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Australian funding officials are increasingly trying to get a better understanding of the green bond market, weighing up relative pricing against conventional debt issuance and figuring out how much investors really care about the product. FinanceAsia and Westpac Institutional Bank sat down with some of the leading experts in the market to find out — and to get a sense of just how big this market could become.
Participants
Pablo Berrutti, head of responsible investment Asia-Pacific, CFSGAM
Mark Goddard, head of DCM and syndicate, Westpac Institutional Bank
Bill Hartnett, head of sustainability, Local Government Super
Richard Lovell, executive director, Clean Energy Finance Corporation
Maria Milis, director, institutional credit sales, Westpac Institutional Bank
James Pearson, manager, responsible investments, QBE
Richard Salmon, associate director, group treasury, Westpac
Ian Woods, head of ESG investment research, AMP Capital
Moderator
Cherie Marriott, FinanceAsia
Since the first Australian green bond was issued by the World Bank in April 2014, deal volume has surpassed A$2 billion. Have you been pleased with the development of the market?
Bill Hartnett (left): At Local Government Super we bought our first green bonds four years ago and now we have total holdings of about A$90 million. Overall we have been happy with the way the market has evolved, particularly in relation to the development of a framework of standards to support the market. All the deals so far have been institutional grade assets with the right guarantees, ratings, coupons and yields to attract investors. Investing in low carbon assets isn’t an easy process. There is greater scrutiny of the assets by investment boards and multiple additional hurdles to jump, so you want to ensure the decision-making process is well thought-out.
Richard Lovell: In many respects, the green bond market has developed in the same way and encountered the same issues as the Australian bond market as a whole. The vanilla bond market is somewhat constrained to investment-grade issuers and green bonds have clustered in this area too, for the moment.
Pablo Berrutti (right): At First State Investments we have been pleased with the primary market deals to date. They have been well structured and well priced. There is still a problem with liquidity in the secondary market. Many asset owners are sitting on their bonds and not trading them, so we are not receiving the liquidity premium in the secondary market that we would expect. This is holding back some investors.
There was a rush of deals at the end of 2104 and then issuance slowed in 2015. Any explanation for this lull?
Hartnett: We were a bit concerned about the slowdown because we wanted to have more deals to choose from and see a curve develop. We realise the market can only grow in line with the availably of green assets to finance, but we want issuers to be maintain their focus on green bonds and help the market to grow exponentially. 2016 already looks better with deals for Flexigroup, Westpac and TCV all coming in the first half.
Mark Goddard (left): The green bond market doesn’t act in isolation from the broader Australian bond market and during 2015 borrowers were holding back from issuing all types of instruments. There was heightened execution risk and investors were going to the deepest pools of liquidity, which are often offshore. That said, green bond volumes have grown from under A$1 billion at the end of 2014 to over A$2 billion now, so the pace has picked up.
All deals thus far have involved refinancing existing assets rather than funding new green investments, is this an issue for investors?
Lovell: We always consider whether any deal is simply a refinancing or whether there is new activity being facilitated by the funding raised. It is an important issue for us, but we also understand that in order to develop an ecosystem for this asset class we have to start somewhere. It makes sense for the first issuers to be seasoned borrowers such as financial institutions and semi-government issuers. Ultimately, however, we would like to see a fully evolved market where these bonds are used to fund assets right across the risk spectrum. There is a dire need for funding for all types of assets that meet the green bond criteria.
Richard Salmon (right): When the treasury team at Westpac sat down to put together the bank’s first green bond we had plenty of discussions about whether investors would be happy buying a refinanced asset and whether we could actually classify it as a green bond since there is no recourse to the underlying assets – the risk is all with Westpac as a group. But the overwhelming response we got from speaking to investors was that they wanted investment-grade names like Westpac to issue and support the evolution of the market. This was a first step for us. Hopefully down the track the market can also look at issuing securitised assets as green bonds as well.
Goddard: It was not surprising that the first deal to come to market was from a supranational with a deal from the World Bank. It provided investors with a local pricing point for an issuer that already had green bonds in other currencies. Following that, the next logical issuers were the Australian domestic banks whose curves are the reference for the broader credit market in the domestic Australian dollar market. The next wave – the semi-government issuers – has now started and we’d expect to see corporates look at it after that.
Maria Milis (left): My guess is the green bond market will develop much like the corporate bond market in Australia. It will start with the big benchmark investment-grade issuers and then move towards smaller deals, possibly private placements or structured deals that are sub-investment grade.
How important is it for issuers to seek third-party verification of their bonds and Climate Bond certification?
Lovell: We have the luxury of being a specialist in the field with strong internal due diligence capabilities, so we have flexibility to invest in bonds that are non-certified. However, most institutional investors want the assets they are buying to be certified and monitored on a semi-annual or annual basis. They also want them included in the green bond index.
