How can green bonds support the net zero transition?

The green bond market doubled in size year-on-year in 2021 and was more than 10 times larger last year than in 2014. As it continues to grow, fixed income instruments will play an increasingly important role in the transition to net zero.

A huge amount of financing is required to meet the targets of the Paris Agreement, which requires states to aim to limit global warming to well below 2°C and preferably to 1.5°C. A range of debt instruments have been developed to support these targets – as well as broader environmental, social and governance (ESG) objectives. 

The first green bond was issued 15 years ago. Since then, green bonds have played a significant role in building the market for sustainability-focused finance, according to Invesco’s Head of European Investment Grade Research Sam Morton.

“As green bonds are use-of-proceeds bonds, we believe that they have already and are likely to continue to make a significant contribution towards the transition to net zero,” he said.

“However, the growth of the green bond market has also played an important part in the broader market acceptance of sustainability finance — green, social, sustainable and sustainability-linked bonds (SLBs) — which are also helping investors and issuers achieve broader ESG targets.”

“Much-needed capital allocation”  

The proceeds of green bonds have a wide range of applications, according to Mayde Sykora, Senior ESG Analyst at Invesco.

“The transition to net zero will be an expensive endeavour. Green bonds are well poised to facilitate the transition and allow an opportunity for equities but also fixed income to play a key role in delivering the much-needed allocation of capital towards solutions that facilitate the transition to net zero,” she said.

“Green bonds are being issued by corporates to finance renewable energy purchases and integration, as well as retrofitting towards LEED-certified buildings¹. In the muni (municipality) space you see green bonds with proceeds towards climate adaptive infrastructure, electrification of mass transportation, clean energy, and energy efficient improvements.”

Room for improvement

Unlike green bonds, SLBs allow the issuer to set more general sustainability goals, usually a pre-defined sustainability or ESG performance targets, or KPIs (key performance indicators).

“We are expecting SLBs with KPIs more closely aligned with the issuer’s attainment of net zero targets. This will be increasingly important as issuers look to demonstrate to investors the progress they are making towards net zero,” Morton said.

“We have already seen some examples in the European Investment Grade space, but we see potential for this to become as pervasive as the green bond over the next few years.”

Although green bonds, and their related cousins, such as SLBs, are useful components for investors, the market is far from perfect.

Problems include a lack of transparency, greenwashing and overstated claims of environmental credentials, said Sykora.

Adaptation: a growth area

Research shows that only 20% of climate financing is committed to adaptation², which encompasses the adjustments in ecological, social, or economic systems that will be needed to respond to actual or expected changes to the climate (as compared with mitigation, or actions to limit global warming and its related effects).

“A low percentage of green and sustainable bond issuers are focused on adaptation, Invesco’s Global Head of ESG Cathrine de Coninck-Lopez said at a recent event. “We’re encouraging issuance for adaptation.”