With Marc Goedhart
Fifteen years ago, the notion that capital raising could have a social or environmental connection would have seemed … different [1]. Today, financing for a broader good is among the highest-profile types of debt. While the market is still relatively small, cumulative issuances of societal and sustainability-linked debt, including green bonds, have risen substantially in recent years, from about $200 billion in 2017 to more than $4.2 trillion by mid 2023 [3].
In this post, we will address sustainability debt specifically [4]. In particular, we want to address three misconceptions
1. 'There is one standard’
In recent years, guidelines on what constitutes green bonds have been provided by, among others, the Climate Bonds Standard (CBS) of the Climate Bonds Initiative, the Green Bond Principles (GBP) by the International Capital Market Association, and the EU green bond standard (EU GBS). There is no end in sight for this confusion.
We find it simpler to think about green debt in two categories that seem to encompass the basic ideas well enough for the practitioner:
2. ‘Green debt lowers the cost of capital meaningfully’
You should always be skeptical that a specific type of financing—including green debt—can be a “silver bullet” to reduce cost of capital. Best we can tell, interest rates for green debt are only about five to 20 basis points lower than standard corporate debt at the moment [5]. That’s before considering any applicable costs for reporting of and auditing for the use of bond proceeds or the achievement of sustainability targets. In our experience, bonds with interest rates tied to sustainability targets trade at a yield equal to a probability-weighted average of the two possible outcomes (the issuer achieves the specified sustainability targets or not). Moreover, the interest rate penalties for not achieving the targets do not seem to be material in many (but not all) cases.
Most importantly, even if you can save cash, this difference - if it exists - doesn't matter in the context of corporate decision making for most corporations. At 20% tax rate and 20% debt in the capital structure, a 50bps difference in cost of debt - if real - would reduce the cost of capital by 20%*20%*.5% = 2bps. This simply doesn't matter unless you are a 100% "green" company with a very high amount of debt. For example, some European energy companies have half of their debt outstanding in the form of sustainable bonds and loans.
Of course, across industries, if there are meaningful opportunities to obtain low-cost funding net of all associated expenses, companies should indeed try to realize them. But this won't matter (at the moment) for strategic decision making. Benefits need to come from the business, they won't come from lower cost of capital.
3. ‘Only sustainable businesses have access to capital’
Depending upon the regulatory regime, financial institutions can be a critically important factor in achieving specific ESG outcomes. Some banks have experimented with revolving credit lines tied to corporate sustainability goals. But bank financing is not the only option. For example, private equity funds raise money specifically to invest in established fossil-energy production sites. Oil companies didn't have any problems financing recent very large acquisitions, and investor money is flowing back into the industry [6]. However, even though there is no imminent lack of access to debt funding, this could become relevant in the future for some businesses under some regulatory regime.
A more interesting question might be the power of insurance companies - will more "brown" projects become uninsurable, like new coal mines already seem to be?
Capital structure will follow corporate strategy
From what we can see at the moment, if a company’s products and services add value within legal and ethical custom, some form of debt or equity funding should always be available from some capital market because the company can offer an attractive return. Sustainability, as part of a company’s business model and strategy, can be a source of value creation in multiple ways, not least in maintaining a company’s social license to operate. But at the moment, it doesn't meaningfully change the cost of capital for decision making in large corporations
[1] In the modern era, “social impact bonds” were pioneered in 2010 by Sir Ronald Cohen, who created bonds with coupons linked to recidivism rates at Peterborough Prison in England.
[2] “Sustainable debt tops $1 trillion in record breaking 2021, with green growth at 75%: New report,” Climate Bonds Initiative, April 25, 2022.
[3] H1 2023 Sustainable Debt Market Summary, Climate Bonds Initiative, August, 2023
[4] While the scope of this article is green debt, it’s worth noting that there are additional forms of sustainability-linked loans and bonds that are structured to meet other social or governance goals. For example, one pharmaceutical company issued bonds for more than €1 billion, which pay higher interest rates if specified targets for providing medicines to less-advantaged patients are not met. Another example is a “gender” bond, which provides incentives for the debtor to increase the number of its women leaders.
[5] Research findings on any premium or discount for green bond yields are not conclusive. See, for example, David F. Larcker and Edward M. Watts, “Where’s the greenium?,” Journal of Accounting and Economics, April–May 2020, Volume 69, Issues 2–3 (find no premium); Andreas Karpf and Antoine Mandel, “Does it pay to be green?,” Panthéon-Sorbonne University working paper, February 24, 2017 (find a yield premium for green bonds of eight basis points); Olivier David Zerbib, “The effect of pro-environmental preferences on bond prices: Evidence from green bonds,” Journal of Banking and Finance, January 2019, Volume 98 (finds a yield premium of two basis points); Malcolm P. Baker et al., “Financing the response to climate change: The pricing and ownership of US green bonds,” National Bureau of Economic Research, October 12, 2018 (find a green yield discount of several basis points); Britta Hachenberg and Dirk Schiereck, “Are green bonds priced differently from conventional bonds?,” Journal of Asset Management, August 6, 2018, Volume 19 (find a yield discount of about four basis points).
[6] Arleen Jacobius, “Private investors are edging back into oil and gas,” Pensions & Investments, October 17, 2022.
