Innogy conundrum challenges green bond market to find its purpose

An unusual kerfuffle in the green bond market raises once again the usually obscured question of what the asset class is actually for.

Innogy, the new German renewable energy and power grids company spun off by RWE in 2016, issued its first green bond in 2017. The €850m deal was issued under a framework approved by Sustainalytics. Proceeds may be allocated to a range of green asset types, including renewable energy, energy efficiency, smart grids and e-mobility.

In fact, the bond’s proceeds were allocated to refinance five windfarms, in Germany, the UK and the Netherlands.

Then in March this year, the managements of RWE, which still owns 76.8% of Innogy, and E.On, its arch-rival in the German energy market, struck a deal to reshape all three companies. E.On would buy Innogy, paying its public shareholders in cash. The payment to RWE will be assets, from both E.On and Innogy — mainly renewable and some nuclear generation stations.

The deal would leave two companies: E.On, focused on networks, distribution and customer supply, and RWE, with both clean and dirty generation assets.

This €20bn deal (€40bn if you count the assets going both ways) is complex, involving regulators in a dozen countries and three companies’ shareholders. E.On is taking on most of Innogy’s liabilities, and has obtained a €5bn loan so it can buy out Innogy’s minority shareholders. It has also done a 20% capital increase, as RWE is taking a one sixth stake in E.On.

With all that going on, it’s no wonder Innogy’s green bond is fairly low down E.On’s list of priorities. But there is an issue to deal with, because while E.On is taking on all Innogy’s bonds, the windfarms to which the green bond funding has been applied are going to RWE.

To many green bond investors, this creates a paradox: they would own a green bond, but the borrower would not own the assets that made it green.

Asked about this by an investor at a non-deal roadshow last week, E.On’s CFO Marc Spieker gave a response that essentially meant: we haven’t sorted this out yet. But the impression he gave to at least some in the room was that E.On was “dismissive” and “almost disdainful” about the idea of green bonds, and didn’t care much whether the bond remained green.

There is a long time in which this issue can be sorted out before the merger closes — and there is an obvious solution: Innogy can reallocate the proceeds to other assets permitted under its green bond framework, such as grids, which will be staying with E.On.

Some investors might be irked, as they might have bought the bond specifically because they liked the idea of their money going to windfarms. 

Green bond investors increasingly like to track and measure the ‘impact’ of their investments, using metrics such as carbon emissions avoided. Some would see windfarms as giving a bigger bang for your buck than grids. But it is unlikely many investors will be cross enough about such a change to make a fuss.

So it is probable this situation can be solved without causing a significant nuisance to anyone.

But it does raise interesting questions for the green bond market. This situation may not have happened before, but it is likely to happen again. As green bonds become more common, more green bond issuers will be affected by mergers and acquisitions.

Green bonds are not a legal construct — the green aspect is not enshrined in contracts, but more a promise in honour.

That means green bonds would not necessarily be noticed when lawyers and financiers putting together a merger or takeover are going through everything that needs to be sorted out.

The first question is: should investors care at all if an Innogy-type situation arises? This goes to the heart of what investors believe their money is actually doing when they invest it in a green bond, and what the function of the issuer’s green commitment is.

In a case like Innogy, investors presumably feel their money has “gone to” those windfarms, or at least “refinanced” investments made earlier by Innogy using other money.

This link is preserved by the process of the issuer reporting to investors on how the money was allocated to the windfarms, and those assets’ environmental benefits. Most issuers commit to such reporting for the life of the bond.

Of course, in reality, money is just money. Innogy, which is investment grade-rated and has ample access to money, built the windfarms with other money, and could have refinanced them with other debt. The green bond investors did not make those windfarms get built.

Every deal is different, but the great majority of the green bond market is like this. The issuers are investment grade, strong credits; they were making a set of green investments anyway; they decide to issue some green bonds and proceeds from those are “allocated” to the green investments in a way that makes the investors feel all their money is being used for the green activities. Some investors regard this as an “impact” that their investment has achieved.

If this is how the investors think, what would they actually lose if, in a situation like Innogy, the assets financed (or refinanced) and the bonds were parted into separate companies?

