The Greenium: challenges ahead for the EU green bonds sector
What is the greenium and how did it emerge in the green bonds market? In this article, we will explore the main theories that attempt to explain the “Greenium” existence and the potential motivations behind its recently observed decrease.
The green bond market
The first “labeled” green bond was issued by the European Investment Bank (EIB) in 2007, and other supranational sovereign agencies (SSA) such as the World Bank entered the market in its early stages. In 2013, private companies, including Bank of America and the French utility EDF, issued the first corporate green bonds and helped issuance surpass $10bn. In 2021 the green bond market exceeded EUR 250bn in Europe alone.
Since the inception of the green bonds market, many analysts have focused their efforts on trying to discover specific trends and their peculiarities, specifically to spot differences with the “traditional bond market”.
What is the Green Premium (Greenium)?
One of the first elements that characterized the green bond market has been the so-called Greenium, i.e. a Green Premium that investors are willing to pay to acquire green bonds. From a different point of view, the latter can be seen as a lower return which investors are willing to accept to invest in such a type of bond. This concept was defined for the first time in 2015 in a research paper by Preclaw and Bakshi (The Cost of Being Green, 2015, Ryan Preclaw, CFA, Anthony Bakshi) observing a group of US ABS issuances.
From that moment on, several theories have been developed that aim at providing an explanation of why the Greenium exists.
How did the Greenium emerge in the market?
There are several theories that attempt to explain how the Greenium emerged inside the green bond market. In the following paragraphs, we are going to briefly review the main theories from market experts.
Decreased risk compared to conventional bonds
One of the first explanations for the existence of the Greenium may lie in the fact that green bonds could be less risky than similar conventional bonds.
However, the structure of green bonds alone is not sufficient to explain the existence of the so-called Greenium. In fact, green bonds are usually pari-passu with non-green bonds of an issuer, with the same seniority and optionality, since they expose the holder to the same issuer’s credit risk, even if they are used to finance activities aiming to achieve environmental objectives: green bonds mimic the mechanism and rating profile of non-green bonds.
Mechanical supply and demand mismatch
Another explanation provided by analysts is that the Greenium could simply stem from a mechanical supply and demand mismatch: higher demand of investors for green issues, relative to their non-green equivalents, which generates a pressure to accept to pay a premium to receive an allocation. Should this be the right rationale, the phenomenon should have a short-term nature and fade away as the supply of green bonds increases.
Supply and demand imbalance could also explain the lower price volatility usually observed in green bonds, which could be a consequence of the low willingness of investors to sell their green bonds (and, therefore, sustain the prices) rather than a reason for accepting to pay a Greenium.
Indirect benefits of applying Greenium
Alternatively, the presence of this Greenium could also be justified by the fact that investors may receive sufficient benefits from investing in a green bond, to offset the lower cash flows. These include psychological benefits for investors, brand value, influence with regulators, or other indirect gains: analysts have been so far cautious about this possible explanation since it is very hard to put an explicit price on “being green”.
The Halo Effect
According to Basars and Krebbers (2019), instead, the existence of the Greenium could be justified by the so-called “Halo effect”, according to which the announcement and then the issuance of green bonds generates a positive attitude of investors towards firms that are perceived as:
- having strong environmental, social, and governance profiles
- lower long-term financing costs
- have a positive impact on share prices.
The possible presence of such a phenomenon is also supported by an observed overperformance in the equity prices of green bond issuers.
A look at Greenium in the European securitization market
The existence of a green pricing premium has also been observed in the European securitization market, where it reached as high as 30bps for some transactions.
The reduction of the green premium in 2022
Having said all the above, in recent months a progressive erosion of the Greenium has been observed, which has become even more evident since 2021.
The reduction of the green premium could be linked to many reasons:
- higher supply of sustainable investments
- the fact that the “alternative benefits” from investing in green bonds no longer compensate for the lower cash flow of the investors.
- investors do not want to sacrifice their remuneration for instruments that have a credit risk profile substantially in line with non-green bonds;
- there are better ways to increase the issuers spending on environmentally sustainable projects, such as the so-called sustainability-linked bond.
In the case of sustainability-linked bonds, interests are structurally linked to the issuer’s achievement of climate or broader sustainable goals: not reaching the selected KPIs results in an increase in the applicable coupon
It is evident that the structure of the sustainability-linked bond is significantly different from the green bonds’ structure. The latter is only characterized by a constraint on the usage of the proceeds raised through their issuance, towards sustainable activities or projects. This makes the proceeds more suitable for polluting industries that are trying to reduce their negative environmental impact.
An additional difference lies in the fact that the true cost or return of sustainability-linked bonds can only be evaluated through the course of their life (given the underlying incentive/penalties mechanism) and not at issuance as per “traditional bonds”.
Significant increase of sustainability-linked bonds sector in 2021
Even though the sustainability-linked bonds sector appears to be in a very early stage compared to the green bonds sector, in 2021 the European market registered a significant increase in the issuance of such a type of bond, passing from EUR ~5bn in 2020 to EUR ~45bn in 2021 a 9x increase that has continued in Q1 2022 that registered a 4.4x YoY.
Due to its relative youth, there is no evidence yet about the existence of a Greenium in the Sustainable-linked bonds market, but such eventuality shouldn’t be excluded and further analysis should be carried out in order to understand if the Greenium might arise, and whether it would materialize at the inception of the bond or later in their lifespan.
If you want to know more about this topic, check out our sustainability inside the private debt market page.