiative, Sovereign, Green, Social and Sustainable Bond Survey 2021) found the gross benefit to be only about 2 basis points, and more than offset by the added cost of issue. Some small sovereigns might benefit from reaching new investors (e.g., activist groups or pension funds seeking an ESG-portfolio), but bringing in some new types of investors can have downsides: for instance, they may reduce the liquidity in the system or be costly to manage.
  • A further goal is to respond to buoyant investor demand for green assets. But as discussed above, green bonds provide only an appearance of supporting green investment. Moreover, they do not offer any kind of hedge against climate change or reduce any environmental risk.
  • Relatedly, issuing green bonds would allow governments to gauge the extent of popular willingness to pay for environmental policy. As pricing information has shown (see above), willingness to pay extra for the environmental policy embedded in current green bonds is near zero (‘greenium’ is very small).
  • Some governments may wish to help set a standard for green bond design. However, standard-setting is complicated rather than helped by having numerous governments try to set the pace; a better approach would be for a few large issuers to set international standards (say, the EIB and IFC). Moreover, green bond issue has outpaced the development of standards—there is little agreement on how to ensure investments are truly green rather than green-washed. Even the EU will begin to issue green bonds before its own taxonomy is finalized.
  • Governments may also hope to promote their national green finance sectors, but this would be a near-zero-sum game (essentially all striving to keep up with the competition), which in the case of EU countries goes against the single-market objective.
  • And finally governments may wish to show moral leadership… but the ‘cheap talk’ associated with what is merely the appearance of supporting green investment is unlikely to be widely persuasive, and may look cynical.
Having dismantled the case for green bonds, Hardy suggested an alternative financing instrument that would be more effective in delivering on the green goals governments say they want to pursue. He proposes an outcomes-based borrowing instrument: green sovereign warrants. Payments on these warrants would be tied to the country’s achievement of its environmental targets (e.g., to its emissions reduction over a specified period): the worse the government falls short of its target, the greater the payment obligation would be on the warrant.

From an economic design perspective, these warrants would be superior to current green bonds. They would genuinely tie governments’ hands to their environmental commitments, reducing incentives to greenwash and strengthening incentives for long-term sustainable investment. Moreover, by being tied to outcomes (emissions reduction or other sustainability goals), they would leave governments with maximum flexibility in pursuing climate goals, avoiding the distortionary earmarking implied by current green bonds. Other attractive advantages include: (i) much easier administration--notably elimination of the need to verify the delivery of green-bond-tied commitments; (ii) a feedback signal via the price of the warrants on whether the government’s climate policy is credible; (iii) the creation of a natural hedge against risk (those hurt by global warming could go long on the warrants, and losers in the low-carbon transition would go short); and (iv) strengthening society’s engagement in the government’s climate action, with investors becoming cohesive advocates against any reneging on government commitments (and possibly the broader public as well, if some warrants were distributed for social purposes).

Koc, reporting on OECD consultations with government debt managers, confirmed that they share some of Hardy’s reservations about sovereign green bonds: their top concerns are the bonds’ uncertain liquidity and effectiveness in delivering their goals. Green bond issuers say that their two main objectives are to diversify their investor base and to enable governments to show moral leadership on climate change. Besides creating an immediate positive market story, they hope the bonds will help develop the broader market for sustainable financial instruments. Given the buoyant interest in ESG investment, and the greater need for borrowing in the wake of the pandemic, green bonds have been expanding rapidly from their low base: 40 percent of the total stock was issued in 2020.

That said—and in line with Hardy’s presentation—debt managers are finding major challenges with the issuances. The administrative requirements are substantial, requiring coordination across ministries (not usual for traditional debt management), new monitoring and review activities, special marketing, and sometimes legislative changes, since earmarking is expressly forbidden in many countries. A lack of eligible government investment to finance may cap their growth (currently only 4 percent of total OECD government spending is green-eligible), as may the lack of standards. They are seen by some as fragmenting the market, and possibly cannibalizing liquidity in other segments.

Hence, unanswered questions cloud the future of sovereign green bonds. Supply and demand dynamics are unclear: currently demand exceeds supply, but if supply expands much, the small existing ‘greenium’ could disappear. Nobody knows yet how successful they will be—or indeed how to measure their success (e.g., given the scope for greenwashing). Progress with standardization will help, but ultimately the future of sovereign green bonds will depend on whether somebody comes up with a more efficient idea for helping governments’ climate action. Hardy’s proposal is one intriguing possibility.

Ellison found Hardy’s idea clever: making the debt service contingent on success would create a good incentive for governments to do the right thing. Alas, however, state-contingent debt has generally not been successful, despite a long history. For instance, Argentine GDP-tied warrants issued in 2005 traded at heavy discounts. Recent IMF work (Roch and Roldan 2021) explains the poor take-up of welfare-improving state-contingent debt by the likelihood that lenders overweight the probability of bad contingencies—i.e., charge a large premium for ambiguity. This work was based on GDP-tied examples; it is likely however, that ambiguities associated with governments’ intent and capacity to bring down emissions are even greater than those associated with their ability to deliver on GDP promises. Hence, Hardy will need to ask whether the premium on the warrants would be too high, despite their positive contribution to welfare.

The offline discussion centred on whether the warrants could be designed successfully. All agreed that product design would be key, with some commentators noting that ESG investors are more passionately committed than GDP-linked investors. In particular, some considered that small retail investors could be a stable source of funding at lower premia. Also, objective anchors do exist for pricing the warrants—such as governments’ ESG ratings and prices in carbon futures markets. These anchors might provide superior mechanisms for strengthening governments ’commitment to decarbonization. Panelists and audience had mixed enthusiasm for the work currently being done by institutions to support green bonds. On the one hand, the work of the OECD, EC, IMF, World Bank, etc. to develop taxonomies and to green the financial system is very welcome; on the other, central banks’ involvement in purchasing green bonds risks doing harm by muddying their inflation-control objective.

Adrienne Cheasty (Academic Visitor, St Antony's College, Oxford)

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