Germany sold its first-ever federal green bond in early September. Analysts and commentators alike have displayed an elevated degree of excitement about the innovation. Some consider it to be a watershed moment for the wider environmental and sustainability bond market but, on closer inspection, the bond will probably disappoint those hoping to see it as an important building block for Europe’s green transition. Two main reasons explain why the bond is less green than first meets the eye.
First, the bond will not lead to any additionality in environmental endeavours because financing follows projects, not the other way round. This assessment could be applied to almost all green bonds, of course. But the somewhat unorthodox design of this German bond makes any additionality even less likely. Normally, green bond receipts are to be used for future green projects; linking receipts to prospective projects is in itself unlikely to create any project additionality. With a forward-looking approach, however, it can at least be argued that a healthy debate will take place inside government cabinets and ministries about how to tilt budget structure more towards sustainable causes.
By contrast, Germany’s green bond receipts will be entirely allocated to green projects that have already been executed in the past. It is not easy to see how this retrospective approach will lead to any structural shifts in the budget to favour commitments that bring the country closer to fulfilling its emission-reduction commitments, for example. Under this framework, green bonds are little more than window-dressing. For 2019, the government has identified up to €12.7 billion of eligible spending to be refinanced by green bonds. In light of this year’s expected budget of over €500 billion, this is a paltry sum indeed.
What is more, the government has counted rather generously. The €12.7 billion include, for example, rail modernisation investment, which is merely beginning to compensate for the underinvestment that has accumulated during the past frugal decade, when infrastructure was allowed to quietly decay. When applying a strict definition, federal budget allocations to ‘environmental protection’ amounted to little more than €1 billion last year.
This trivial sum is partly due to Germany’s federal structure: much green public investment happens at the level of local and regional government. But it also indicates that radically rebalancing the budget towards environmental causes is a much more urgent task than issuing green bonds, which act as little more than fig leaves.
Second, hopes that setting a risk-free green yield curve will pull other issuers into the green bond market are likely to be dashed. The basis for this prediction is that the German government has developed the quirky structure of ‘twin bonds’. Under the twin concept the green bond is merely an instalment of an existing conventional bond, with an identical coupon and maturities.
The government has made it clear that the debt-management agency will purchase the green twin in the secondary market should its price fall below that of the conventional benchmark twin. In a so-called switch transaction, the agency would simultaneously sell the same amount of the conventional twin to keep the overall debt outstanding unchanged. In theory, the green twin could disappear completely from the secondary market through agency intervention. Similarly, should the green twin’s price rise above the conventional twin, the agency would perform the opposite switch, as long as it holds green bonds in reserve that it had previously acquired.
In other words, the government targets a 1:1 ‘exchange rate’ between the conventional and green twins. This eliminates the potential concerns of investors that the green segment might be less liquid, and thereby demand a liquidity premium on issuance. Such a premium would raise the government’s funding costs, which it is understandably keen to avoid.
At the same time, targeting price equalisation prevents the emergence of a true green bond yield curve, along which other green debt could be priced. The government wants the green yield curve to mimic the conventional one. The green and conventional bonds are not only twins, they are identical twins. This way, Germany’s contribution to the green bond market remains below its potential.
We should not be too worried about this, however. In fact, there are AAA-issuers already providing a ‘pure’, non-interventionist green yield curve, including Germany’s own government-guaranteed KfW Development Bank. The European Investment Bank (EIB) has already established a green yield curve extending to 25 years. The outstanding amount of EIB green bonds (€35 billion) is bound to increase sharply as it consolidates its policy mandate as the green bank of the EU.
Despite the idiosyncratic choice of design for the green bond, a positive outcome is still possible. The auction result of this bond suggests that investor appetite for Germany’s green bonds could be so voracious that their prices consistently fall below their conventional twins. In this case, the debt agency cannot intervene to equalise yield curves. It simply will not hold enough green bonds in reserve for sale in the market to lower their prices to those of their conventional twins.
A green yield curve would then establish itself below the conventional one. The government could realise a funding advantage by issuing more green bonds in the future. That would require ramping up climate-mitigating public investment to absorb green bond receipts. Maybe projects will follow financing after all. That would be a win-win and improve the climate – both on the green bond market and on the planet. Good news for both bond bulls and polar bears.