Managers Tighten Up Their Due Diligence to Find the Best Green Bonds

Supported by Impax Asset Management


Early last year, Duke Energy wanted to raise $600 million through green bonds, money that would go toward a range of renewable energy projects. It was to be the second green bond issuance from the North Carolina-based utility, and it would fund projects that would undeniably lead to reduced carbon emissions.

One of the leading asset managers in the green bond space, Impax Asset Management, adviser to Pax World Funds, took a close look at the proposed offering issue as it considered investing. But in the end, the manager took a pass. The reason? Duke’s history with coal ash.

“We didn’t participate, even though the green bonds would reduce carbon emissions,” says Tony Trzcinka, portfolio manager on Impax’s Pax Core Bond Fund. “But we thought their historical mismanagement of coal ash didn’t meet our sustainability framework.”

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The issuance went ahead anyway; in fact, Duke Energy issued another $700 million worth of green bonds later in 2019. But Impax’s review, and reluctance to invest, is a good example of the due diligence that investors and consultants expect their green bond managers to do before they commit to such instruments.

As more and more companies and governments issue green bonds, it will become increasingly important for investors in those bonds to ensure they are truly green — that the money is going to projects that improve the environment and that are in harmony with the needs and desires of the bond buyers.

Managers with deep expertise in the green bond space say they’re ready to do just that.

Worldwide, green bond issuance reached $255 billion last year, with the U.S. leading the world with issuance of $51 billion, according to the Climate Bonds Initiative. That was an all-time record and a 51% jump over the $171 billion issued in 2018. CBI is forecasting about $350 billion this year, which would be another record, although Moody’s has cut its forecast for the year to a range of $175 billion to $225 billion, down from its previous outlook for $300 billion, after a first-quarter coronavirus-related slowdown in issuance.

Green bonds can be issued by national and local governments, development banks or financial and non-financial corporations to fund various green-related projects and programs; they are increasingly being issued by banks who use the money to fund a broad array of low carbon projects.

A growing number of Institutional investors are investing in green bonds. To take one example, in February the New York State Common Retirement Fund committed $250 million to the Nuveen Core Impact Bond Fund, which invests in bonds backing projects related to renewable energy, climate change, economic development and more. New York Common also invested $250 million in the Calvert Core Bond Strategy, which has a focus on green bonds and affordable housing. These investments were part of a new $800 million commitment to the New York fund’s Sustainable Investments and Climate Solutions program.

Japan’s $1.5 trillion Government Pension Investment Fund, the world’s largest pension fund, has been partnering with a range of third parties — including the African Development Bank and Kommuninvest, the Swedish local government debt office — to encourage those agencies to issue green bonds, and to encourage GPIF’s own asset managers to invest in them. The goal, GPIF says, is to help the further development of the green bond marketplace.

Issuance has continued despite the coronavirus pandemic. This month alone, green bonds have come from E.On, Credit Suisse and Citibank, which issued $1 billion worth of green bonds that it says will fund projects in areas like renewable energy, sustainable transportation, energy efficiency and green buildings.

What all of these issuers have in common is that they’ll face sharp scrutiny from the asset managers they hope will buy the bonds.

While some data providers and other third parties will review a green bond proposal to give it some sort of certification or verification, asset managers typically will base their decision whether to invest in a green bond primarily through their own proprietary sustainability framework.

At Impax, for example, “We will look at all the use of proceeds, transparency, the reporting — we look at all of that together to make sure there’s no greenwashing, and to ensure that the use of proceeds is toward what we want,” Trzcinka says. Impax will also take a close look at the issuing company’s overall ESG profile.

“The degree or sophistication of impact reporting by the issuer can be helpful too, i.e., a sound methodology for articulating how the projects being funded are better than a business as usual scenario,” adds Greg Hasevlat, sustainability research analyst at Impax.

Nuveen has its own proprietary “impact framework” for evaluating bonds for its Core Impact Bond Fund.

“We focus on transparency and disclosures,” says Stephen Liberatore, portfolio manager and head of the firm’s ESG/Impact Fixed Income Strategy Team. “We look for a security that presents a direct and measurable environmental outcome. We approach it in such a way that we can identify and understand how the proceeds will be utilized. We want to know, how is our capital going to be deployed?”

Managers will also consider certification from third parties. The big names in this space include CBI, Cicero and Sustainalytics. “There are many other organizations offering this service, including some of the Big 3 accounting firms,” says Hasevlat.

