Ask the experts: Green gilts

Kate McGrath, fixed income ESG analyst at abrdn, explores some of the key investor issues relating to green gilts
by Paul Golden


Sovereigns have long played an indirect role in redistributing capital by devising and implementing policies that incentivise sustainability. The shift to green sovereign bond (gilt) issuance signals a move towards the direct financing of a less carbon-intensive global economy.

A green bond is different from a typical sovereign bond because it specifically earmarks or ring-fences proceeds for the financing or refinancing of eligible green projects. These green projects may include energy efficiency, green buildings, renewable energy, clean transport, and sustainable agriculture.

The UK government’s green financing framework has been developed in accordance with the most recent iteration of the International Capital Market Association (ICMA) green bond principles, a voluntary set of guidelines for green bond issuance.

The first UK green gilt was issued in September 2021, followed by a second issuance of a longer dated gilt in October 2021.

What factors should investors consider before investing in green gilts?

They should be careful not to take the term ‘green’ at face value and acknowledge that the issuance of a green gilt isn’t a substitute for a long-term, credible environmental strategy.

We must view green sovereign bonds holistically in the context of a country’s overall sustainability ambition – it is vital that the political environment is conducive to sustainability goals.

In the case of the UK green gilt, I am encouraged by the UK government’s ten point plan for a green industrial revolution which strives to protect the environment, boost jobs and accelerate the economy’s path to reach net-zero by 2050. The green gilt issuance is just one initiative of a multi-pronged strategy to decarbonise the UK economy.

The issuance of a green gilt isn’t a substitute for a long-term, credible environmental strategyGiven the choice I would rather purchase a brown bond (a transition bond that allows firms in ‘brown’ industries – those that generate significant emissions – to raise funds to finance transition to sustainable models) from a responsible (including sustainable, ‘green’, ethical, ESG) issuer, than a green bond from a brown issuer. This is because any issuance could be labelled as green by the issuer and I have seen some poorly structured green bonds where the environmental benefits are unclear, and the projects have potential to cause longer term negative consequences. For example, a project that necessitates deforestation in biodiverse areas, or induces land grabbing, creating human rights issues for indigenous people.

A green bond must consider the full lifecycle impacts of projects. Issuers display best practice when they utilise lifecycle assessment methodologies to make a complete assessment of the environmental impacts of projects financed by green bonds.

Because of the risk of greenwashing, investors should always look for third party verification. The UK green gilt has received a second party opinion from Vigeo Eiris on the framework, and a pre-issuance impact report by the Carbon Trust on the UK’s green financing programme.

Are green gilts a better option for retail investors looking to access the sustainable bond market than other types of green bonds?

It is not just institutional investors who are keen to allocate capital towards responsible objectives – retail investors are also increasingly considering these. However, green sovereign instruments are unique and cannot be compared like-for-like to corporate green bonds. Green gilts are simply government-backed bonds and therefore will have very similar characteristics to conventional gilts from a fundamental credit perspective.

Fiduciary duty could extend to ensuring that beneficiaries retire into a world where natural resources are not depleted

The democratisation of savings has allowed retail investors to actively allocate capital in a way that not only generates return, but also aligns with individual beliefs. So if a retail investor wants to get into the responsible finance market, green gilts could produce the dual benefit of meeting investment objectives and having a beneficial impact on society. The issuance of UK green gilts could be a win-win strategy – supplying a broad investor base with a much sought after green instrument, enabling the transition to a net-zero economy, and repositioning the UK as a green finance leader.
How do green gilts compare to other green bonds in terms of duration and returns? About the expert

Kate Mcgrath is an ESG analyst within the fixed income department at abrdn. She works for the global team with a particular focus on company engagement and research for ESG-tilted funds, including SDG and climate funds. Kate has worked in ESG for three years and has a first class honours degree in geography from Durham University.
So far, green gilts are typically long dated (the UK’s second green gilt is the longest dated green sovereign bond issued to date, maturing in 2053). This long dated issuance is in line with expectations since most green sovereign bonds are issued by European countries who typically issue longer-dated debt.

