Climate Change Acts As Catalyst to Green Bond Market Growth

Perspective from Franklin Templeton Fixed Income

CLIMATE CHANGE ACTS AS CATALYST TO GREEN BOND MARKET GROWTH

December 2020 In this paper, David Zahn, Head of European Fixed Income at Franklin Templeton, discusses the rising demand for environmentally conscious investments. He highlights exciting developments in the green bond market, particularly in Europe, which is at the vanguard of sustainable investing. He then looks at some of the questions that are likely to face both green bond issuers and investors over the months and years ahead.

David Zahn, CFA, FRM SHIFT TOWARDS SUSTAINABLE ECONOMIES MAKES ESG INVESTING MORE RELEVANT THAN Head of European EVER BEFORE Fixed Income The signifi cant impact of climate and environmental changes across the globe has become Franklin Templeton Fixed Income increasingly apparent, with the world about to record its warmest fi ve years on record and warnings of a collapse in biodiversity.1 In fi nancial markets, the result has been a corresponding increase in demand for investments that can help fund projects with positive environmental and/or climate benefi ts.

Green bonds made their fi rst appearance in 2008 with an issue from the World Bank. Since then, growing concerns about greenhouse gas emissions and climate change have prompted a surge in environmental, social and governance (ESG) mandates and an increase in bond issuance to help fi nance climate-related projects. Green bonds have quickly become common across jurisdictions, industries and currencies. Today, European countries are taking the lead; several major governments, corporates and fi nancial institutions have now issued green bonds, with others potentially to follow. WHAT ARE GREEN BONDS? Green bonds have a similar structure to traditional bonds but are used to fund schemes covering a wide range of environmentally beneficial projects, such as renewable wind energy, pollution reduction, water management, clean transportation and renewable solar energy. They offer investors an array of potential benefits, highlighted in Exhibit 1 below.

WHAT GREEN BONDS OFFER INVESTORS IN EUROPE Exhibit 1: Potential benefits of green bonds

CONTRIBUTION RECOGNITION TRANSPARENCY DIVERSIFICATION ACCESS towards a sustainable for investors and asset from quantifiable by not only income- to a diversified pool of future without taking managers as a reporting on climate based decisions but European green bonds, additional risk or cost Responsible Organisation impact of fixed income environment-based which is the largest and that fulfills a investments and into a decisions most advanced regional sustainable investing bond’s use of proceeds market in the world fiduciary duty

Source: Franklin Templeton. For Illustrative purposes only. Diversification does not guarantee profit or protect against the risk of loss.

EUROPE LEADING THE WAY IN THE GREEN BOND MARKET Since its inception, the green bond market has experienced rapid growth. In 2020, global green bond and green loan issuance reached over US$268 billion.2 With the highest percentage of total issuance worldwide, green bonds are comfortably also the most popular form of eco-friendly debt. This issuance is spread across several sectors and countries, as shown in Exhibit 2 below, with Europe, Middle East and Africa (EMEA) taking the lead.

GREEN BONDS, THE MOST USD billions POPULAR FORM OF $300 $273.3 ECO-FRIENDLY DEBT

Exhibit 2: Growth in $250 global green bond issuance $221.4 (US$ bn) by region $200 $175.6 As of 30 September 2020 $168.6

$150

$100.3 $100

$50.6 $50 $38.6

2014 2015 2016 2017 2018 2019 2020 AMER APAC EMEA Supranational Source: Bloomberg Barclays Bond Database.

2 Climate change acts as catalyst to green bond market growth The expansion of the European green bond market has benefited from the commitment of many European governments and institutions to environmental issues. Around 30% of the European Union’s (EU’s) coronavirus rescue fund (€750 billion) and €1 trillion of its seven-year budget are earmarked for initiatives directed at fighting the detrimental impacts of climate change.

