It pays to enter China’s green bond market early, before prices take off

The lack of ‘greeniums’ – the premium that green bonds can command – for China’s products won’t last
As China aligns its green bond standards with the rest of the world, capital flows will ramp up and the boom should have plenty more room to run

Martin Dropkin

Published: 2:30pm, 13 Nov 2021

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Among the financial market fallout from the Covid-19 pandemic was a slump in green bond issuance in China, where a five-year growth streak was snapped last year.

The government orchestrated the sale of more than 1 trillion yuan (US$156 billion) in pandemic control and relief bonds last year, capturing what remained of investor demand already weakened by the public health crisis.

But the green bond market has made a strong comeback this year as economic recovery continues and, more importantly, China fires on all cylinders to cut carbon emissions.

This has led to China ranking fourth in the value of its internationally aligned green bond issuance so far this year, after the United States, Germany and France, according to the Climate Bonds Initiative.

Most of the action is onshore. More than 80 per cent of Chinese green bonds are yuan-denominated and issued to domestic investors, with the rest primarily dollar bonds offered through the Hong Kong exchange.

In the first half of this year, the value of Chinese green bond sales that comply with domestic definitions and criteria surged to 242.5 billion yuan, while those aligned with international standards jumped to a record 141.9 billion yuan.

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Sustainability: Green bonds to help drive China's push towards carbon neutrality

As policymakers step up their support for green finance, Chinese green bond sales have continued to flourish and are on track for an annual record.

The question investors must ask is: is this the right time to enter the market?

For green bond investors, returns are often as important as environmental priorities, but the two can sometimes work against each other due to “greeniums” – in Europe and America, green bonds often command price premiums over comparable brown issues, despite no difference in credit risk between the same companies’ green and non-green bonds.

Green bond yields were often 5 to 15 basis points lower than those of comparable brown issues over the past few years, according to many research groups including ING Think, the Climate Bonds Initiative and Eurasian Economic Review.

Despite the risks, China’s green bonds will prove rewarding for investors

In contrast, in China’s onshore market, our review of the data points to a clear lack of the so-called greeniums, which could be a boon to global investors.

The spread difference between Chinese green bonds and comparable brown issues of the same maturity is negligible. This appears to hold despite differing levels of rating quality, and even across sectors.

The gap in green bond definitions between China and the West remains a challenge to global investors. European standards have a prime focus on climate change, but China defines green bonds more broadly, covering pollution control, energy saving and biodiversity, among other areas.

Significantly for investors focused on promoting environmental, social and corporate governance (ESG) outcomes, Chinese rules appear looser on the use of proceeds, allowing issuers to allocate up to 50 per cent of funds raised to loan repayment and working capital, while international standards usually require full allocation to green projects. This leaves loopholes for possible fund misuse in the Chinese market.

Recognising these differences, Beijing has been trying to harmonise its green bond standards with international ones.

Last year, the People’s Bank of China removed so-called clean coal, which involves a purifying process to boost the fuel’s efficiency, from its green bond definitions. This is a bold move, given Chin’s heavy reliance on coal-fired power. Coal accounts for about half of China’s energy use, compared to only around a tenth in the US.

How China and the EU can work together to drive green finance forwards

This year, the Chinese central bank followed European regulators in adopting the “do no significant harm” principle in updating its catalogue. This is important in filtering out projects that bring environmental benefits in some ways but cause damage in others.

Change will take time, but the direction of the market is clear. In the first half of this year, green bonds aligned with Climate Bonds standards, which are based on the European Union taxonomy, accounted for 58 per cent of the value of Chinese green bonds – a small increase on 54 per cent last year and 57 per cent in 2019.

It pays to be early in China’s green debt space, where greenium-free days may well be numbered. The price of entry is bound to rise with demand.

As China further opens its capital markets and aligns its green bond standards with the world, capital flows will ramp up and the boom should have plenty more room to run. This is one case where the grass probably will grow greener, and no less costly, on the other side.

Martin Dropkin is head of Asian fixed income at Fidelity International