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

The market, already the world’s second largest, is expected to grow further in size, depth and liquidity to meet China’s ambitious net-zero carbon target
Strengthening information disclosure and a more rigorous definition of what counts as a green bond will add to the appeal, on top of its diverse offerings and high yields

Aidan Yao

Published: 8:45am, 22 Apr 2021

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While China may be late to the global game of eliminating carbon emissions, its commitment is an ambitious one – to achieve net-zero emissions by 2060.

As the world’s largest emitter, China’s goal will require trillions of yuan in new investments to revamp its carbon-intensive economy and energy system over the coming four decades. The green bond market in China, developed to mobilise private-sector resources to facilitate this transformation, has tremendous growth potential.

For global investors, there are a number of reasons the Chinese green bond market could appear attractive. First, it is large enough to accommodate significant foreign investor participation.

Green bonds as such did not exist in China until late 2015 but, since then, the country has become the world’s second-largest market, with about a 13 per cent share. Building on the stellar growth momentum, the market is set to grow further in size, depth and liquidity to meet China’s net-zero target.

Second, the market offers a decent level of diversification in terms of project and credit exposure. In China, green bonds finance a wide range of environmental projects, with an emphasis on pollution reduction, ecological protection, resource conservation and global warming mitigation.

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Transport – mostly electric vehicles and railway projects – and energy – predominantly renewable fuels, such as wind and solar – account for over 50 per cent of green bond issuance in 2019. Water conservation, waste management and high-efficiency building construction account for the vast majority of the rest. This composition is broadly in line with the global aggregate, but more diverse than many smaller markets, which can be quite concentrated on clean-energy projects.

Finally, the financial appeal of Chinese green bonds is amplified by the prevailing low interest rate environment. According to the FTSE Chinese Internationally-Aligned Green Bond Index, the average yield of Chinese green bonds was 3.44 per cent as of March 31, compared to 0.58 per cent for the Bloomberg Barclays MSCI Global Green Bond Index.

This yield premium is partly the result of structurally higher interest rates in China. At the same time, local investors do not pay a premium for green bonds, as is usually the case in Europe.

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But there are some unique risks to be aware of. On top of the need to navigate the partially open capital account, a currency with limited convertibility, and a constantly evolving bond market, there is an extra layer of complexity in assessing the “greenness” of bonds. This complication is further underlined by the lack of a unified global green bonds standard, with all major markets – the US, China and Europe – operating under somewhat different regulations and guidelines.

If we use the Climate Bond initiative (CBI) standard as a yardstick, we can see three categories of discrepancies that still exist between China’s definition of “green” and the international definition.

The first is simply a lack of information on how the bond proceeds are utilised. While this was an important driver of bond exclusion by the CBI in the early years, it has gradually become less of a concern as Chinese issuers have strengthened information disclosure.

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The second category relates to the definition of “green”. The most notable example is the treatment of clean coal projects. While they qualify for green bond financing in China, provided the reduction in carbon dioxide emissions meets a certain threshold relative to regular coal technology, no fossil fuel projects are accepted by the CBI, given the presence of emissions.

However, the People’s Bank of China plans to remove clean coal in the next edition of its green bond catalogue, which will further align the Chinese and international standards.

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The most significant discrepancy – accounting for over 70 per cent of Chinese bonds’ exclusion by the CBI in 2019 – is the percentage allocation of proceeds for specified green projects. While the CBI requires at least 95 per cent of the proceeds to go to earmarked investments, some Chinese regulators allow up to 50 per cent of the proceeds to be used as general working capital.

Despite these hurdles, the extra costs are small in comparison to the benefits and opportunities offered by what is looking to be the world’s largest, most diverse, and highest-yielding green bond market.

Aidan Yao is senior Emerging Asia economist at AXA Investment Managers