Salmon: Globally the sub-set of fully certified green bonds is small. When we issued in the market we asked investors if they required certification and while many of them said not necessarily, the feedback was that it would make the decision process easier. As it was our inaugural issue, we went ahead with the process of seeking a Climate Bond label to support the bonds’ appeal to as broad an investment base as possible. We report on this certification semi-annually in line with the group’s clean tech reporting schedule.
James Pearson (right): We ideally want certification and verification on the deals we invest in because of the reputational risk that comes with saying we are a green investor we need to make sure the assets we buy are truly green. Often we use the certification to support our own internal assessment of a bond’s credentials. We also want to see regular monitoring and measuring of green credentials because what might be classified as a best-in-class green bond today may not be so in three years’ time.
Hartnett: We like our bond holdings to be certified but we don’t insist upon it because we want to see the market develop. We will consider any bond that can prove that at least it isn’t high carbon. However, we are pleased a certification process has been established and is improving. It may one day lead to bond issuers being required to make disclosures around the sustainability attributes of their non-green bonds.
Ian Woods (left): I agree with this. My hunch is that while issuers may not receive a premium for issuing green bonds there may come a time when non-green bonds are discounted because of the uncertain climate change risks they may carry.
Are deals being targeted at dedicated green bond investors only and, if so, what’s the idea behind such a directed distribution strategy?
Goddard: When we managed the transaction for the World Bank the focus was on allocating to investors with specific green bond mandates. The deal was limited in size to A$300 million and the World Bank wanted to build the foundations of a new market. Since then attitudes have been changing and it’s now broadly accepted that a green bond is defined by the assets, not the investors who buy it.
Salmon: When Westpac issued its bond it was our objective to appeal to both dedicated green bond investors as well as general fixed-income investors. In terms of allocation, we tried to place more with dedicated green bond investors because our aim was to expand the size of the whole market.
When will the market be ready to embrace green bonds issued to finance new no-carbon or low-carbon investments?
Hartnett: It’s hard to put a timeframe around this. When green bonds are used to finance new investments a whole new set of credit risks come into play. A lot needs to be done for the market to welcome these bonds and we’re not there yet.
Berrutti: Traditionally the use of bonds to fund new projects has been limited. Fixed-income investors haven’t yet become comfortable with the underlying risks in greenfield assets, such as renewable energy projects, so the question is whether green bonds can be structured to form part of these financing packages. We still don’t know whether investors will be ready to support non-investment grade credits or bonds that don’t have full recourse back to the borrower but are tied to the assets themselves.
Pearson: At QBE our internally managed credit book is focused specifically on investment-grade credits. We have some high-yield exposure but we use external managers for this. We are likely to be restricted to investing in investment-grade issuers that have a borrowing track record. This means we are unlikely to invest in a green bond from a sub-investment grade issuer where the risks are harder to quantify.
Hartnett: Our situation is different. We have the capacity to invest in high-yield, and we do so. We look at any opportunity that comes along but at the moment the closest thing we’ve been able to find in the lower-grade space is a social impact bond, and these look more like loans than bonds. Eventually we hope to see corporate issuers in the green bond space, with a credit rating and backed by a corporate guarantee.
Lovell (right): We receive enquiries from non-investment grade investors looking for green opportunities. They don’t tend to have the same risk constraints as the larger superannuation funds. But the demand for these investments vastly outstrips supply and to get lower grade issuers to come to market takes a lot of intermediation. One of the CEFC’s policy objectives is to develop programmes in several sectors – some of which may not exactly meet the climate bond standards – and then bring in other investors to partner in these deals. We have our own high standards regarding eligibility for clean energy projects and the types of activities we will finance. And of course, we are also always careful not to back a deal that has the potential to negatively impact perceptions of “green” branded bonds. Market faith in these areas is important and if it’s damaged it will take a long time to recover.
Salmon: I am not sure whether greenfield assets will ever have the type of risk profile to make the bond prices attractive to investors. Unlike some other offshore jurisdictions, the Aussie bond market has a very small high-yield component. I see green bonds as an opportunity to allocate more of bank balance sheets to existing green projects. Being able to fund existing assets like Westpac did with its bond in May is a good first step, although the credit risk infrastructure of a bank means it will probably be best placed to assess the credit risk of a greenfield asset.
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It was initially thought that issuing a green bond would offer borrowers a cost saving. Has this transpired?
Goddard: From a borrower’s perspective, the decision to issue a green bond versus another bond instrument is always a commercial decision based on which market offers them the best pricing at a particular time. The Westpac bond showed that a green bond and a vanilla bond can price flat to one another. When issuers were first looking at these instruments there was a perception that issuing a green bond would be cheaper but this hasn’t eventuated. Now the focus has shifted and issuers have become focused on establishing a curve and building a viable market. Over time there may be a saving that comes with issuing a green bond.
