Global, July, 22 2019 - Green bonds remain a tiny segment of the fixed-income market even as the number of institutional investors chasing climate-related investments is on the rise globally.

Issuance of green bonds is much exceeded by demand for them. And investors' growing expectations over how issuers should invest the proceeds has discouraged some companies from issuing green bonds.

"Pricing is currently not providing for a buyer's market, reflecting on the demand, which is much higher than supply," said Magnus Billing, CEO of Alecta Pensionsforsakring, Stockholm, the 877 billion Swedish kronor ($92.8 billion) workplace retirement plan provider, and an experienced green bond investor with 35 billion Swedish kroner invested in the asset class.

Large global asset owners such as the ¥159.2 trillion ($1.48 trillion) Government Pension Investment Fund, Tokyo; the €35.8 billion ($40.1 billion) PKA, Hellerup, Denmark, and the 837.5 billion Danish kroner ($125.8 billion) ATP, Hilleroed, Denmark, have recently directly invested small amounts of their allocations into green bonds. But challenges associated with lack of issuer variety and liquidity prevail for most pension funds, preventing the market from becoming more mainstream, sources said.

Currently, there are $389 billion of green bonds outstanding, according to data from the non-profit investor organization Climate Bonds Initiative. That compares with more than $92.3 trillion of debt securities outstanding overall as of Dec. 31, according to data from the Bank for International Settlements.

Even if the issuance of green bonds is steadily growing — and is set to hit a record $250 billion this year, up from $168.5 billion in 2018, according to the climate initiative, sources said, the market will grow when issuers with different levels of credit quality have access.

Some sources see the European Union's incoming green bond standards, as part of the solution to help issuers define how proceeds should be invested.

"One of the problems is greenwashing, which I'm hoping the European Union's taxonomy will help with," says Mikael Bek, head of environmental, social and governance at PenSam, a 140 billion Danish kroner multiemployer defined contribution plan for elder care, technical service and education workers based in Farum, Denmark. Under its policy, the plan will increase green investments to 10% of the fund's total strategic allocation by 2025.

"We are considering investing in green bonds," Mr. Bek said. "We need a larger market. The EU taxonomy will help with clarifying the requirements for proceeds. Then we hope the market will increase."

Market structure

However, for Alecta's Mr. Billing, challenges when investing in green bonds stem from a shortage of scalable investment vehicles that could help investors access local green bond issuances, rather than lack of regulation defining what green bonds are. Alecta began investing in green bonds in 2014. Last month, it invested an additional undisclosed amount with bond aggregator Kommuninvest, Orebro, Sweden, which finances Swedish municipal investment projects in renewable energy, green buildings, public transport and water management.

"We like green bonds, but we see challenges," Mr. Billing said.

Mr. Billing said there is a need — and opportunity — for investment vehicles to aggregate local governments' bond issues to accommodate mainstream institutional investment capital, which could lead to market improvements.

Other sources also say institutional investors are limited in how they can currently absorb green bonds from the market.

Jean-Jacques Barberis, head of institutional and corporate clients coverage at Amundi in Paris, said small and medium corporations need assistance to access buyers of green bonds.

"We need to see more issues and diversification into green securitization, green high yield and green private lending," Mr. Barberis said.

For this reason, Amundi has developed a program in conjunction with the European Investment Bank to allow European companies to get loans to speed up their transition away from fossil fuels. Unveiled July 9, the Green Credit Continuum — Amundi's second initiative, following the Planet Emerging Green One fund launched with the World Bank Group in 2018 — will supply €1 billion for the development of green financing.

Improved verification

Green bond investors say an evolving market structure could also help investors verify how proceeds from green bonds are being invested by corporations and local governments. A shortage of mainstream verification processes affect market diversification and size, sources said.

"We still see some issuances done without third-party verification and that is a concern," said Colin Purdie, chief investment officer of credit at Aviva Investors in London.

"Most managers don't have the resources to check how proceeds are being spent, and it might put some of the mainstream managers off buying green bonds. Somebody has to be doing the verification during (bond) syndication," Mr. Purdie said.

Francis Condon, sustainable and impact investing research analyst at UBS Asset Management in London, added that multilateral organizations such as the European Investment Bank can support green bond issuance with proceeds verification.

However, in absence of these multilateral frameworks and due to the current high concentration of local issuances, Mr. Condon said issuers start to question if it is worthwhile for them to issue green bonds at all. "One of the challenges is that the more localized you get, the smaller the issue becomes, and then the greater the proportion of fixed costs for verification," Mr. Condon said.

"It's much less attractive to an issuer," he added.

Sources also said better diversification among issuers to include shorter-duration bonds could help the market's liquidity and improve access to well-diversified funds for investors.

"We would welcome shorter maturities because the most recent sovereign Dutch issue, (released by the government of the Netherlands for the first time in April), with maturity in 2040, has increased the duration of the index by 0.4," said Arnaud-Guilhem Lamy, co-head of aggregate specialty fixed income at BNP Paribas Asset Management in Paris.

"We would (also) welcome issuers from other sectors such as non-cyclical and consumer services," Mr. Lamy added. "I don't need more financials or utility companies to do it, but I always welcome new issuers."

Aviva's Mr. Purdie said: "We've seen a lot of focus on AAA green bonds to date, but there hasn't really been sufficient development elsewhere — for example in the corporate space — to provide a truly diversified fund."

Change of status

However, other sources fear shorter-duration bonds, desired by managers to boost and improve liquidity in the secondary market, could change their status from green to transition investments as they won't match the longevity of the project.

A transition bond, contrary to a pure green bond, is aimed at helping corporations move to a low-carbon business model, for example, to gas from coal. For example, oil and gas bond proceeds of companies such as Repsol SA are invested in projects still exposed to carbon emissions and could be excluded from funds. For this reason, some money managers such as BNP Paribas Asset Management and DWS Group say they exclude transition bonds from their green bond funds.

Looking ahead, under the EU's green bond standards, analysts say the regulator has classified only the purest green projects, such as renewable energy or energy-efficient transportation, as green bonds.

"What's been defined as green in the EU framework creates a limited space for eligible projects and assets," UBS' Mr. Condon said.

Mr. Lamy added that transition bonds and green bonds "are different things, and the taxonomy will have an impact on the market."