The issuance of U.S. municipal green bonds – bonds backing projects with positive environmental effects -- is increasing, joining a trend in the broader market for similarly labeled debt instruments. S&P Global Ratings estimates the municipal market will see between $6.3 billion and $7.2 billion of green bonds in 2016 (see chart 1), a meaningful step up from $4.1 billion in 2015 and $2.4 billion in 2014. Our 2016 estimate is based on actual data through July from Climate Bonds Initiative (CBI) assuming issuance stays on pace and average par remains the same.
However, we believe the market for U.S. municipal green bonds could be significantly larger. A recent HSBC report conservatively identified $30.3 billion of municipal bonds issued from 2014 to 2016 that met its green standard, only $10.9 billion of which were actually labeled green by issuers. This suggests the potential for significant growth simply by a broader acceptance of this asset classification. The same HSBC report estimates that green labeled municipals represented about 8% of the total $118 billion in labeled green bonds issued globally since 2007.
- The U.S. municipal market could see $6.3 billion-$7.2 billion of green bonds issued this year, up from $4.2 billion in 2015;
- In our view, the potential for broader participation by municipal market issuers into green bonds is high, and will be a function of costs relative to benefits, investor demand, and broader public support for infrastructure projects that promote sustainable long-term environmental objectives.
- Over time we expect to see metrics to evaluate the level of disclosure and environmental credentials of green bonds becoming more important to investors.
Issuance of green labeled transactions in the corporate debt market may reach $15 billion this year while they are just beginning in the real estate sector. Globally, the market for green bonds is expected to expand significantly as signatories to the December 2016 Paris climate change agreement increase efforts to reduce carbon emissions.
Where Is The Municipal Green Bond Market Headed?
Current low interest rates and other municipal market fundamentals obscure efforts to discern any preferential pricing for green bonds in the primary market. This would suggest that rather than a lower cost of capital, near-term growth of the market will come from a combination of reclassifying eligible (but unlabeled) bonds as green and continued recognition by issuers of the potential long-term social benefits derived from these investments. Successful marketing will also contribute to near-term growth as many municipal issuers seek to serve different segments of the investor base, including institutional investors with environmental mandates and focused investors with separately managed accounts serving high net worth clients.
Over the longer term, we believe the broad and deep $3.7 trillion municipal market, which is on track to see issuance in 2016 in excess of $400 billion, can meaningfully add to the global green bond market. But we have questions as well:
- Will the municipal sector embrace the global trend toward greater transparency and comparability in financing public infrastructure assets that meet broad environmental objectives and investor demand, particularly if it requires dedication to independent external review, ongoing reporting, and additional costs? and,
- If the U.S. municipal market for green bonds expands as expected, how will investors evaluate the qualitative environmental credentials of these projects relative to other green fixed-income investments?
U.S. Municipal Asset Categories
Following the first self-labeled municipal green bond, issued by the Commonwealth of Massachusetts in June 2013, the market has seen growth both in issuance volume and the asset categories represented. Chart 2 illustrates that after the initial green bonds were issued primarily for water projects, the range of asset categories has expanded to include buildings, power, land conservation, and transportation. Water projects still represent about half of all par issued for green bonds as well as half of all issues. Transportation comprises 24% of the par but just 6% of the issues, reflecting the capital intensity of the sector and attributable almost exclusively to the nearly $1.4 billion issued since 2013 by the New York Metropolitan Transportation Authority. The prevalence of energy efficient buildings in education and health care drives that category to 15% of par and 23% of all issues.
There has been significant progress in the development of common definitions to support the green market. Through its technical and industry working groups, CBI is developing taxonomy with supporting criteria to group like-asset classes under broad categories for the purpose of standardization and leveraging common data across related projects. One challenge is balancing the need for global consistency across and within asset categories while serving the often unique features of local infrastructure providers in different markets. For example, many U.S. municipal water utilities operate as combined enterprises with water, wastewater, and storm water assets as part of an integrated system. Other water and wastewater utilities operate as separate enterprises. CBI's current taxonomy has yet to fully develop wastewater as part of the water category, which could leave many municipal issuers that operate wastewater and particularly stormwater enterprises without a CBI-certified green bond option.
The International Capital Markets Association (ICMA), which defines green bonds very broadly, serves as the de facto market leader in establishing voluntary guidelines that encourage transparency and disclosure, known as the Green Bond Principles (GBPs). Initiated in 2014 by several banks and last updated in June 2016, the GBPs outline process guidelines for issuers and their agents that focus on transparency, accuracy of data and disclosure at issuance beyond, with the objective of providing standardization across the market and limiting "greenwashing" (see below, "Four Pillars of the Green Bond Principles").
