What are green bonds and why is this market growing so fast?

This article has been updated.

Tackling the climate crisis won’t come cheap. The United Nations’ Intergovernmental Panel on Climate Change estimates that limiting the temperature increase to 1.5°C, the goal of the Paris Agreement, will require over $3-6 trillion of investment every year to 2050.

To raise those vast sums, governments and corporations are increasingly turning to green bonds.

Green bonds work like regular bonds with one key difference: the money raised from investors is used exclusively to finance projects that have a positive environmental impact, such as renewable energy and green buildings.

With countries around the world stepping up their efforts to reduce carbon emissions, the market for green bonds is booming. This rapid growth was first highlighted in October 2021, when the European Union (EU) issued about $14 billion of the bonds – the largest deal ever at that time.

The first green bonds were issued in 2007. The market grew slowly for nearly a decade, but then it started to take off. Global green initiatives such as the Paris Agreement on climate change and the UN Sustainable Development Goals have helped spur this expansion.

Strong demand for green bonds is also driving growth, with major investors from asset managers to insurers and pension funds keen to scoop them up.

In November 2023, Brazil sold its first-ever green bond, intended to support President Luiz Inacio Lula da Silva's ambitious plans to safeguard the Amazon.

Turbo-charged by this combination of political resolve and investor appetite, the green bond market is expanding steadily.

Annual issuance of all GSSSBs (green, social, sustainability, and sustainability-linked bonds) could hit $1.05 trillion in 2024, up from $0.98 trillion in 2023, according to S&P Global.

It’s still just a niche in the overall global bond market, but the GSSSB share of global bond issuance may reach 14% in 2024. So there’s plenty of room for GSSSBs and green bonds to keep on growing.

The first green bond was issued in 2007 by the European Investment Bank, the EU’s lending arm. This was followed a year later by the World Bank. Since then, many governments and corporations have entered the market to finance green projects.

The US is one of the largest sources of green bonds, led by the government-backed mortgage giant Fannie Mae. Corporations from Apple to Pepsi and Verizon have got in on the act. State and local governments have also turned to green bonds to pay for infrastructure projects.

Green bond issuance reached a total of $575 billion in 2023, up 10% year on year, according to S&P Global. This was largely due to increased issuance from Europe, with another year of contraction from US issuers.

Nonfinancial corporates still make up the "largest portion of the green bond market, but the financial services sector now has nearly equal volumes after three consecutive years of growth", says S&P Global.

Green bonds operate within the debt capital markets to fund climate and environmental solutions.

The most common type is the "use of proceeds" bond, where the funds raised are earmarked for specific green projects but backed by the issuer's entire balance sheet.

The issuance process involves several steps, including identifying eligible green projects, creating a Green Bond Framework aligned with the Green Bond Principles, and often obtaining third-party verification.

Various types of green bonds are available in the market, each with specific characteristics. These include "use of proceeds" bonds, revenue bonds, project bonds, securitization bonds, and covered bonds.

For example, project bonds are limited to a particular underlying green project, with investors having recourse only to the project's assets. Securitization bonds, on the other hand, pool multiple projects into a single debt portfolio.

The management of green bond proceeds typically involves tracking, allocation, and reporting to ensure transparency and maintain investor confidence in the bond's green credentials.

Issuing green bonds offers several advantages to organizations. Firstly, it enhances the issuer's reputation by demonstrating a commitment to environmental sustainability, which can improve public perception and stakeholder relations.

Green bonds also provide access to a broader investor base, including those focused on socially responsible investing, potentially leading to oversubscription and more favorable pricing. This expanded investor pool can help diversify funding sources and potentially reduce borrowing costs.

Additionally, green bonds may offer tax incentives in some jurisdictions, such as tax exemptions or credits, making them more attractive than comparable taxable bonds.

By issuing green bonds, companies and governments can align their financing strategies with their sustainability goals, potentially attracting environmentally conscious customers and partners.

While green bonds are specifically designed to finance environmentally friendly projects, they share similarities with other sustainability-focused bonds but have distinct purposes.

Blue bonds, for instance, are a subset of green bonds used to finance projects that protect oceans and related ecosystems.

Climate bonds, sometimes used interchangeably with green bonds, are more specifically focused on projects that reduce carbon emissions or mitigate climate change effects.

In terms of structure, green bonds typically function like standard bonds, sharing the same financial characteristics such as seniority, maturity, ratings, and interest rates.

The key difference lies in the "use of proceeds", which are earmarked for green projects in the case of green bonds.

Unlike conventional bonds, green bonds require additional documentation, such as a Green Bond Framework, to articulate the selection, management, and reporting of green projects.

Greenwashing – making false or misleading claims about the green credentials of a company or financial product – is a major challenge for the market in green bonds and other sustainable investments.

Regulators and the industry itself are working hard to address this issue.

Many borrowers adhere to guidelines called the Green Bond Principles, which have been endorsed by the International Capital Market Association to help bring transparency to the market. There’s also a range of companies that offer to assess and certify bonds.

The EU is taking transparency a step further with its voluntary European Green Bond. This is intended to help the market grow by giving investors the information they need to assess and compare securities that claim to be green.

For all the urgency around tackling the climate crisis, the fossil fuel industry raked in far more financing than green projects in the years following the signing of the Paris Agreement. That changed in 2021, according to Bloomberg Green, indicating that we may be at a tipping point in the fight to save the planet.

The green bond market continues to grow rapidly, according to the World Economic Forum's report, Fostering Effective Energy Transition 2023, which noted $270 billion worth of issuances in 2020.

Sustainable investment looks set to continue its breakneck growth as governments put climate concerns front and centre. These plans include the European Green Deal and US President Joe Biden’s infrastructure framework.

Green bonds will remain a crucial element in this push towards sustainability, providing financing for major projects around the world.