Given the scale of the environmental threats at hand, policy-makers must amplify green finance swiftly and significantly to help reverse climate change and manage related growing financial risks.
Responding to these trends, in early 2019 Magyar Nemzeti Bank, the Hungarian central bank, launched its green programme, consisting of three main pillars. The first relates to greening the domestic financial sector, the second to developing the MNB’s social and international relations, and the third to further greening of the central bank’s day-to-day operations. In January last year the MNB joined the Network for Greening the Financial System, which facilitates collaboration between central banks globally to accelerate change in the financial sector. In mid-November, MNB, in partnership with the NGFS and European Bank for Reconstruction and Development, organised an international conference to promote sustainable and environmentally friendly financial services.
The MNB aims to lead by example and embrace this important and dynamic market. In June the monetary council elected to establish a dedicated green bond portfolio as part of its foreign reserves, one of the first such portfolios to have been introduced by a central bank. The portfolio is intended to encourage the development of this market segment, be consistent with any potential future recommendations issued by the NGFS, and signal the MNB’s commitment to international co-operation.
The MNB has started its green bond investments with a relatively small allocation for two reasons. First, this market segment is in the early stages of development, with evolving standards and practices. Second, the low level of secondary market liquidity restricts management of large portfolios. Overall, the central bank expects that the risk-return characteristics of its green bond portfolio will not be materially different from similar types of investments in the foreign reserves.
The key issue in green finance and impact investing is standardisation. Defining what is and is not ‘green’ is essential in achieving a positive environmental impact and avoiding reputational risk triggered by green defaults or allegations of greenwashing. In this respect, the green bond market is deemed to be outperforming other green and environmental, social and governance market segments. It already benefits from comprehensive frameworks such as the Green Bond Principles (issued by the International Capital Market Association) and Climate Bonds Initiative, widely accepted taxonomies and an industry of external reviewers. A soon-to-be-released European Union green bond standard may give another boost to the market.
In the light of the proliferation of green bond standards and external reviewers, it may be worth considering applying only some simple rules to determine the ‘greenness’ of a given bond.
Alignment with the Green Bond Principles and a positive second party opinion could be a good starting point. Nevertheless, it cannot be emphasised enough that this evaluation process should never be completely automatic. Investors must analyse thoroughly the issuance documentation, paying special attention to the use of proceeds and background of the issuer. Issuers’ ESG rating can be used as a first-order filter in avoiding green washing.
Monitoring green bonds from an environmental angle does not stop after purchasing them. Policies and actions may change with time, so continuous monitoring of issuers is paramount. Fortunately, impact reporting is becoming increasingly standardised, making it easier to assess the impact of a green bond portfolio.
An oft-cited criticism of green bonds is that they predominantly underperform normal bonds, and therefore cannot be reconciled with asset managers’ fiduciary duty. There is some evidence of a green premium or ‘greenium’ phenomenon, according to recent studies, but this is either small or non-existent. Moreover, on a risk v. reward basis, green bonds seem to have some advantage due to their stable investor base, which might result in lower long-run volatility. Moreover, given the changing investment and regulatory landscape, fiduciary duty can and should in the future incorporate sustainability elements.
Reactions to the public announcement of the green bond portfolio were extremely positive. Green bond issuers in particular found it especially promising, reflecting the importance of the signalling effect of such statements. There are financial motivations, too, to adapt to a changing market structure, where dedicated green bond investors can expect to reach better allocation in primary issuance than less committed investors.
For years, people have treated green bonds as a niche market. This is no longer the case. Green bonds have captured the attention of larger asset managers, including central banks. There is a long way to go before green bonds become a separate asset class of their own, and monetary policy-makers and regulators have the responsibility to play a role in supporting this market segment. The MNB believes that we, central banks, can do this without sacrificing our policy goals or compromising our usual conservative approach.
Dániel Palotai is Executive Director and Chief Economist, and István Veres is Head of Treasury Division of Magyar Nemzeti Bank, the central bank of Hungary.