A new green bond framework in Denmark could address potential liquidity issues on the Danish market and pave the way for green sovereign bonds further afield, according to Scope Ratings.

The country's central bank and finance ministry are working on a model that would let small sovereign issuers such as Denmark tap the green bond market, without hurting liquidity.

Under the proposal, the country would add a green certificate to a segment of conventional bond issue. This would give investors focused on environmental, social and governance, or ESG, concerns a new green-labeled security, and could also help maintain liquidity levels. The two parts of the bond would be sold together at auctions but could be traded separately in the secondary market, the rating agency said.

The government would use the funds raised for sustainable projects. Green bonds are generally used to finance projects such as wind farms and solar panels.

Tiny debt market

The small size of Denmark's sovereign market makes it challenging for the country to issue sovereign green bonds, Scope Ratings said.

"Together with the scarcity of suitable green investment projects, one of the main dilemmas that Denmark faces is a risk that the issuance of green bonds could reduce liquidity in Denmark's conventional sovereign bond markets, which already see low outstanding volumes, with demand outstretching supply," Giulia Branz, associate analyst at Scope, said in a report.

Global green bond issuance has been rising rapidly as investors increasingly apply ESG criteria to their investments. The market rose by 49% in 2019 to $254.9 billion, according to the Climate Bonds Initiative, but remains a tiny fraction of the overall debt market, and has been beset by problems of liquidity, with demand outpacing supply.

Sovereign green bond issuance accounted for about 10% of the 2019 total at just over $25.8 billion, with France and the Netherlands among the top issuers.

Because it has a fiscal surplus and low government debt levels, Denmark does not have very large funding needs — about 4% of GDP in 2020, Scope estimates.

Driving green bonds

Dennis Shen, lead analyst at Scope on Denmark, said the Danish proposal to issue green bonds while maintaining liquidity "may clear the way for other lowly indebted, highly rated sovereigns to consider entry to the green bond market."

"Conceiving such a design could indeed prove useful in advancing the global green bond market and making it a more frequent domain for issuance by the most creditworthy sovereign issuers," he said.

The lack of liquidity on the green bond market has led to calls for a green assessment for all bonds.

"If you ring-fence something too much you don't create sufficient investability from large asset owners," Richard Mattison, CEO of Trucost, part of S&P Global, said in a recent interview. Major pension funds find it difficult to invest in green bonds because of the opaqueness of the market and liquidity concerns, he said.

"What is missing is more of a market-wide assessment of bonds," Mattison said.