The ICMA defines a green bond as any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance in part or in full new and/or existing eligible projects that provide clear environmental benefits -- assessed and quantified by the issuer where feasible. Examples of project categories or asset types that are recognized as Green Bond Principles-eligible includes those supporting:
- Renewable energy,
- Energy efficiency,
- Pollution prevention,
- Sustainable management of water and natural resources,
- Transportation, or
- Adaptation of infrastructure to the effects of climate change.
This broad spectrum of green categories suggests a need among investors for further refinement and independent evaluation of a project's environmental credentials.
The Four Pillars of The Green Bond Principles
Use of proceeds
Transaction documents should clearly describe that the environmental benefits of the asset being financed or re-financed are consistent with recognized green categories and include a quantifiable assessment by the issuer if feasible.
Process for project evaluation and selection
Issuers should detail the criteria by which the projects fit within the GBP categories and the environmental sustainability objectives.
Management of proceeds
Issuers should separately segregate and track bond proceeds through the use of sub-accounts or other means throughout the drawdown period. Reporting
After the drawdown of proceeds have been matched to eligible projects, issuers should provide and keep current ongoing disclosure regarding the qualitative and quantitative performance measures if possible, verifying the environmental impacted expected or experienced.
U.S. Municipal Market Examples
While adherence to the GBPs provides uniformity to the process, confirmation that the assets financed are green is often left to an external reviewer, and it is here where we see a range of disclosure in the U.S. The vast majority of municipal issuers of green bonds have provided no third-party external review relative to other segments of the capital markets, though we have found several reports associated with 2016 issues (see table). More common are examples where issuers include the "green" label in their offering statements and disclose a range of descriptions regarding use of proceeds. For those U.S. municipal issuers that sought and included in their offering statements a report by an independent third party, the report typically offers an opinion confirming that the financing is achieving a specific industry-accepted level of energy conservation or that proceeds more broadly meet the ICMA's GBPs (see below, "Types Of External Reviews Of Green Bonds").
|2016 U.S. Municipal Labeled Green Bonds (through July)|
|Issuer||Series||State||Par ($ mils.)||Rating||Sector||External review|
|Vermont Educational and Health Building Financing Agency||Series 2016B||VT||$89.00||A-||Buildings & industry||Yes|
|American Municipal Power||Series 2016 A Meldahl Hydroelectric Project Revenue Bonds||OH||$80.05||A||Power||Yes|
|Greater Chicago Metropolitan||2016 Series C, D, E, F GO Unlimited & Limited GO Tax Capital Improvement Bonds||IL||$104.00||AA+||Water||--|
|San Diego Water Authority||Series 2016A Water Revenue Refunding Bonds||CA||$98.95||AAA||Water||--|
|Maryland Economic Development||Series 2016A, Series 2016B, Series2016C, Series2016D||MD||$313.04||BBB+||Transport||--|
|Massachusetts Development Finance Agency||Series 2016-A and Series 2016-B Emanual College Issue||MA||$50.20||NR||Buildings & industry||--|
|Rhode Island Infrastructure bank||Series 2016B Water Pollution Control Revolving Fund Revenue Bonds||RI||$18.79||AAA||Water||--|
|New York Metropolitan Trans Authority||Subseries 2016B-2 Dedicated Tax Refunding Bonds||NY||$588.31||AA||Transport||Yes|
|New Jersey Environmental Infrastructure Trust||Series 2016A-1 Environmental Infrastructure Bonds||NJ||$29.32||AAA||Water||--|
|San Francisco Public Utilities Commission||2016 Series A||CA||$240.58||AA||Water||Yes|
|Massachusetts Water Authority||2016 Series C General Revenue Refunding Bonds||MA||$681.62||AA+||Water||--|
|California Infrastructure and Economic Development Bank||Series 2016 Clean Water State Revolving Fund Revenue Bonds||CA||$410.74||AAA||Water||--|
|Columbia University||Subseries 2016A-1||NY||$50.00||AAA||Buildings & industry||--|
|City of Saint Paul||Series 2016B Sewer Revenue Bonds||MN||$7.72||AAA||Water||--|
|Cleveland||Series 2016 Ohio River Polluction Revenue Bonds||OH||$32.39||A+||Water||--|
|Indiana Finance Authority||Series 2016A, Series 2016B State Revolving Fund Program Bonds||IN||$115.79||AAA||Water||--|
|Ramsey County||Series 2016A GO Sold Waste Facility Revenue Bonds||MN||$17.90||AAA||Waste & Pollution||--|
|New York Metropolitan Trans Authority||Series 2016 A-1, A-2 Transportation Revenue Bonds||NY||$782.52||AA-||Transport||Yes|
|Massachusetts State Clean Water||Series 19 State Revolving Fund Bonds||MA||$207.81||AAA||Water||--|
|San Diego Unified School District||Series 2016 General Obligation Bonds (Dedicated Unlimited Ad Valorem)||CA||$100.00||NR||Buildings & industry||--|
|University of Texas||Series 2016B Revenue Financing System Bonds||TX||$206.04||AAA||Buildings & industry||--|
|Source: Climate Bonds Initiative and S&P Global. Water category includes clean water and wastewater projects.|
In May 2016, the San Francisco Public Utilities Commission (SFPUC) issued $308.4 million of wastewater revenue bonds, comprising $240.6 million series A (designated as green bonds) and $67.8 million of series B. The SFPUC provided data to CBI and received certification that the series A bonds qualified as green bonds. As part of the certification process, the SFPUC received a separate third-party external review report (although not included in the official statement) confirming compliance with the GBPs. The SFPUC indicates that it will "undertake reasonable efforts" to maintain that certification going forward and report information of the use of bond proceeds on their website.
