For green bond issuers, the purpose is vital

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WASHINGTON – Amid debate over green bond issuance, essential is an emerging buzzword.

“When municipal credit analysts look at a municipal credit, one of the first questions they ask is what are they using the money for, how essential is the public purpose,” Tim Coffin, senior vice president and director of sustainability for Breckinridge Capital Advisors, said Tuesday at the Brookings Municipal Finance Conference.

“The bigger picture there is, banking green bonds is not the problem, funding is the problem,” said Coffin.

“You have to go out, make the case for essentiality, figure what you need to build, how you’re going to pay for it, and the bankers are waiting right outside the door. As are the investors."

While green, or environmentally conscious, instruments represented just 2% of total U.S. municipal issuance of $436 billion in 2017, green bond sales have oversubscribed by more than three times on average, according to London-based Climate Bonds Initiative, which certifies issuance.

The Initiative is bullish on the long-term prospects for U.S. municipal green bonds.

"Municipal bonds are a good starting point for the ESG [environmental, social and governance] fixed-income investor," said Erin Ortiz, a managing director at Janney Capital Markets. "More of our clients are adding or thinking about adding mandates to buy bonds that fund environmentally sustainable or social impact projects."

Climate change, rising sea levels and increasingly freakish weather -- ranging from West Coast conflagrations to Midwest tornadoes -- have triggered a need for resilience funding.

According to Ortiz, labeled green bond municipal issuance will increase long-term despite a drop this year. Compared with 2017, it was down 70% through the end of May.

"The drop is not surprising given that the broader muni market is down 22%," she said. "This sharp decline is unlikely an indicator of an emerging negative trend but a function of the small size of green bond issuance that magnifies any year-over-year change."

Debate has evolved from feel-good esoteric to pragmatic.

“This is a growing market with many markers of maturity,” said Jeffrey Wurgler, a finance professor at New York University’s Stern School of Business. “There’s a subset of investors willing to pay a little premium to hold green bonds. That shows up in prices. That shows up in the pattern of ownership.”

Green bonds, said Wurgler, are slightly larger than average at the CUSIP level and with slightly longer maturity; they are more likely federally taxable, tracing to issuance around 2010; they are typically new-money revenue bonds associated with specific projects; and a subset, around 7%, has certification from Climate Bonds Initiative or other third parties.

While the financial risk of a labeled bond is the same whether the investor buys that bond or an unlabeled bond for the same issuer with the same security features, investors with specific ESG mandates face a "buyer beware" scenario, said Ortiz.

Even green and other labeled bonds may not meet the standards of a particular mandate.

"Additionally, failure of a project to meet certain standards or metrics has no recourse," Ortiz added. "The lack of an enforcement mechanism is an impediment to the labeled bond market’s growth.

"Despite this, key factors supporting the high likelihood of growth."

The European Investment Bank and World Bank issued the first labeled green bonds in 2007. Massachusetts in 2013 issued the first labeled green municipal bonds. Bank of America, Apple and other headline firms have issued green corporate bonds.

The green-bond label is far from standardized. Bloomberg, for instance, cites “many shades of green.” They include self-labeling and certified.

Coffin said Breckinridge integrates sustainability into its research for municipal and corporate credit.

“Everybody who is looking for capital markets solutions to environmental solutions that are out there can’t help but come back to the municipal bond market,” he said. “Municipal bonds have been green since the beginning of time.”

The muni market, he said, has already modeled out financings for clean water, public transportation and energy efficiency “that will ultimately be employed, hopefully on a more scalable level, to address many of the capital projects that are going to be needed to address environmental issues and social issues.”

Larger issuers include environmental utilities and power suppliers, said Coffin.

“It’s easier for public utilities and energy bonds to arrange green finance because if you’re ever creating energy efficiency, what you’re doing is you’re creating a savings, and therefore you’re creating a receivable and bankers can bond against that.”

Only about 14% of green bonds are general obligation, which Coffin said speaks volumes about the challenge for green financing.

“When Marty Walsh, the mayor of Boston, comes out and says we need to build a $10 billion seawall, clearly that’s going to be financed in the capital markets. They’re not going to have a bake sale to raise that money. But at the same time he, politically, has to make the case of essentiality to his constituency, to voters, to legislators.”

So-called smart city initiatives, said S&P Global Ratings, "lie at the convergence of politics, technology, service delivery and energy."

According to S&P, decarbonizing technologies, whether renewable energy, electric vehicles, energy efficiency or battery storage, can affect individual financings from an environmental standpoint. Additionally, the ability to manage these risks can influence credit ratings. S&P cited its own study that concluded that ESG shortcomings contributed to many rating actions.

“As the green bond market continues to develop in U.S., where its growth has historically been slow, corporate entities looking to fund smart-city developments could look to this market to fund their efforts,” said S&P. “Given the enormity of the task at hand, the name of the game in smart-city development is coordination and planning how to efficiently allocate scarce funds to attain maximum benefits."

The Massachusetts Bay Transportation Authority, which operates mass transit in Greater Boston, provided recent evidence of a pricing differential for a labeled bond compared with a mainstream bond.

In what MBTA officials said represented the first tax-exempt sustainability bonds issued in the U.S., the authority issued a combined $300 million of subordinated sales tax bonds and bond anticipation notes late in 2017. It yielded a slightly better result on its impact-focused issuance compared with traditional issuance.

Except for the maturity in 2031, the difference ranged between 1 to 4 basis points -- with 3 basis points in most maturities.

"While 3 basis points is not overwhelming, it is meaningful as the lower borrowing cost is important for issuers in an increasingly constrained financial environment," said Janney's Ortiz, "The MBTA is a good case study because it issued two series of bonds on the same date around the same time with identical maturities and coupons and similar par amounts, making comparability easy."

The MBTA obtained no external certification. Instead, it provided relevant information in its official statement.

"For this issuance and other green bond municipal issuances, failure of an issuer to report on the use of proceeds or progress is not an event of default, so bondholders are taking in good faith that the issuer will abide by its commitment," said Ortiz.

The issuance won the 2017 Northeast Deal of the Year award from The Bond Buyer.

Current muni impact investing, according to Municipal Market Analytics, is more about providing investors incremental benefits to supplement the low income and yield today’s prices can deliver. MMA said it also helps justify management fees endangered from low-cost, passive investing products.

"Although most traditional municipal investors have scoffed at attempts to define a slice of the U.S. municipal bond market as more green or socially responsible than another, manager interest in these designations is growing," MMA said.

"This is not about backfilling traditional investor demand which, to be clear, is at present so strong vis-à-vis supply that market discipline on credit and structure is rapidly eroding, to the detriment of long-term market and borrower resilience."

Coffin suggested that increased investor demand with bonds that show constructive use in the municipal market could carry over to equity or corporate bond markets.

“Will investors all of a sudden say ‘these people are only raising equities so that a VC can only flip a deal’? I don’t want as much for that because the proceeds are not as constructive.' "

Coffin also touted transparency benefits.

“I think what’s positive about the green bond movement and the socially responsible investment movement, as it moves closer and closer to the mainstream, is that it’s increasingly asking investors to pay attention to what they own," he said. "And we, as a sustainable investor, would make the case that that’s very material to long-term investment performance as well.”

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