By John Ploeg, co-head of ESG research at PGIM Fixed Income
The idea behind a green bond is relatively simple – the issuance should support an issuer’s transition.
Therefore, when investing in the green bonds space, the first step should always be a detailed analysis of the issuer – as the instrument’s fundamentals will only ever be as credible as the issuer’s transition plan.
When evaluating sovereign entities, the case for green bonds is often particularly weak. Here, I am sceptical of the UK’s green gilt programme, as we continue to witness an accelerated rollback of the country’s environmental ambitions. This was clearly evident in the UK government’s recent move to allow a major expansion of oil and gas drilling in the North Sea.
Further, green gilt proceeds do not seem to be additional. In general, the UK’s budgeting process starts in parliament, with the government deciding on the projects it will undertake. Importantly, the government only reveals how it will fund a project after it commits to it. So, even without a green gilt programme, a development would likely still occur.
Additionally, green gilts ‘fund’ green projects only in theory, not in practice. Looking at the fine print when it comes to UK green gilts, proceeds are managed in line with HM Treasury’s ‘normal cash management guidelines’. This means funds stemming from the issuance are unlikely to immediately go into green projects but are mixed in with all other government monies. At that point, the cash would be used for general purposes. Later, when green projects are funded, different cash would be used. So, the green gilts do not directly fund the projects, they only reinforce a commitment to do so out of general sources.
Green gilts also have essentially the same seniority and credit profile as non-green gilts and are repaid out of general government funds – not directly from green projects. Structurally green gilts are almost indistinguishable from regular UK government debt. In other words, the idea green gilts are funding green projects is only a theoretical construct.
Hidden in the small print
Although green gilts do not actually add green projects to the budget and do not truly fund any works – no more than UK’s standard gilts – the instruments do somewhat strengthen the commitment of the government to undertake sustainable endeavours. However, this is still not a particularly strong benefit.
First, the list of eligible green projects is lengthy and lacks specificity. As such, it should be relatively straightforward to find qualifying projects. Second, it is important to put green projects into the context of the entire issuer. In this case, the UK issued around £16bn of green gilts across 2021 and 2022. While this is large in absolute terms, it is still quite small in the context of a roughly £1trn government budget. It is also somewhat insignificant in the context of the roughly £11bn of fossil fuel subsidies provided by the government in 2021 alone. Due to energy support programmes, this figure is likely to come in far higher for 2022.
Next, the commitment under the green gilts is not a firm commitment. In the disclaimers, it is a clear intention of HM Treasury to apply an amount equivalent to the proceeds of green financing to eligible green expenditures, but there is ‘no contractual obligation to do so’. In addition, the small print also says there is no assurance that projects ‘will be completed as expected’, and no guarantee ‘adverse environmental, social and/or other impacts will not occur’.
Finally, should the proceeds of the green gilt not flow through to a sustainable project, the matter does not constitute an event of default or breach of contract. This means it cannot be challenged by investors, as there are no financial or legal ramifications for HM Treasury. Taking this into consideration, green gilts as not very different from plain vanilla gilts.
The structural features and credit profiles of an issuer’s green bonds and vanilla bonds are essentially identical. Therefore, the primary motivation for green bond buyers is presumably not a better risk profile, but a desire to improve environmental outcomes. If this is the case, the rollback of the UK’s environmental ambitions should have knock-on effects on its green bonds.