In terms of pricing, green sovereign bonds typically price through the non-green sovereign bond curve, trading at a ‘greenium’. This is when a green bond is issued with a higher price and thus a lower yield compared to outstanding non-green debt.

Returns are largely driven by UK interest rates, which are currently higher than many European countries.

What types of activities are being funded by green gilts?

The UK government’s green financing framework is a public document that outlines all the use of proceeds clearly and (encouragingly) also aligns to the UN’s Sustainable Development Goals. The projects are categorised into a number of pillars: clean transportation; renewable energy; energy efficiency; pollution prevention and control; living and natural resources; and climate change adaptation. Specific projects range from zero-emission buses to flood protection, waste management, and energy.

It is also important to consider what is not funded. The UK framework is transparent and contains a section dedicated to exclusions so investors can be sure that their funding won’t be used to finance projects that are inconsistent with a low carbon economy.

How can investors be sure that the money they invest in green gilts is used exclusively to fund activities that have positive environmental benefits?

Currently the proceeds raised are earmarked for eligible projects, not segregated from central funding. Poland displays best practice by creating a separate ‘green cash account’ which is ring-fenced specifically for green bond eligible projects, so I would strongly encourage the ring-fencing of a separate green account to manage funds as opposed to earmarking in the next iteration of the UK green gilt framework.

Nonetheless, HM Treasury will publish an allocation report on its eligible green expenditures on an annual basis, which will also contain impact reporting and metrics including both environmental and social benefits. This reporting will be subject to external verification to provide further assurance to investors.

As mentioned, the green gilt is an example of a well-structured green sovereign bond with clear use of proceeds and transparent reporting. However, since the green label is self-certified and the ICMA principles are voluntary, issuers have the potential to greenwash investors with vague use of proceeds and opaque frameworks.

Is the UK Debt Management Office committed to building out a green gilt curve to ensure green gilts are issued at multiple maturities?

The DMO’s strategy is less about building out a full curve than providing liquidity to investors. As an investor it is more important that gilt issuance is liquid. Also, investors that invest in green gilts are typically asset managers and insurers who require longer duration bonds.

Are pension fund trustees allowed to invest in green bonds?

The short answer is yes, although there is a debate over whether they should be. The argument against doing so is that pension scheme trustees have a fiduciary duty to ensure they are maximising returns. The greenium means that green issuance is slightly more expensive than non-green gilts of a similar maturity, so purchasing a more expensive green gilt over a cheaper conventional gilt may be considered a breach of fiduciary duty.

On the other hand, fiduciary duty also requires pension fund trustees to explicitly consider and manage ESG risks, including climate change. There is a more philosophical argument that pension schemes’ fiduciary duties extend to protecting the environment and climate so that when beneficiaries retire they not only have sufficient capital, but they also retire into a world where temperatures remain less than 2ºC above pre-industrial levels and natural resources are not depleted.

Green gilts are a way of demonstrating the management and mitigation of climate risks through the projects that are being financed. This topic was covered in some depth in a recent edition of CISI TV.

Could we see pooled green gilt funds emerge in the future?

Currently there are only two green gilts, but there is investor appetite for a green sovereign fund. More governments are issuing green bonds, so the market will develop and become more mainstream, creating an investable universe.

A green sovereign bond fund shouldn’t just focus on green bonds – it needs to look through the labels and also invest in responsible, climate-aware governments that have strong climate policies. This final point highlights the importance of investors doing their own research when considering whether to invest in green gilts.
Published: 21 Apr 2022
  • Bonds and fixed income
  • Wealth Management
  • Risk
  • Corporate finance
  • Sustainable Development Goals
  • sovereign funds
  • responsible finance
  • pension freedoms
  • green investing
  • green finance
  • green bonds
  • ESG
  • climate change
  • brown bond

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