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August 21, 2022updated 06 Sep 2022 6:26am

Explainer: What is a green bond and how does it work?

This is part of a new series of simple guides explaining the basics of all aspects of sustainable capital. First up: green bonds

By Silvia Pellegrino

green bonds, green bond
A strong connection: the growth of green and sustainable bonds is supporting the development of the renewable energy sector. (Image by
dem10 via iStock)
  • Green bonds are a tool to raise funds for new and existing projects that focus on environmental benefits and a more sustainable economy.
  • To qualify for green bond status, they are often checked and confirmed by a third party, like the Climate Bonds Standard Board.
  • A major concern for investors is “greenwashing”, where companies pretend to engage in green investment in order to attract impact-oriented investors.

The energy business is extremely capital-intensive. In 2023, the International Energy Agency predicts that a total capital investment in energy infrastructure to reach $2.4trn in 2022, well above pre-covid levels. 

Coinciding with this is the global transition to renewable energy. From 2010 to 2020, renewable investments have increased dramatically, from less than $50bn per year in 2004 to about $300bn per year and is expected to continue growing over the next three decades.  

This is where green bonds come into play. Green bonds are a way to procure this money for such investments, and, in turn, provide investors with exposure to environmentally friendly assets. Green bonds can also be referred to as climate bonds, although the two terms are not always synonymous. 

What are green bonds? 

Green bonds are a tool to raise funds for new and existing projects that focus on environmental benefits and a more sustainable economy. The word ‘green’ represents the concepts of renewable energy, sustainable resource use, conservation, clean transportation and solutions to climate change

The European Investment Bank (EIB) circulated the first such bond – called the Climate Awareness Bond – in 2007. The World Bank is a major issuer of green bonds. In fact, since 2008 it has issued 164 such bonds worth a total of $14.4bn. 

In 2020, the total issuance of green bonds was almost $270bn, and the total issuance since 2015 is over $1trn. Capital Monitor analysis of data supplied by Global Data also reveals that the total issuance in 2021 was $396bn, $306bn of which was issued by corporates. 

How do green bonds work? 

Green bonds are intended to encourage sustainability and support climate-related or other kinds of special environmental projects, as well as fund the cultivation of environmentally friendly technologies and the mitigation of climate change. 

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The World Bank’s green bond funds have been used to support 111 projects around the world, with 33% in the renewable energy sector, 27% in clean transportation, and 15% in the agriculture and land use sector. 

Green bonds do not differ from any other corporate or government bond, at least in how they work. Borrowers issue these securities to achieve funding for projects that will have a positive environmental impact –for instance, ecosystem restoration or pollution reduction. However, there are no obligations that such investments be successful.   

This is where they differ from sustainability-linked bonds, which have specific key performance indicators (KPIs) attached to the performance of the company. Should an issuer fail to meet a KPI they could face a financial penalty.  

To qualify for green bond status, the bonds are often checked and confirmed by a third party – like the Climate Bonds Standard Board – which certifies that a bond will fund projects that include benefits to the environment. 

What are the risks of greenwashing?

It’s important to note there are no guarantees that green bonds are, in fact, green. A Technical Report by the European Commission’s Joint Research Centre has stated, for instance, that ‘greenwashing’ – where companies pretend to engage in green investment in order to attract impact-oriented investors while in practice engaging in investments that have little environmental value – is a major concern among practitioners and investors.

One of the solutions to prevent greenwashing is the Green Bonds Principles (GBP), which support issuers in financing environmentally sustainable projects that promote a net-zero emissions economy and look after the environment.

According to GBP website, they “promote a step change in transparency that facilitates the tracking of funds to environmental projects, while simultaneously aiming to provide insight into their estimated impact”.  

As of June 2022, the four core components for alignment with the GBP are: 

  • use of proceeds 
  • process for project evaluation and selection 
  • management of proceeds 
  • reporting 

Are green bonds tax-exempt? 

Tax incentives, such as tax exemption and tax credits, might be tied to green bonds. All green bonds issued in China, the US, Brazil and India are tax-exempt, while in Malaysia tax deductions are applied. 

These tax advantages provide a monetary incentive to support and resolve social issues such as climate change and fund movements toward renewable sources of energy. 

There are several types of tax incentives to support green bond issuance: 

  • tax credit bonds 
  • direct subsidy bonds 
  • tax-exempt bonds 

The first one entails that the bond investors receive tax credits instead of interest payments, therefore issuers have no interest to pay on their green bond issuance. The second one means that bond issuers receive cash rebates from the government to finance their net interest payments. The last one is put into place so that bond investors do not have to pay income tax on interest from the green bonds they hold. 

The future of green bonds

Since 2021, green bonds issuance has been on an upward trajectory, rising by about 70% per year over the past five years. However, issuance volume dropped by 18% year-on-year in the first quarter of 2022, according to research conducted by Natixis.

This decline shows that green bonds are not immune to the external factors that impacted the bond market as a whole, such as the war in Ukraine and poor economic conditions, while investors are less willing to pay a premium for green bonds – called the ‘greenium’ – compared to normal bonds. 

However, the outlook seems positive, as despite the relative slowdown in green bond volume issuance, total volumes peaked €1.9trn at the end of March. The market is still growing.

And it is also diversifying. For instance, while in 2016 and 2018 traditional green bonds accounted for up to 90% of the market, they took up only 32% at the beginning of 2022. Today, the rest of the green and sustainable bond market is comprised of: 

In conclusion, the green bond market is continuing to diversify and evolve and is showing promise as a tool to support investment into the energy sector. It seems unlikely that the relatively new asset class is going away any time soon.

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