How UNDP is contributing to a more efficient cost of capital for developing countries
Identifying the ‘greenium’
April 25, 2022
Global indebtedness has been growing in recent years and has been further exacerbated by the COVID-19 pandemic. Many developing countries are now facing the triple challenge of climate change, unsustainable debt burdens and COVID impacts. According to UNDP analysis: “Most vulnerable countries identified are not on the verge of a default, but rather risk facing a future of high economic and development costs of having to deal with large debt overhangs. How the vulnerable developing countries will come out of this crisis will depend crucially on liquidity risk in the short term and their ability to undertake quality investments in physical and human capital to boost future growth, as well as external demand for their commodities. For all countries, this will require access to stable and low-cost finance, and for some countries a debt restructuring will have to precede such access.”
How to deliver on this means identifying debt solutions that are sustainable and appropriate to their fiscal situation, and tied to sustainability goals.
Over the past years, UNDP has assisted sovereigns in their thematic bond issuances with a clear focus on tying the use of proceeds to the attainment of the Sustainable Development Goals (SDGs). For UNDP, the issuance of thematic bonds – i.e. financial instruments with a measurable impact on national development targets and nationally determined contributions (NDCs) to global climate action – conforms to the 2015 Addis Ababa Action Agenda for financing development.
Notably UNDP has contributed already to a number of issuances across the world:
- Indonesia’s SDG Bond issued in September of US$500 million, and the first sovereign Green Sukuk issued in 2018 raised $1.25 billion and has had additional issuances since
- Uzbekistan’s SDG bond issued in July of 2021 in two tranches for a combined $870 million
- Mexico’s EUR 750 million SDG Bond issued in September 2020 and EUR 1.25 billion issued in July 2021
- China’s New Development Bank RMB 5 billion SDG Panda bond was aligned to the UNDP SDG Impact Standards for Bonds in March 2021
- Fiji’s forthcoming sovereign listed blue bond is under development in cooperation of UNCDF and the UK Government
Global thematic debt issuance has proliferated exponentially in recent years, toppling $1 trillion in 2021 and nearly doubling from the previous year. The reasons behind this proliferation are multiple. On the investors side, environmental, social and governance (ESG) achievements and lower risks (e.g. climate change-related risks leading to stranded assets). On the issuers side, thematic bonds provide not only long-term development gains but also a diversified and steady investor demand, which could lead to pricing benefits – notably the much-debated presence of a ‘greenium’ (or ‘green premium’).
There are several technical arguments to support the existence of a favourable ‘greenium’ pricing –defined as the difference in yield between thematic bonds and ordinary bonds of a similar maturity, based on the logic that investors are willing to pay extra for a bond with a sustainable impact. Among others:
- Firstly, a greenium is fundamentally a part of the overall discount factor (or the required rate of return) in the vantage point of the investor. The sustainability factor associated with a thematic bond is a credit positive – such that the issuance of the bond is perceived to improve sustainability. This in turn results in lower overall risk of the issue (issuer). This would warrant a lower yield (higher price) relative to the normal curve (i.e. greenium).
- Secondly, the demand and supply equation: higher demand for thematic debt, and in instances where specific funds mandate investments in sustainable instruments, would create excess demand for thematic debt resulting in higher prices for investors, thus lower yields.
- Thirdly, the mission value or the true appreciation of sustainable features results in a willingness from investors to accept a lower return for a thematic bond.
Irrespective of the circumstances, empirical evidence suggests the existence of greeniums – although this might not always be the case, and its range may differ from a few basis points to more significant values. The spread could perhaps explain the varying degrees of the different vantage points above. For example, for an issuer, signalling a stronger sustainability use of proceeds, greater risk reduction and long-term positive impacts, which also improve operations, could yield a larger greenium, while a less compelling green story could have the opposite effect.
Advocating for more thematic debt would not exacerbate the debt crisis as long as these instruments are only deployed when fiscally appropriate. The greenium works as a signal-sending mechanism and to showcase in a way the ‘most sustainable’ bonds—in the long term it is unlikely to persist but for now it is a useful signal-sending mechanism.
While issuers could benefit from lowered borrowing costs on sustainable debt, some investors are questioning the logic behind greeniums –paying extra for a bond with a sustainable label – arguing there are more effective ways to incentivise issuers to boost their spending on sustainability. For example, key performance indicators (KPI) bonds such as sustainability-linked bonds do not have their proceeds set aside for any specific ESG purpose but rather reward (or penalize) the issuer by requiring lower interest payments to investors in the case that pre-agreed sustainability KPIs are met.
UNDP’s track record helping countries issue thematic debt – through either use of proceeds or KPI bonds – together with its unwavering resolve to see meaningful and measurable impact – holds it in good stead with the issuers of thematic debt. Issuing debt sustainably will not add to the over-indebtedness burdens, especially when multiple solutions are deployed for restructuring and forgiveness when appropriate. UNDP can tout an improvement in efficiency and a lower cost of capital for the sovereigns it works with – helping governments build capacity internally rather than outsourcing, providing expertise at reduced costs through the process, and guiding a compelling use of proceeds tied to SDG delivery that will ultimately support sustainable development. With its comprehensive suite of impact measurement and management (IMM) platforms – and one specifically geared for thematic bonds (UNDP SDG Impact Standards for Bonds) – UNDP helps issuers rigidly focus on sustainability that would lower overall risk and help harness better pricing.