BBVA held last month its 8th annual Public Sector Investors & Issuers Seminar bringing together 60 central banks, sovereign wealth funds, public pension funds, sovereigns, supranational and national development agencies, for 4-days of discussions on a broad range of investment themes.

One of the key subjects discussed in the BBVA Seminar was sustainable finance and the role of public sector issuers and investors in fostering its development. This is a very relevant issue for BBVA having launched in 2018 its Pledge 2025 committing to mobilise EUR 100bn of sustainable finance by 2025.

The role of public sector issuers in sustainable finance

Public sector issuers, specifically Multilateral Development Banks, can take credit for launching the green bond market, arguably the most notable sustainable finance development of the past decade. The first green bonds were issued by the EIB in 2007 and the World Bank in 2008, and both institutions remain very active players. However, green bond volumes by development banks peaked in 2016 and, since then, sovereign and sub-sovereign borrowers have become the most important public sector issuers. The first sovereign green bond was issued by Poland in December 2016 followed a few weeks later by France. As of December 2018 a total of 9 nations had green bonds to their name, including Fiji the first developing country to issue a green bond.

Public sector issuers can take credit for launching the green bond market

Sub-sovereigns have also become important issuers of green bonds with French and Swedish local governments leading the way in 2012 and 2013 respectively. In total, public sector issuers - comprising multilateral development banks, sovereign and sub-sovereigns - represent over a quarter of the global green bond market according to the Climate Bonds Initiative.

The role of public sector investors

The catalytic role played by public sector issuers in developing the green bond market is clear. However, the role of public sector investors presents a mixed picture. Public sector investors manage assets of close to USD 40tn globally with Public Pension Funds (40%) leading the way, followed by Central Banks (35%) and Sovereign Wealth Funds (25%).

Sovereign wealth funds and public pension funds have been very active investors in green bonds. Norway’s Norges, the world’s largest SWF with USD 1tn of asset under management, has been leading the way on sustainable investment.

Central banks, on the other hand, have played a less significant investor role given their distinctive fixed-income investment requirements which place great importance on security and liquidity. This often is at odds with the characteristics of green bonds namely:

• Credit rating: central banks typically invest in very high quality bonds with AAA and AA credit ratings, yet less than 50% of climate-aligned bonds (a broader investment category than green bonds) are rated at this level
• Liquidity: central banks tend to invest only in very liquid instruments.  However, due to the relative scarcity of supply vs demand, green bond buyers tend to be “buy-and-hold” investors which results in lower market liquidity for green bonds versus their non-green brethren. Another factor affecting liquidity is issuance size since liquidity generally improves with issuance size. However, approximately 40% of climate-aligned-bonds have outstanding amounts below USD500m.
• Tenor: generally speaking central banks invest in fixed-income instruments with a maximum tenor of 5 years, yet only 25% of green bonds outstanding meet this requirement.
• Currency: while most central bank reserves are held in USD (60% on average) followed by the euro (25%), these two leading reserve currencies represent less than 50% of climate-aligned bonds.

All these considerations weigh against central bank investments in green bonds, which is not to say that central banks have remained on the side-lines in promoting sustainable finance.

A notable development is the Central Banks and Supervisors Network for Greening the Financial System (NGFS), a forum launched in 2017 that seeks to mobilize finance to support the transition to a sustainable economy and advance the “greening” of the financial system.

And the ECB, for example, has recognised this challenge and is looking at ways in which its “greening efforts” can go beyond the policy implementation level and include its own investment mandate in an effort to “practice what you preach”. In this regard, the ECB is monitoring the dynamics of the sustainable finance market and, later this year, will publish a handbook for central banks on ESG best practises in portfolio management.

What will the future hold?

The rate of growth of the green bond market has been nothing but spectacular yet it is still miniscule compared to the conventional bond market. The challenge ahead is to scale it up significantly in order to achieve a real impact in the fight against climate change. This, however, cannot be done without the very significant involvement of public sector issuers and investors. The scope for public sector investors is certainly enormous considering that the cumulative value of green bond issuances represents just over 2% of total fixed income investments by public sector investors globally.

Interestingly some very relevant public sector investors are warning that green bonds may not achieve the status of a mainstream investment product unless they became truly cost-effective for issuers. Perhaps the most vocal of these investors is Japan’s GPIF, the world’s largest pension fund with $1.4tn of assets under management, which recently warned that green bonds may become a “passing fad” unless issuer concerns with cost and complexity, and investor concerns with liquidity, are not properly addressed.

Given this mixed picture, what does the future hold for sustainable finance? Based on the discussions held with leading public sector issuers and investors during the recent BBVA Seminar, I believe that these legitimate concerns will be solved ultimately through a potent mix of innovation, standardisation and greater market transparency. Voluntary guidelines will probably evolve over time into compulsory and legally binding requirements. And greater issuance volumes should address the issue of liquidity. In parallel, the currently environmental, social and governance (ESG) asset classes should eventually outgrow their niche status and enter the mainstream investment universe.

The famous Danish physicist Niels Bohr apparently once said that “predictions are very difficult, especially about the future”. Acknowledging my own imperfect crystal ball, I do believe that the future of sustainable finance looks promising and will receive further impulse through industry regulations internalising carbon costs and through financial regulations (developed by central banks and supervisors) requiring investors increasingly to adopt ESG principles in their investment decisions.