Getting a certification from such an agency can signal the bond’s adherence to still-developing industry-wide green bond standards, but it won’t be the final determinant. It can, at the least, provide a manager with a little bit more confidence in their decision to invest or not.

“We get more confidence if those guys are signing off, or if [an issuer] is using the Green Bond Principles,” Trzcinka says.

The principles are a voluntary set of process guidelines for issuing green bonds. “We like to see alignment with the Green Bond Principles, which, at a minimum, provides us with a starting point for our analysis, as the four main components of the GBP are where we focus our attention,” Hasevlat says. Those four components are use of proceeds, process for project evaluation and selection, management of proceeds, and reporting.

Similarly, for Nuveen to invest in a green bond, it needs the issuer to commit to impact reporting as the project moves forward.

Getting this information serves two purposes. “It lets us generate an impact report for our investors, so they can know how their dollars are being employed,” Liberatore says. “We also believe it provides insight into the project’s future financial cash flow and stability. As a lender, that’s crucial for us.”

It’s becoming increasingly common for asset managers to ask for such impact reporting, Liberatore adds, though not everyone demands it yet.

While the asset manager is assessing the green bonds and the issuer, institutional investors and their investment consultants will be assessing the asset manager. Consultants want to trust the manager to select the right green bonds — and that comes only when the consultants know the manager is doing the right thing.

“As a consultant, we perform ESG-related due diligence on asset management firms and portfolio management teams to parse out whether the team has the green bond expertise to reliably vet and purchase high-quality green bonds,” says Sonia Ruiz, manager research consultant at RVK.

Part of that means avoiding bonds that won’t necessarily do what is advertised, or that don’t meet the environmental goals of the investor — in other words, avoiding “greenwashing” bonds. In fact, that’s one of the most important components of the green bond review process that managers undertake.

For the most part, experts say, bonds that can be seen as “greenwashing” aren’t coming from bad intentions. “The vast majority of issuers are doing it for the right reasons, and believe what they are proposing is beneficial for the environment,” says Trzcinka. “It’s just that there can be different levels of interpretation” of what makes a bond a green bond.

Indeed, there are plenty of bonds that managers view differently than the issuer, and that managers steer clear of.

Bonds that Spanish oil & gas company Repsol wanted to issue in 2017 are a good example. Repsol wanted to issue bonds to improve the efficiency of its operations, including extraction and refining. It would have reduced greenhouse gas emissions from those operations, yes — but both Nuveen and Impax ruled that it was not a good idea to help a company pull more oil out of the ground, and both managers passed on the Repsol issue. “This is where the concept of green is different for everyone, which is why you want transparency,” Liberatore says.

Similarly, last year Teekay Shuttle Tankers was issuing green bonds to build four new oil tankers that were to be more efficient and emit fewer greenhouse gases as they carted oil around the world. Impax declined to invest. “We did not participate because the underlying activity was inconsistent with a transition to a more sustainable economy,” Hasevlat says. Impax was not alone: Teekay’s bonds received a cool reception from the market and ultimately raised $125 million, short of the $150 million to $200 million the company had hoped for.

Another example Liberatore cites: a university had a parking shortage and wanted to float a bond to build a new parking structure. It was a green bond, the university insisted: they had done studies showing that students were spending a lot of time just driving around the campus as they looked for a parking space. Provide more parking, the university’s argument went, and drivers would drive less, thus emitting fewer greenhouse gases.

Nuveen passed on the bond.

It’s important that managers keep an open mind when looking at green bonds — but also be reasonably skeptical. “We don’t want to miss deals,” Liberatore says. “We want to be innovative, and we don’t want to miss a transaction because we are being too prescriptive. We want to be as flexible as possible, but the issuers still need to provide proof.”

For managers, it’s all the more important they get that proof because there is no industry-wide standard for what exactly constitutes a green bond.

“Without a single industry standard for verification, there is little recourse a client may have when proceeds of a labeled green bond fail to meet client expectations,” Ruiz says. The onus for that falls on the asset manager. “We hand the responsibility for vetting to the asset management teams and then expect these teams will continue to engage with [the issuer] throughout the relationship with our client, to confirm those expectations are still being met.”

The managers then pass that pressure, that demand for transparency and reporting, on to the green bond issuer. If the issuer won’t play ball, they won’t get the manager’s money.

“We need to understand, in a way that’s direct and measurable, how the proceeds are going to be used. And we want to see the impact data,” Trzcinka says. “If the issuer can’t produce the data, or it doesn’t make sense or it isn’t clear, it’s just not something we’re going to invest in.

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