The European Union's coronavirus pandemic recovery plan could act as a catalyst for green bonds by providing the basis for a highly rated safe asset and spurring more private investment in the fledgling debt instrument, experts and market participants said.

EU leaders agreed in July to establish a coronavirus recovery fund offering €390 billion in grants and €360 billion in low-interest loans to pandemic-stricken EU countries. It will spend 30% of the money on climate-related projects, sparking hope among green bond specialists that it will reinvigorate the market that has been dogged by poor supply despite increasing investor interest.

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Although they represent a fraction of the overall debt market, green bonds — debt that finances environmentally friendly projects such as wind farms or solar power — have grown rapidly over the past eight years, from virtually nothing in 2012 to issuance of $254.9 billion in 2019, based on figures from the Climate Bonds Initiative, a nonprofit that promotes green investment.

Liquid market

The recovery plan is "an opportunity for the EU to establish a liquid market for safe green bonds in the sense that they would be very highly rated and considered to be safe from a credit perspective," said Michael Wilkins, head of sustainable finance at S&P Global Ratings.

The plan could increase the size of the global green bond market by €225 billion over time, he said. "That kind of scale would be big enough to create a liquid market which in essence could have ... positive consequences."

"It would encourage more private sector green bond issuance as [it would establish] a green pricing curve or yield curve for a safe green asset and that would help the pricing of green bonds," Wilkins said.

"That, plus the liquidity, would encourage more private green issuance because at the moment it is very small relative to the overall size of the capital markets," he added. Green bonds account for 3.7% of total global bond issuance, according to S&P Global Ratings.

ECB asset buying

Demand from EU-issued green bonds would not just come from environmental, social and governance-focused investors and ESG funds, but also the ECB's asset purchase program, Wilkins noted. ECB President Christine Lagarde has made it clear that she wants to direct that program toward climate change mitigation, which implies green bonds, he said.

The climate-related aspect of the plan fits in with the EU's environmental strategy. In December, it presented its European Green Deal, which seeks to mobilize at least €1 trillion of sustainable investment over the next 10 years. In 2018, it launched its sustainable finance action plan, including the creation of a taxonomy for green investments and an EU green bond standard.

"The miracle of the green bond market has been to take the debate around green [issues] and the environment and turn it into something practical that you can evaluate for investment," said Nicholas Pfaff, head of sustainable finance at the International Capital Markets Association, which has established guidelines for green bond issuance known as the Green Bond Principles.

EU green bond issues would reinforce the body's pledge to the green deal and would encourage institutional investors such as pension funds to include green investments in their portfolios, said Marion Amiot, senior economist at S&P Global Ratings.

"You can demand from banks or insurance companies that they [have] some of those in their portfolio but if they don't exist that's not possible," she said.

It would also reinforce the euro's position as an international green currency and provide a "safe green asset" from a supranational body, reducing the risk of political dynamics from individual member states, she said.

Amiot believes issuance triggered by the climate commitment in the EU recovery fund would take place for three years or longer from 2021.

Building back better

The EU taxonomy is key because it would identify and direct green investment, which should lead to a sharp rise in bond issuance, Climate Bonds Initiative CEO Sean Kidney said in an interview.

"The recovery fund should be looking at what is involved in building back better and making sure we don’t mess it up by building back things that are bad in the past," he said.

Projects that could benefit from green bond financing might include transportation in Eastern Europe, for example in the railway system, while investment in energy-efficient buildings might create construction jobs and boost recovery efforts, Kidney said.

Growth in the green bond market in the first half of 2020 has been eclipsed by social and sustainability bonds, a hybrid of green and social bonds, as investors shift their funding needs because of COVID-19. But Pfaff said he was optimistic about the longer-term growth of the market. Social bonds could possibly form part of the financing for the EU recovery plan, he noted.