How long before such a decoupling occurs?
Goddard: The domestic market needs to develop considerably more depth and liquidity as a whole for this to happen.
What about the issue of secondary market liquidity which Pablo at Colonial First State raised earlier. How can this be improved?
Milis: We have found that where there is a seller there is always a bid, but there aren’t many sellers around. For as long as primary supply is less than demand, this dynamic will exist.
Hartnett: We hold about A$90 million in green bonds at present and we don’t classify them as any less liquid than our other bonds. We know that if we had to sell them quickly, we would be able to find a buyer.
Okay, looking ahead at the potential pipeline for green bonds in Australia, what type of assets are likely to be eligible for green bond classification?
Woods: Following on from the bank and semi-government deals, the next issuers are likely to be the utility companies and the commercial property developers. After that, the field of domestic corporate issuers quickly thins out. However, there is plenty of potential for offshore borrowers to sell Aussie-denominated bonds into the Australian market. There is growing awareness of the demand for green bonds from local institutional investors, especially the big superannuation funds.
Salmon: If we look at global precedents, particularly China, there is a possibility to structure deals around the transport sector such as rail infrastructure.
Lovell: We are excited about the potential in the renewable energy market. In Queensland alone the current total renewables capacity in the state is a fraction of the capacity required in the next 15 years if the government is to meet its renewable targets. This is a massive funding requirement and there is only so much that can be absorbed by the banks. We see significant potential in other asset classes related to energy efficiency as well.
Woods: I agree there is plenty of money needed to meet renewable energy targets in Australia and the equity market will be able to fund some of this. But there are many hurdles to be overcome before these targets can be turned into bankable assets, not least the issue of regulatory settings.
Hartnett: As a fund we don’t have any issue with technology risk and the cost competitiveness of new-build renewable energy versus new-build fossil-fuel energy. We are more concerned about how renewables can compete with existing fossil-fuel electricity providers when they have had all their upfront costs written off over 30 or 40 years, and are at a stage of benefiting from efficiencies. Renewable assets represent disruption technology and are therefore harder to value.
What about the commercial property sector as a source of deals?
Goddard: The commercial property sector already has its own framework of best practice benchmarks for sustainability such as the Green Star rating system which makes this an easy sector to measure and turn into a fixed-income product. Not only is there a solid pipeline of new stock being built in commercial centres around Australia, there is a large stock of existing buildings that are being refurbished that could be included.
Lovell: The standard of Australia’s existing commercial building stock is generally very poor. There is a great opportunity for building owners to use the green bond market to refurbish their buildings and turn them from a 2.5 star building to a 4.5 star building, for example.
What sort of innovations have we seen in more recent deals?
Lovell: The Flexigroup transaction was interesting. It had a A$50 million green bond tranche within a $260 million general fixed-income deal. The green tranche was identical in almost every respect to the equivalent non-green tranche and yet Flexigroup was able to use scarcity to drive price differentiation. We expect to see issuers try and be a bit smarter around some of the structuring techniques as time goes on.
Milis: By offering a green tranche within a standard bond issue – which is also what Westpac did – you are able to issue a larger amount of fixed bonds. These multi-tranche deals will become the norm.
I can see how issuers benefit from a level of kudos by bringing their first green bond to market, but what is likely to motivate them to come back again and again?
Pearson: I have asked this question myself and it is something investors are concerned about. I can see the advantages of doing an inaugural issue – it brings a certain public relations benefit. But does this benefit trail off in the third or fourth deal? Investors will be expecting ongoing verification and monitoring of the green assets and this adds to the cost of maintaining a green bond programme.
Goddard: Yes, however, once you have the structures in place and you have issued once, it is easier to reissue and to keep the monitoring process going. I think the corporate feel-good factor that comes with issuing a green bond has a certain amount of stickiness. And, of course, the other benefit is the ability to access a new pool of investors. This Australian pool might not be deep at the moment but the whole market is growing and as more green bond investors emerge it will be important for issuers to show they have a track record in the green space.
Hartnett: I would also argue that it isn’t prohibitively expensive to issue a green bond. It’s something like 0.1% of one basis point and corporates and governments should be prepared to wear this cost if they are serious about de-risking their assets.
Is there any equity upside for a corporate to issue a green bond? Do shareholders really care?
Goddard: I believe shareholders have an awareness of the issues around carbon footprints and sustainability, and public companies recognise this. It has become necessary for all companies these days to have some sort of policy statement about their approach to sustainability and how they plan to minimise their environmental footprint.
