What are ESG Bonds and Green Bonds and Should You Consider Issuing Them?
October 13, 2021
When an investment banker is marketing the bonds of your municipality, authority or school district, the more investors that show interest in purchasing your bonds, the lower your interest rate will be on those bonds.
This has traditionally been true for “bank qualified bonds,” in which issuers who issue less than $10 million principal amount of tax-exempt debt in a calendar year achieve lower interest rates because banks are able to purchase the bonds. The ability to borrow money at lower interest rates means your municipality, authority or school district may be able to supplement any federal funds received with additional funding sources.
There is a new development in the debt market which could also lead to lower interest rates for issuers as a result of increased demand: ESG bonds and Green bonds.
ESG bonds and Green bonds are increasingly attractive to investors as the concept and practice of socially responsible investing is recognized as valuable in the bond markets. Currently, these types of socially responsible bonds only make up approximately 2% of the municipal bond market, but the demand is increasing from investors. In the past decade, issuance of ESG bonds and Green bonds has increased substantially — but so has demand.
The term ESG bonds stands for Environmental, Social, and Governance bonds. They are a type of debt instrument in which an issuer has identified certain environmental, social, or governance criteria for the use of the bond proceeds. In general, municipalities, authorities, and school districts have been providing environmentally-friendly and socially-responsible projects, so the ability to borrow at a lower interest rate to continue to provide these services is a big benefit.
Your municipality, authority or school district may issue these ESG bonds for a wide variety of types of projects. Many issuers appreciate the flexibility that this type of offering provides. Examples of projects funded with ESG bonds by municipalities, authorities, and school districts include renewable energy, smart infrastructure, and clean transportation. These types of projects may be partially funded with federal funds pledged for sustainable infrastructure and the remaining funding may come from ESG bonds.
In addition to the environmental components, ESG bond financings may focus on social or governance projects. Examples of social projects include a municipality, authority, or school district’s plan for safety management, workplace diversity initiatives, and health and safety of employees or citizens. The Pennsylvania Housing Finance Agency has designated recent bond issues for housing projects as social bonds. Examples of governance projects include the everyday operations of a municipality, authority, or school district, ensuring financial transparency, and establishing internal policies and procedures.
The term “Green bonds” means a type of debt instrument used to support environmental- and climate-focused projects. Green bonds may be used to raise funds for specific environmental and climate projects in areas such as energy (projects such as wind or solar) and buildings (projects such as efficient buildings and low carbon materials).
In order to issue either ESG bonds or Green bonds, the issuer’s counsel and the underwriter’s counsel will work with ESG specialists to determine and draft the framework of the criteria used by the issuer as the basis for this designation. The counsel will work together to evaluate the request for either general funding or project-specific funding and then determine which type of bonds best fit the required funding request. The issuer’s counsel and the underwriter’s counsel may also work with the ESG specialist to determine if there will be a continued reporting obligation on behalf of the issuer following the issuance of the bonds.
In response to questions regarding the qualifications as either an ESG bond or a Green bond, the International Capital Market Association (ICMA) published “Social Bond Principles” and “Green Bond Principles” to provide issuers with guidance on criteria for these issuances (www.icmagroup.org). While the Securities and Exchange Commission (SEC) is considering establishing a standard set of principles regarding ESG bonds and Green bonds, no other standards exist except for the voluntary guidelines described in the Social Bond Principles and the Green Bond Principles. As these guidelines are voluntary, issuers do not need to follow them. However, they are generally accepted as a framework to evaluate the socially responsible principles of these bonds.
The “Social Bond Principles” and “Green Bond Principles” guidance is based on four main components: (1) use of proceeds; (2) process for project evaluation and selection; (3) management of proceeds; and (4) reporting. The Green Bond Principles focus on climate-related or environmental projects including investments related to clean energy or pollution reduction. The Social Bond Principles focus on projects “that address or mitigate a special social issue and/or seek to achieve positive social outcomes.” The third qualification for ESG bonds is governance, and it is broadly understood to mean the way in which an organization’s internal system of rules, policies, and procedures are managed.
Prior to marketing either an ESG bond or a Green bond, an issuer will post the framework that the issuer used to make the determination as to why this financing qualifies as either type of bond in accordance with either the Social Bond Principles or the Green Bond Principles. This disclosure is important for investors to understand the reasoning behind either of these designations. Once this disclosure has been made to potential investors, the investors are able to analyze each component to determine whether the disclosure meets the investors’ specific socially responsible investing requirements and guidelines.
In addition to the initial disclosure, there may be a continued obligation to report on the impact of the ESG bond proceeds or the Green bond proceeds depending on the issuer and the investor. Some issuers may hire a third party to track the spending of the ESG bond proceeds or the Green bond proceeds to ensure that the funds are creating the outcomes desired by the issuer and the investor. Until such time as there is a standard requirement for either the designation of ESG bonds or Green bonds, the disclosure and reporting obligations will remain subject to the discretion of the issuer and the demands of the investors.
The Securities and Exchange Commission has taken an active role in monitoring ESG bonds and Green bonds to identify any type of misconduct. In March 2021, the Climate and ESG Task Force (the “Task Force”) in the SEC’s Division of Enforcement was created in response to the increasing investor interest in these types of bonds (www.sec.gov/news/press-release/2021-42). The Task Force evaluates certain concerns regarding the criteria used for establishing these issuer frameworks by identifying any disclosure gaps. In addition, the Task Force will monitor the continued compliance requirements associated with ESG bonds and Green bonds.
As this market continues to grow, issuers are finding an opportunity to move forward with socially responsible projects and investors are supporting these projects.
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