Their money would have “gone to” those windfarms, which now exist — the good impact has been achieved — would that not be enough? Does there need to be a permanent link between the bond obligation and the assets?

Most green bond investors expect regular reports on how their money has been spent, and might object that they would lose that benefit. But in this case, the need could easily be fulfilled by RWE committing to supply the annual reports on the state of those windfarms, perhaps with E.On paying its costs.

Would that satisfy investors, or would they still want some other link between the assets and the bonds? And if so, what would be the real meaning or value of such a link?

It is also worth considering the scenario that Innogy does reallocate the proceeds to other assets, such as grids. Should the investors who tot up their impacts then count the windfarms the money was originally used for, or the grids? Surely not both, as that would be double counting — but the difficulty of deciding which of the other two is more appropriate highlights the artificiality of the arrangement.

One point in favour of a link is that if the environmental virtue of the assets earmarked declined during the life of the bond — for example, windfarms were neglected and fell into disuse — the reporting link and bond obligation between the issuer and investor provide a channel for the investor to pressure the issuer to tighten up its performance.

Perhaps then the investor should consider the assets its money has financed as being those over which it enjoys this long term governance privilege.

The situation is slightly different when a bank (including a public sector development bank) is the issuer. Banks make loans, which are repaid. Green bond investors usually expect that if the loans to which their money has been assigned get repaid before the bond has matured, the issuer will redeploy that money in fresh green loans, so the investor can still feel its money is allocated to green assets on the issuer’s balance sheet.

Were the assets and bond to be separated in a deal of this kind, the investor might want not only a continued stream of investor reports but a loan replacement commitment.

What this discussion reminds us is that green bonds are like a viewing glass, used to look under the surface of the sea.

They give the investor a view on what is happening in one part of the issuer’s business. While that glass is there, the issuer promises to make sure that what happens in the viewed space is roughly what the investor has been led to expect. The investor can choose to believe that it is somehow responsible for that activity having happened — although usually it would have happened anyway.

The glass tells the viewer nothing about what is happening in the rest of the ocean — just as a green bond gives the investor no control over what happens in the rest of the issuer’s business.

For that, conventional environmental, social and governance investing techniques are needed, such as observing the whole organisation’s performance, comparing it with peers and asking it questions — or even, making demands.

The green bond investor may feel better about this investment than other investments, because it can point to reports and say “my money did that”. But for this to actually help the environment, things need to happen that go beyond what is strictly required by the green bond.

One of these outcomes is that issuing and investing in a green bond can raise awareness about green issues, in either the issuer or the investor, so that it pays more attention to greening its activities more broadly.

Alternatively, some kind of preferential financial outcome needs to occur, which incentivises more green investment than would otherwise have occurred.

This can happen when the issuer is a weak credit that would have a poor range of financing options, but has better options if it offers a green bond. It can happen if subsidies are applied to the market, which is the most logical culmination of its creation, and which is now visible as a possibility on the horizon in Europe.

Or it can happen if investors decide that, for certain kinds of investment — such as long term infrastructure investment — they will only buy green bonds. This is the direction in which the new Green Bond Pledge initiative is tending, although it stops short of demanding signatories make such a commitment.

The green bond market has grown impressively, and has helped engage thousands of financial professionals in thinking about the environment as part of finance. That is very valuable.

But the market still remains in the anteroom of its real mission: helping the environment.

That will begin to happen either when subsidies start to be applied, decisively and effectively, to green finance — with all the risk of unintended consequences that subsidies always bring — or when green-minded investors start to hunt out green investments, especially riskier ones, and price them more favourably than they would similarly risky brown investments.

This does not mean accepting a few basis points less yield at new issue, which has been happening for years and is irrelevant to outcomes in the real world, but conceding 10s or 20s of basis points and preferably whole percentage points. Or not buying brown debt at all. 

Some investors do this — such as the 230 who invested $35bn in 2017 into over 11,000 impact investment deals. But this is mostly away from the mainstream bond market, including green bonds.

Green bonds are an issuer-led market, but their point is to allow investors to express a view and direct capital a certain way. Investor signals are price signals, and so far the green lights are still just flickering.