Explained: What exactly are green bonds that FM announced in the budget and how are they issued?

Representative image.

In the Union Budget speech 2022-23, Finance Minister Nirmala Sitharaman announced that the government will be issuing green bonds ‘for mobilising resources for green infrastructure’. This article looks at the idea behind green bonds and how the Indian government can design and issue these green bonds.

What is the need for green bonds?

Climate change has emerged as a major concern for policymakers. The relation between climate change and financial markets runs in both directions asymmetrically. On the one hand, climate change impacts financial markets unfavourably as climate shocks could lead to losses on banks and financial institutions. On the other hand, financial markets can address climate change favourably by designing financial products to lower the risks. This article reviews the second relation and in particular the role and design of green bonds to lower climate-related risks.

Financial markets serve the real economy by channelising finance towards projects that add value to the economy. This function applies to climate goals as well as more finance can be channelised towards greening of the economy. This can be done by both funding new green projects and greening the existing brown projects. Green bonds can help in achieving this important objective of greening the economy.

What is green bond?

Projects are financed via two sources viz. equity and bonds. In green finance, equity has anyways played a limited role as the number of ‘green business firms’ has been rather small. But green bonds have been popular with both issuers and investors. The issuers like green bonds as it is a clean way to raise funds for specific projects. The investors also like bonds for clarity in design and fixed returns.

Moreover, while private organisations can still choose between either equity or bonds, the governments can obviously raise funds only via issuance of bonds.

The yields of government bonds also act as a benchmark for corporate bonds. Once the yields are established for green bonds, it will help corporates raise funds issuing similar tenure bonds.

How can governments issue green bonds?

One can see recent examples from Germany and Denmark which have issued green bonds as twin bonds. What this means is that green bonds are issued like a twin to an existing bond. The green bond has the same financial characteristic of a running bond of the central government. The green bonds also allowed to be used for securities lending to encourage trading and liquidity in these bonds.

In 2020, the German government had allotted total green spending of 12.3 billion euros of which 11.5 billion euros was met by issuing green bonds. The German government first issued a 10-year Green Federal bond worth 6.5 billion euros in September 2020 followed by a 5-year Green (5 billion euros). The funds were used towards transport, energy and research (details here). Given the interest rates have been zero in Germany, both the bonds were issued at 0 percent.

Seeing large investor interest for the two bonds, the government issued a 30-year bond in May 2021 also at 0 percent. In this way the yield curve for green bonds is also getting established in Germany which will help corporates raise funds. As the green bonds carry similar interest rates as conventional bonds, the corporates will not have to pay higher interest rate for issuing green bonds.

Denmark adopted a similar strategy as Germany and issued its first 10-year green bond in December 2021 also at 0 percent (Source: Denmark Central bank)

What will be India’s green bond strategy?

We have to await the details on how green bonds will be issued in India. There is a possibility that India also follows similar ‘twin bond strategy’ as Germany and Denmark. The twin bond issuance will ensure that green bonds carry similar financial characteristics as conventional bonds. For instance, the current 10-year benchmark bond in India is 6.54 percent GS 2032 which has an interest rate of 6.54 percent. So the green twin bond will also have a similar interest rate and be issued as 6.54 percent GS 2032 (Green) bond.

The finance minister has announced that green bonds will form ‘part of the government’s overall market borrowings in 2022-23’. This means there will be no extra borrowing for greening the economy. The budgeted borrowing programme for 2022-23 is Rs 16.6 lakh crore and as per the finance minister, ‘the proceeds will be deployed in public sector projects which help in reducing the carbon intensity of the economy.’

In fact, India already has a history with respect to twin bonds. In the period 2003-08, the Indian economy got a high amount of foreign capital inflows which led to excessive liquidity in the markets and also put appreciation pressure on the Rupee. In order to absorb this excess liquidity, the government of India issued Market Stabilisation (MSS) Bonds. The MSS bonds were issued as a twin to an existing conventional bond.

However, there is one major difference between MSS bonds and green bonds. The proceeds from MSS bonds were not included in government borrowing as it would defeat the purpose of absorbing liquidity. The proceeds were kept with RBI as a special deposit. However, in the end it did not matter as the government used the entire MSS corpus towards meeting its deficit which had risen significantly in the 2008 crisis.

As government readies itself for serving this new green bond to the investor, the question is how do markets want these bonds? To paraphrase James Bond, do they want the green bonds twinned or separated?