The sustainable finance market in Europe has seen dynamic growth in the past few years. In Germany, for example, the volume of sustainable investment rose by more than 70% between 2014 and 2018. Green corporate finance and project finance aim to reduce greenhouse gas emissions. They also serve as a way of investing in innovative, low-carbon technologies. There is a huge need for investment in sustainable projects, according to the October issue of the Bundesbank’s Monthly Report, but it is unclear how the strong market growth observed recently will continue to develop.

Investors face uncertainty

The experts attribute this to various factors relating to both the demand and supply sides of the market as well as the real economy. For example, it is not yet clear what conditions need to be in place for sustainable investment strategies to also be financially worthwhile for investors. After all, these strategies do narrow the range of investments available to investors in the first place. This typically means that an investment has a worse ratio of risk to return. On the other hand, though, there is the chance that sustainability analyses will make investors aware of previously neglected risks – such as those resulting from climate change. Although there is a broad consensus among academics that these risks will have negative repercussions for the economy, the exact form they will take is still unclear.

Looking at the supply of green bonds in the market, it can be seen that these were initially issued predominantly by development banks and government-backed entities such as the Kreditanstalt für Wiederaufbau (KfW). Over the past few years, however, private financial institutions – particularly mortgage banks – and also the public sector have issued more green bonds. It is not yet known how the issuance of a green bond affects its yield. Whether or not it is also financially worthwhile for the issuer depends, for example, on whether investors are willing to pay more for a green bond than a conventional bond, given the same level of credit risk. The current academic research does not come to any clear conclusions. A Bundesbank analysis arrives at the same result. “Comparing conventional and green bonds of the two issuers [KfW and the European Investment Bank (EIB)] does not reveal a clear pattern in terms of yield spreads,” the report states.

According to the authors, further growth in the market will depend, not least, on enterprises and their willingness to revamp product ranges in a sustainable way, make more sparing use of natural resources and reduce environmentally harmful emissions. Because this kind of reorientation will require extensive investment, based on estimates made by German industry, there would also have to be engagement from private investors.

Sustainable finance for retail investors as well

How can incentives to promote sustainable economic growth be created? The Bundesbank’s experts believe this is a task for politicians. Amongst the examples highlighted in the report are the efforts made by the European Commission, which is working on a reliable and transparent classification of financial products. The Commission is also planning to introduce a common “taxonomy”, containing a consistent classification of sustainable economic activities, which will be applicable to sustainability labels for financial products, for instance, or for the EU green bond standard. The Bundesbank economists believe that efforts such as these are a step in the right direction towards enabling financial market participants to accurately assess the opportunities and risks of different investments and thus reducing the aforementioned uncertainty. They also lower the risk of investors being misled about how sustainable their investments are. Sustainable investments are therefore likely to be open to retail investors as well, according to the report. A glance at the global numbers shows that this is worth pursuing: despite appreciable growth rates, outstanding green bonds so far only account for just under 2% of the international bond market as a whole.