The European Commission (EC) has made a pledge to decarbonise the economy, with a vision of zero net greenhouse gas emissions by 2050. In her recent State of the Union speech, EC President Ursula von der Leyen proposed an even more ambitious target of 2030 to achieve a 55% reduction in emissions and suggested that €225 billion of green bonds should be issued to aid green initiatives. If agreed by member states, this would consolidate Europe’s position as the leading issuer of green bonds.

The European Central Bank (ECB) has also been a keen supporter of the green bond market. As at the end of 2019, the ECB owned nearly a quarter of the eurozone’s eligible public sector green bonds and a fifth of its eligible corporate green bonds. ECB President Christine Lagarde has consistently pushed for environmental issues to be an essential part of monetary policymaking, with climate change a “mission-critical” priority for the central bank. Given her commitment to this agenda, it seems highly likely that the ECB will remain a willing buyer of green bonds.

In September of this year, Germany issued a 10-year green sovereign bond that met with record demand, raising €6.5 billion. Moreover, Germany intends to create a green bond curve, with the addition of two-year, five-year and 30-year instruments. The creation of a benchmark curve in the green bond space is an important step, allowing investors to trade these bonds more freely.

In addition to Germany, new issuance from Belgium, Lithuania, ongoing issuance from France and Poland and upcoming issuance from Italy, Sweden and the EU, the European green bond market continues to make impressive progress in terms of breadth and depth (see Exhibit 3).

EUROPEAN COUNTRIES USD billions ARE TAKING THE LEAD $150 IN GREEN BOND ISSUANCE $125.1 Exhibit 3: EMEA green $123.6 bond issuance (US$ bn) $120 by industry As of 30 September 2020 $90 $71.1 $59.9 $60

$30 $23.7 $26.1 $17.4

2014 2015 2016 2017 2018 2019 2020 Government Industrials Utilities Financials Others Source: Bloomberg Barclays Bond Database.

3 Climate change acts as catalyst to green bond market growth OTHER TYPES OF ENVIRONMENTALLY CONSCIOUS BONDS Alongside green bonds sit many other investments that are described as environmentally conscious, some more persuasively than others.

The first category represents climate-aligned bonds—a label that has been formalised by the Climate Bond Initiative (CBI)—and refers to bonds that satisfy the CBI’s internal methodology. Their methodology identifies eligible sectors and requires that projects within these sectors are consistent with the goals of the Paris Agreement. The takeaway for investors is to know that not all green bonds will be deemed to be ‘climate-aligned’. A green bond may contribute to reducing emissions or increasing energy efficiency but unless the emissions key performance indicators of project or asset are aligned with a two-degree global warming target set by the Paris Agreement, they will not be deemed to be ‘climate-aligned’.

Another variation on the concept of environmentally conscious bonds is that of the energy transition bond. These are issued by companies that—despite a history of significant carbon emissions—wish to reduce their impact on the environment. This is an instrument that tends to stir up controversy; the primary ‘push-back’ being that organisations should be demonstrating a genuine desire to transition, in order for this instrument to be well received by investors. In our opinion, the suitability of these bonds is not universal. There may be a short-term benefit from energy transition bonds in certain countries or economies that face immediate risks. A good example of this would be an energy system that is heavily reliant on coal, where the immediate threat of pollution might be abated by decreasing the emissions of fossil fuel infrastructure.

In these instances, investors should carry out their own due diligence to gain comfort around the use of proceeds, the environmental credentials of the issuer and the overall ‘greenness’ of the bond.

INVESTING IN GREEN BONDS IN PRACTICE Franklin Templeton has significant experience in green bond investing. We believe our active approach helps us uncover the most compelling risk-reward opportunities that also provide environmental benefits. In our opinion, a portfolio of green and climate-aligned bonds built around a diversified set of relatively uncorrelated positions has the potential to generate attractive risk-adjusted returns.

