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  • Writer's pictureVipanchi Jain

What makes a bond green?

Green bonds enjoyed a 49% growth rate in the five years before 2021, according to Climate Bonds, whose analysis suggests the green bond market annual issuance could exceed the $1 trillion mark by 2023 (currently, $1.7 trillion issued since inception, over $500 billion in 2021 alone). While the success of green bonds has also inspired the creation of other labeled bonds, such as social bonds, in today's edition we will focus on what classifies as a “green” bond and MSCI and S&P’s ESG index.

What to expect today:

What classifies as a "green" bond?

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Green bonds are financial instruments that finance green projects and provide investors with regular or fixed income payments. Green bonds are designed to connect environmental projects with capital markets and investors and channel capital towards sustainable development.

How is a green bond issued?

Potential issuers (companies who want to raise capital for their green initiatives) start by putting together a green bond framework outlining how the proceeds will be used and the impact the bond will have in years to come. Next, issuers present their green bond framework to second party opinion providers for verification. They determine whether the bond is truly green. Once the bond has been verified, the borrowers meet with potential investors, who ask questions related to usage and impact of bonds. Lastly, issuers of green bonds are expected to report to investors annually.

How much capital is tied to green bonds?

A tidal wave of money has flowed into funds focused on environmental, social and corporate-governance principles in recent years. In 2022 alone, $129 billion has been issued in green bonds (over $500 billion issued in 2021), however only $6 billion was issued in certified green bonds whereas $122 billion was not certified but voluntarily aligned with CBI definitions of a green bond. An appetite for green stocks with the best credentials means those shares now come with a premium. Some fund managers are looking instead to invest in companies that are still working to improve their ESG footprint.

Tough road ahead

While green bonds have seen tremendous activity, there are several challenges that investors must navigate:

  • While credit ratings are used in the bond market to provide information of the borrower’s creditworthiness, green bonds do not have a universal standard that determines the “greenness” of the bond

  • Green bonds are more expensive than traditional ones. This is because green bonds must demonstrate their “green” credentials such as the Green Bond Principles. The process of showcasing environmental impact along with periodic audits of activities adds to the additional cost. The term “greenium” is used by investors which means a premium on an issuer’s green bonds compared to their traditional ones.

Overview of an ESG Index

Image Source: Photo by Craig Adderley

The S&P 500 ESG Index uses environmental, social and governance data to rank and effectively recommend companies to investors. Recently, the S&P 500 knocked out electric vehicle maker Tesla from its ESG Index. It said that Tesla’s “lack of a low-carbon strategy” and “codes of business conduct,” along with racism and poor working conditions reported at Tesla’s factory in Fremont, California, affected the score.

Importance of ESG Indices

The S&P 500 ESG Index uses environmental, social and governance data to rank and effectively recommend companies to investors. Its criteria include hundreds of data points per company that pertain to the way businesses affect the planet and treat stakeholders beyond shareholders — including customers, employees, vendors, partners and neighbors. These indices help to mitigate and assess the risk of companies against ESG factors, thus allowing companies to be more socially responsible. In 2020, net new assets into ESG funds jumped to $51.1 billion — more than double the year before. Last year alone, these funds attracted nearly $70 billion in new assets.

MSCI World Index vs S&P 500

We looked at two popular ESG indices - MSCI and S&P 500 and found little difference in their methodologies. Sharing the methodology for MSCI here as more capital is tied to the MSCI index as compared to the S&P index

MSCI ESG Ratings calculate each company’s exposure to key ESG risks. Risk exposure is scored on a 0-10 scale, with 0 representing no exposure and 10 representing very high exposure. For example if a company produces large carbon and toxic emissions, it must have strong risk mitigation programmes to score well. There are 35 ESG key issues. Environmental issues include:

  • Climate Change (Carbon Emissions, Carbon Footprint)

  • Natural Capital (Water stress, Biodiversity and land use)

  • Pollution and Waste (Electronic waste, Packaging material and waste)

  • Environmental Opportunities (Opportunities in green tech and green building)

Social issues include human capital related issues like health and safety, labor management. Lastly, governance issues include corporate governance like pay, ownership etc. Feel free to go through the entire methodology here.

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