Emenike Omeye
As noted above, the poor investment appetite that results from this situation creates significantfinancing challenges for smaller issuers, including most sovereign issuers in Africa and many other countries across the world. Specifically, the issuance of green bonds by such countries would typically be smaller and illiquid, thus when compared with conventional bonds would be unable to attract significant economic concessions in the form of reduced financial returns to investors. In addition, the opportunity cost to the issuing green bonds entails a reduction in the volume of conventional bonds issued by such issuers.
In view of the liquidity constraints confronting the extant structure for green bond issuances, Denmark announced in December, 2019 that it is “working on a model for sovereign green bonds that will enable small sovereign issuers like Denmark, with limited funding needs, to access the green bond market without compromising liquidity.” The proposed model identifies the fundamental commitments in green bonds – the financial commitment to settle coupon and the principal sum in relation the bonds, and the commitment to apply proceeds to green projects/initiatives – and then seeks to split them into two. Following such separation, the financial commitment will be issued as a conventional government bond, while the remaining green element of the commitment will be issued as a green certificate. In practical terms, only the purchase of both the conventional government bond and the green certificate will vest title over the sovereign green bond. Hence, the green certificates constitute a commitment by the sovereign issuer, that the green expenditures at least match the proceeds from selling a package of a conventional government bond and a green certificate.
Importantly, stripping the bonds guarantee that when an investor wants to sell, it can sell such bonds to regular Danish government bond investors, thus making the green bonds just as liquid as conventional bonds. To ensure that the ethical motivations of investors are protected, the investors will receive the green certificates which reflect the binding commitment of the sovereign issuer to apply the proceeds of the bonds only to environmentally beneficial project. Hence, buying a package of a conventional government bond and a green certificate will enable investors to support the green agenda to exactly the same extent as if they had bought a conventional green bond, with transparent reporting on the use of proceeds. Given that the purchasing investor will be receiving the package consisting of the regular bond and the green certificate, it should presumably increase the premium receivable by the issuer – thus addressing issuer’s concerns about reduced pricing of standalone green bonds due to liquidity constraints. Notably, the proposed stripping ensures that the green certificates can be traded separately in the secondary market, with their own ISIN codes. The green certificates will cancel at the same maturity date as the matching government bond they are sold with. Holders of conventional bonds may also convert same into green bonds by acquiring the matching green certificates, whilst green bond holders may convert such bonds into conventional bonds by trading the certificate.
Essentially, the splitting and separate trading of the bonds entail that whilst the regular bond component trades for its value, the value of the green certificate could fluctuate based on market’s perception of the issuer’s commitment to apply the proceeds to environmentally beneficial projects. In other words, this commitment will have some value of its own. Thus, while the green certificates will technically be “a zero-coupon bond with zero redemption at maturity”, it will possess intrinsic “non-cash flow” driven market value of its own and may be sold to interested investors or form the basis for speculation on the market value of the green commitment.
Although the finer details of the Danish model are still in the works, it could present an interesting financial engineering solution to the green bond liquidity challenge that may potentially benefit many sovereign issuers in Africa, as recognition of the benefits of green finance continues to grow in the continent. In addition to countries that have already issued green bonds, many African governments have indicated their intention to facilitate and undertake green bond issuances at the sovereign level, supported by various country-specific initiatives to encourage further issuances of green bonds. Splitting green bonds may facilitate the market’s general development process by strengthening the flexibility of investment portfolios within it. Most importantly, it could provide some trading synergy between the conventional and green bond market, requisite to forestall the illiquidity that may be expected to result from the isolation of an embryonic green bond market.
Whilst the African bond market is still at a nascent stage, the long term success of the green finance in the continent will depend on critical financial innovation around present and potential constraints, such as the proposed model. In adopting the model, issuing African sovereigns can infuse some creativity into the structuring and possibly adopt variant patterns of the model as may circumstantially meet specific financing and investor needs. Particularly, it may be prudent to enhance the functionality of the model by incorporating supportive government policies which would positively impact liquidity. This may include tax incentives, carbon credits or similar incentives. It is expected that with prudent structuring, extensive marketing and careful implementation, the bond-stripping model will facilitate improved liquidity in the trading of green bonds issued by African sovereigns.
Concluded
Omeye is an LL.M Student and a Research Assistant in International Finance at the Harvard Law School