Our team employs a rigorous bond selection process to determine whether a security and issuer meet a labelled or unlabelled green bond standard and profile. Securities are evaluated using both a top-down and bottom-up process focusing on four sources of return alpha: sector, duration, country and security selection. Our team uses a proprietary sovereign ESG model and includes ESG analysis in the corporate credit research process. ESG datapoints are integrated into each analyst’s risk-based assessment, and a sector specific view on the ‘greening’ impact of the bond is given.

At Franklin, we also consider unlabelled green bonds where we believe the issuer and project support a low-carbon future. Our own internal methodology for inclusion requires that the company issuing them 1) demonstrates a core business that supports the transition to a low-carbon future, 2) has an appropriate governance structure, and 3) has a good operational environment management system.

4 Climate change acts as catalyst to green bond market growth Compared to green bonds, the climate-aligned bond space is relatively under-researched, with lower turnover and a less efficient market. In contrast, the popularity of green bonds means they typically trade at tight spreads, as demand for the securities exceeds the supply. For this reason, we believe climate-aligned, unlabelled bonds offer compelling opportunities for active managers who can conduct diligent research to take advantage of the segment’s inefficiencies.

Exhibit 4 below illustrates our green bond assessment process.

FRANKLIN TEMPLETON GREEN BOND INVESTIBLE UNIVERSE EUROPEAN FIXED INCOME INVESTIBLE UNIVERSE Exhibit 4: Green bond assessment process

Is this a labelled Y green bond? N

Are we satis ed Does the bond with project impact, Are we satis ed support the governance & with governance & Y Y transition to a environmental environmental low-carbon future? management? management? N Y N N

GREEN BOND ETF INVESTIBLE UNIVERSE UNINVESTIBLE FOR GREEN BOND ETF

Source: Franklin Templeton. For Illustrative purposes only.

The green bond and climate-aligned markets are still immature, with an inconsistent methodology, and much of the investment universe remains lightly regulated. This can make it difficult to obtain data on carbon emissions and gauge the environmental credentials of issuers, particularly regarding ‘unlabelled’ bonds.

However, guidelines for green bonds are evolving rapidly and becoming increasingly comprehensive. The Green Bond Principles (GBP) help clarify the approach for issuance of a green bond by improving transparency and set standards for disclosure in the market. The Climate Bond Initiative (CBI), a standard that provides issuers with the opportunity to get their bonds certified, encourages the flow of capital towards climate-aligned projects. Independent third parties are required to verify that the bond complies with the Climate Bond Standard (CBS) before certification, thereby ensuring the bond’s credibility among investors.

5 Climate change acts as catalyst to green bond market growth CONCLUSION The green bond market has grown rapidly in the decade-plus since it first came into existence. Over that time, Europe has been at the forefront as the market has evolved, in terms of clarity of regulation and depth of issuance. The market’s expansion appears not only set to continue, but potentially quicken its pace, as the imperative of addressing climate and environmental change pushes it further into the mainstream of investing. With both the EU and the ECB putting green issues at the heart of their fiscal and monetary agendas, it seems likely that the European green bond market will maintain its leading position, barring a significant shift in US policy.

As with many nascent markets, the green bond market can be challenging to navigate. A green bond label offers assurances to investors, but its selectivity risks overlooking unlabelled issues with strong green credentials. At Franklin Templeton, we have been actively involved in this market from an early phase and have gained significant experience and capacity. We believe that an active approach can help to identify a portfolio of issues that is drawn from all corners of the market but at the same time maintains an authentic green profile.

Endnotes 1. Sources: UN Environment Programme, “How Climate Change is Making Record-Breaking Floods the New Normal”, 3 March, 2020, The Nature Conservancy, Financing Nature Report, Closing the Global Biodiversity Financing Gap, 2020. 2. Source: Bloomberg Barclays Bond Database. As of 30 September 2020. 3. Source: FTSE Russell, “ECB Developing an Appetite for Green Bonds”, 10 July, 2020. 4. Source: Bloomberg, “Germany Seizes on Demand for Green Debt with $7.7 Billion Debut,” 1 September 2020.

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