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Can Saudi Bonds Really be Green Bonds?

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It was announced recently by CNBC Arabia that Saudi Arabia’s Public Investment Fund is considering an issuance of “green” bonds. I think the first reaction of most people hearing about this for the first time would be, “What the heck is a green bond?”. And the second reaction of most people should be “how the heck can Saudi Arabia, one of the world’s largest producers of fossil fuels, qualify for anything being green????”

These are both very reasonable questions.

What is a Green Bond?

A green bond is a relatively new type of financial product. Essentially it is a loan where the lender has certain contractually enforceable expectations for the borrower’s behaviour. This is not unusual as most loans have controls on the borrower’s behaviour so as to make it more likely the lender will receive their money back. These are things like maintaining certain debt to equity ratios, or refraining from paying dividends until the loan is paid off. What’s unusual about green bonds is that these contractual requirements don’t impact the ability of the borrower to repay the loan (at least not directly), but instead are specifically designed to improve the environmental impact of the borrower’s operations. The green bonds typically pay an interest rate that is lower than the typical market rate. Basically what this means is that the lender takes a discount on their return from lending the money so that they can influence the borrower to be more environmentally friendly.

Qualifying for a Green Bond

The second question is easier to answer. Yes of course Saudi Arabia can qualify for a green bond. In fact, arguably as one of the largest producers of fossil fuels in the world, they have the most “upside” for people looking to invest in green bonds. If we’re looking for a transition to generating energy with something other than fossil fuels, then Saudi Arabia has a lot of transitioning to do!

These green bonds are therefore different than the typical “ESG” funds we have seen pop up over the past few years. ESG stands for Environmental, Social, and Governance standards and ESG funds promise to invest in companies that only meet higher standards when it comes to these three factors. There have been a few problems with these ESG funds however.

First Major Problem

For one thing, what qualifies for an ESG fund is often hard to quantify and there have been some questionable inclusions. I have seen ESG funds which include Amazon, despite the environmental criticisms of its delivery model. One of the more common holdings in ESG funds has been Tesla, which is obviously trying to help the environment, but also has been heavily criticized on its social and governance aspects (it’s hard to claim you have good governance when the SEC requires your CEO’s Twitter account to be supervised).

Whether or not Tesla belongs in an ESG fund isn’t that interesting to me. But I don’t think it’s obvious that they should be included, and that raises a question about the validity of many ESG funds.

Second Major Problem

The second major problem that I see is that ESG funds don’t really address the issue that investors are concerned about. People who are investing in ESG funds want to impact change. They want the economy to be more environmentally friendly/socially conscious/well governed. Who wouldn’t?! But ESG funds don’t actually force that to happen. The theory behind them is that by denying capital to companies who do bad things, they are raising the cost of capital for them, which theoretically makes it harder for them to grow or operate their business, therefore limiting their ability to do bad things. The problem with this is that if a company has a higher cost of capital, then implicitly that also means there is a higher expected return in investing in that company. That’s just the way finance theory works. It’s almost certain that any ESG investors who refuse to invest in bad companies will be replaced by investors who like that bad companies offer an opportunity for higher returns. So the actual impact on the bad company is likely minimal if it has any impact at all.

Interesting Proposition

Green bonds offer a new and more interesting proposition though. They are actually putting the onus on the bad company to improve their bad behaviour. This is much better! But it does come with some ethical conundrums.

Saudi Arabia is issuing green bonds. Many people who like investing in ESG funds will not like investing in Saudi Arabian bonds. They are one of the biggest producers of fossil fuels in the world as we already discussed. On top of that, they also have some real troubles on the social and governance aspects as well. The Saudi Government has a reputation for not being democratic and is often criticized for their human rights record and their treatment of women. Not exactly what you want to see for any investor, let alone an ESG investor.

So ESG investors are in a bind. Here is a chance to really influence environmental policy of a very large polluter and make a real impact with their investment dollars. But in order to do so, they will have to support a questionable regime who might miss the mark on both the “S” and the “G” components of an ESG fund (and also have a long way to go on the “E” component as well).

I’m not sure how this space of “green bonds” will develop, but it is interesting. I can say with a high degree of certainty that despite all of what I said above, I doubt Saudi Arabia will have any trouble selling as many green bonds as they want to. After all, their oil wealth makes them an excellent credit risk!

- Craig White, BA, LL.B., CIM®

Craig White is an Investment Advisor at Endeavour Wealth Management with iA Private Wealth, an award-winning office as recognized by the Carson Group. Together with his partners he provides comprehensive wealth management planning for business owners, professionals and individual families.

This information has been prepared by Craig White an Investment Advisor for iA Private Wealth and does not necessarily reflect the opinion of iA Private Wealth. The information contained in this newsletter comes from sources we believe reliable, but we cannot guarantee its accuracy or reliability. The opinions expressed are based on an analysis and interpretation dating from the date of publication and are subject to change without notice. Furthermore, they do not constitute an offer or solicitation to buy or sell any of the securities mentioned. The information contained herein may not apply to all types of investors. The Investment Advisor can open accounts only in the provinces in which they are registered.

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