Impact bonds are a relatively new and rapidly growing branch on the tree of impact investments. They offer investors the opportunity to invest in clearly defined projects with environmental or social impact, such as energy efficiency, green buildings and social housing. This article highlights the growth of this market, the additionality of impact bonds, and key advantages for investors. It also pays attention to the worrying trend of greenwashing.
Over the last few years, the market experienced an impressive increase in impact bonds (green and social bonds) issued by corporates, supranational organisations and governments.Since the first green bond was issued in 2007, the market has grown rapidly to roughly USD 250 billion of new issuance in 2019 with an estimated USD 350 billion by the end of 2020. With market sentiment shifting away from a sole focus on making money regardless of side effects, investor appetite for impact bonds is strong. Issues are almost always oversubscribed, with buyers wanting more than they are allocated. This means that secondary trading in the first days after the issuance can be very attractive.
The basic principle behind impact bonds is to allocate money to new projects that bring social and/or green benefits, meaning that the balance sheet of the issuer also becomes more sustainable. This 'greening' is referred to as the additionality of the bonds.
Mandating that bond proceeds may only be allocated to new projects, though, presents a risk for issuers, as they may not be able to identify enough new projects that qualify under their framework. And as the market expects liquidity, issuers need to raise a minimum of EUR 500 million in the bond offering. So, for these kinds of impact bonds to be successful, issuers need to have a significant pipeline of new eligible projects.
An often used strategy by issuers of impact bonds is to register projects that fall under the framework. Only when they have reached a large enough stock, often around EUR 500 million worth of projects, will they issue the impact bond. The look-back period for these bonds is often a maximum of one year, to ensure that the projects are indeed (relatively) new. This strategy is often used by governments. The advantage of this strategy is that it is clear what projects will be financed and that there are no unallocated proceeds.
Key advantages for investors
Investing in impact bonds brings two key advantages to investors:
- The use of impact bonds' proceeds is specified (that is, the issuers have clearly defined what types of projects are eligible for financing by it). This allows investors to make informed decisions about which activities they will directly invest in. Standard vanilla bonds do not offer such transparency.
- Issuers are to report on the impact that will be or has been made with the capital raised by the bonds, allowing investors to measure the impact of their portfolios.
A worrying trend in the market, however, is that impact bonds are increasingly used as a basic refinancing tool. In this strategy, the issuer develops a framework and then checks its balance sheet for eligible existing projects. Once enough projects are identified, the impact bond will be issued and the proceeds used for refinancing.
Increasingly, impact bond frameworks lack a defined look-back period, and projects qualifying under the framework could be more than 10 years old. This raises the question whether these bonds have any additionality; because they already exist, they do not really contribute anything additional to the sustainable transition. In short, the balance sheets of these issuers do not become any greener. This is a relatively new phenomenon, which emerged alongside the rapid growth in investor demand for impact bonds.
A refinancing-only strategy should be qualified as greenwashing. It is surprising to see frameworks with long look-back periods still receiving positive qualifications from second party opinion providers. These second party opinion providers judge impact bond frameworks based on their intended use of proceeds, the processes for project selection and allocation, and proposed impact reporting. Apparently, though, they do not consider the lack of additionality.
Issuers and second party opinion providers will hopefully (re)adopt a requirement for a look-back period of a maximum of one year so that these impact bonds do exactly what they are aimed for: to bring about positive change.
 Additionality can also relate to two kinds of activities. First, to finance new green activities that the issuer will finance with the proceeds from the bond. Second, to finance already existing activities that qualify as green under the framework. This article refers to the latter category.
Social and green bonds: earmarked for impact