Sovereign green bonds: What role can they play in transition to net zero?

What are sovereign green bonds?

Green bonds are fixed-income instruments designed to finance projects that have been specifically earmarked as climate or environment-related. A green sovereign bond is simply a green bond that has been issued by a sovereign government.

What is innovative in the UK's green gilt programme?

Mario Pisani, Deputy Director at HM Treasury, kicked off the event by providing an overview of the UK's sovereign green bond programme.

In September 2021, the UK government launched the United Kingdom's first green "gilt" (i.e., gilt-edged security or UK government bond), a 12-year bond which raised £10 billion. This was followed in October by the issuance of 32-year green gilt of £6bn.

The key design features of the green gilt are as follows:

• The specific categories of expenditure that can be financed with green gilt proceeds are published in a use of proceeds framework document. They include areas such as clean transportation, energy efficiency and climate change adaption including flood defences (see the full report for details).
• The proceeds can be used to fund green expenditures within a 4-year window, which includes both new expenditure as well as expenditure that occurred in the year prior to issuance. At least 50% of the proceeds will be allocated to new projects.
• The expenditure will be overseen by a new Inter-Governmental Green Bond Board, chaired by HM Treasury and with participation from government departments benefitting from the proceeds.
• As part of the pre-issuance assurance process, the UK government sourced two independent second-party opinion reports. A report by Vigeo Eiris (VE) found that the framework is consistent with the Green Bond Principles developed by the International Capital Market Associated (ICMA). A report by the Carbon Trust found that the intended use of proceeds is consistent with targets set by the Committee on Climate Change. This assurance process was felt to be particularly helpful given the forward-looking nature of some of the intended expenditures.
• The UK government will publish an annual Allocation Report, detailing the use of proceeds and the balances that remain unused. It will also publish a biennial Impact Report, which will include information on the social as well as environmental impact of the programme.
• Alongside the green gilt programme, the UK government is offering a green retail savings product, which offers households a 3-year fixed rate savings product whose proceeds will be earmarked for green spending projects.

Why do investors value green bonds?

Sovereign green bonds command a higher price – i.e., they offer a lower yield – than conventional bonds issued by the same entity. This is sometimes referred to as the "greenium". This price difference is somewhat puzzling in that the coupon and principal on these bonds will be paid from the same revenue stream as conventional bonds – they have identical credit risk.

Philip Smith (Blackrock) led off the discussion by explaining the considerations driving the demand for sovereign green bonds by investors despite their lower yield.

One rationale is an expectation that the demand for green bonds will continue to outstrip supply for some time to come, increasing their relative price further and yielding a capital gain for current investors.

A second possible driver is regulatory pressure – for example, The Pensions Regulator in the UK recently introduced guidance that pension fund trustees need to take ESG considerations into account in their portfolios. Although this raises questions about whether investing in such lower-yielding assets cuts across pension schemes' fiduciary responsibility to achieve the best financial outcome for their members.

A third explanation is that the demand reflects non-economic factors – a belief that investing in such assets will lead to increased green investment, creating long-term benefits for society. There was not yet concrete evidence that such programmes generate more investment than would otherwise have been the case, however.

What role can sovereign green bonds play for emerging markets?

Matteo Bigoni (British International Investment - formerly CDC Group) followed by describing the purpose of sovereign green bonds from the perspective of a development finance institution.

British International Investment (BII) had recently published its new 5-year strategy, under which it will commit to allocating at least 30% of new investments into climate finance. The geographical regions in which it operates have also expanded, and include sub-Saharan Africa, South-East Asia and the Caribbean. This reflects their development objective to achieve social impact as well as climate impact.

The societies that are most susceptible to the adverse effects of climate change are those that are most vulnerable at present. Recognising this, the BII's priorities are in quantifying the impact that sovereign green bonds can have in alleviating such effects – for example, by financing adaptation and resilience initiatives in developing countries.

Sovereign green bonds also offer a perfect financial vehicle for countries to finance the pledges they have made to reduce greenhouse gas emissions to levels consistent with the Paris Agreement (i.e., their nationally determined contributions (NDCs)). The large-scale investment required for the transition will create strains on public finances, which can be alleviated by sovereign green bonds. Issuing such bonds can also act as a commitment device, signalling the direction of travel to stakeholders and helping to kickstart private sector green bond issuance.

What are potential limitations of sovereign green bonds and the UK's programme?

Sarah Bracking (KCL) ended the initial round of presentations by offering some critical reflection on the promises and limitations of the UK's sovereign green bond programme.

First, while this is a promising initiative by the government, green gilts still only account for a small portion of overall funds raised through government bond issuance. There is scope to expand the scale of this programme significantly – a point reinforced by the fact that the order book was 12 times oversubscribed by investors.

Second, the extent of "additionality" (i.e., new investment that would not otherwise have occurred) created by this programme is unclear. Some of the proceeds can be spent on eligible expenditures that have already occurred. Moreover, the funding is not entirely ring-fenced as HM Treasury maintains the right to manage any unallocated proceeds. And there is no guarantee that governmental departments that are successful in securing some of the proceeds of green gilts will not see an offsetting reduction in their normal funding.

Third, while impressive, the impact framework requires further work to refine some of the indicators used. There are also questions about how the UK's green taxonomy will dovetail with the EU's taxonomy published last year given the benefits for investors of standardisation. Sarah emphasised that climate change is a social problem primarily and monitoring the distribution of the costs and benefits of a just transition requires a wider frame of reference than the impact monitoring framework provided by this programme.

General discussion

In the ensuing discussion, the panellists explored some of these issues further, alongside questions from the audience.

Responding to a question about the small scale of the green bond market, Philip Smith noted that in the UK's case, this undoubtedly reflected the newness of the sovereign green bond programme. The experience in other countries has been that sovereign issuance leads to a scaling up of issuance in the private green bond market. He also noted that there remain challenges with the definition and administration of green taxonomies to ensure that the quality of green bonds is maintained.

Matteo Bigoni explained that when deciding whether to invest in a green bond, BII employs the taxonomy used by other multinational development banks, such as IFC and EBRD. This attempts to define green in a granular way based on the intrinsic features of the underlying eligible assets, helping to reduce the risk of "greenwashing". He also noted the importance of alignment in methodologies, which help to promote transparency, consistency and coherence in this market.

Mario Pisani reinforced this point, stressing the need for interoperability across green taxonomies in national jurisdictions. In response to a question as to why the UK government had not used the principles developed by the Climate Bonds Initiative, he explained that the UK's taxonomy has wider scope, covering environmental aims as well as those relating to climate change.

In response to a question from the audience, Mario Pisani explained that, in the UK, as in most other countries, revenue flows from taxes or borrowing cannot be hypothecated to particular projects. The principles, taxonomy, verification and reporting requirements of this programme guarantee to investors that the proceeds will be earmarked in the advertised way. Matteo Bigoni noted that this inability to ringfence the proceeds created a challenge for investors, particularly those investors in countries with greater political instability and lower confidence in the government.

On plans for this scheme going forward, the Chancellor of the Exchequer's Spring Statement had outlined plans for a minimum of £10bn further green gilts issuance in 2022-23. This was somewhat lower than markets had expected. Mario Pisani explained that the scale of the programme was constrained by the amount of eligible expenditure in the window. The forward-looking nature of the scheme meant there was a trade-off between additionality and providing ex ante transparency to investors on how the funds would be allocated. But the Committee on Climate Change had estimated that the UK would require £50bn per year for next 30 years to finance the transition to net zero (a legally binding commitment). While not all this would come from the public sector, it was inevitable that the scale of this scheme would increase in future.