Other third-party reports provide anticipated green credentials, but not at the time of issuance. In June 2016, the Massachusetts Development Finance Agency's issued $188.24 for Emmanuel College comprising $137.9 million series 2016A bonds and $50.27 million series 2016B taxable green bonds. The series 2016B taxable green bonds were issued to finance a 692 bed residence hall. No third-party external review report was provided, however the college will apply for and expects to receive a Leadership in Energy and Design (LEED) certification for the building, which is provided only upon completion and inspection several years after the bond sale. Bond proceeds will be tracked and disclosed, however the college will not be providing any further reporting to investors after the expected LEED certification.
Finally, the vast majority of green labeled municipal bond issues lack any independent third-party external reviews. Some, like the City of Saint Paul, Minn., which in April 2016 issued $7.72 million of sewer green revenue bonds, simply state their intention to comply with the ICMA's GBPs. Less common are transactions like the San Diego Unified School District, which issued $100 million in January 2016 for a variety of energy efficiency, renewable, water conservation and waste management projects. Instead of referencing the GBP standard, the district provided a significant level of disclosure regarding projects categories and alignment with a green standard developed as part of city-wide climate action plan.
Thus, it is clear in the developing U.S. municipal market for green bonds that we observe both good intentions and a wide variation in reporting, including independent third-party confirmation of environmental credentials. Over time, a key issue will be the pre- and post-sale level of commitment to timely and complete reporting by municipal issuers which operate in a segment of the capital markets where consistent disclosure has been a continuing concern voiced by investors. In our view, the heightened focus on disclosure in the green bond market is a positive that could carry over to more traditional financial disclosure and improve diligence in satisfying those ongoing requirements.
Types Of External Reviews Of Green Bonds
This type of review includes advice from institutions with recognized expertise in environmental sustainability or other aspects of the issuance of a green bond (previously called Second Party Reviews and Consultation).
These are independent external reviews of a green bond, green bond framework, or underlying assets. In contrast to certification (below), verification (previously called audits) often focus on the bond's alignment with the internal standards or claims made by the issuer.
This includes a review of an issuer's green bonds, the associated green bond framework, or use of proceeds certified by a third party against an external green assessment standard.
This includes a review of an issuer's green bond or green bond framework by an independent third party, rating agency, or research provider, and differs from a company's broader environmental, social, and governance (ESG) rating because it would be limited to individual green bonds or the issuer's green bond framework.
Global Market Expectations For Independent Opinions
While standards have developed, we believe that investors would benefit from a more comprehensive approach to understanding the actual, and comparative, environmental credentials of a potential green bond investment. Many current second-party opinions focus on a check-box review of the GBPs, producing a binary outcome, whereby a bond is either certified if it reaches this standard or failed if it falls short. We believe that as the market develops investors will look for a more relative assessment of green projects to see which of two certified bonds provides the greatest environmental benefit.
Toward this end, S&P Global Ratings has proposed a green bond evaluation framework and scoring methodology to provide greater transparency to investors and a clear understanding of the credibility and benefit of a green bond. Under the proposed framework distributed for market comment, the methodology would provide an analysis and estimate of the environmental impact of the projects or initiatives financed by the bond's proceeds over its lifetime relative to a local baseline. This would be in addition to assessing the governance and transparency surrounding the bond. When evaluating environmental impact, the methodology would consider both climate change mitigation projects (that focus on efforts to reduce or prevent the emission of greenhouse gases) and adaptation projects (that aim to take practical steps toward reducing the exposure to and managing the impacts of natural catastrophes, such as building the resilience of communities and critical infrastructure).
In our view, we believe that there may be a gap in the market for a green bond evaluation to measure what the green label means in terms of its qualitative environmental element, whether that is related to the mitigation of, or the adaptation to, climate change. There are numerous taxonomies that list the categories of projects (defined as the assets or approaches financed by the bond) that are potentially eligible for green bond financing. However, as noted, these approaches face problems defining what is green, especially as climate change mitigation and adaptation technologies are expanding rapidly in many sectors. The evaluation would also take account of the adequacy of such products' governance relating to their environmental impact, management of proceeds, and transparency and disclosure in line with assessments currently provided by second opinions.