Sovereign Green Bond (SGrB) Framework 2022 

Policy Update
Anushree Khare

Introduction 

In 1693, the British Parliament passed the Million Act for financing the Nine Years’ War. Specifically, they agreed to collect all beer and liquor taxes directly toward servicing the new debt. As such, this was one of the first instances of earmarking government borrowing. Making a specific funding source or spending objective to legitimize a borrower’s commitment.

Modern Public Finance has been retreating from earmarking since then through the consolidation of America’s revolutionary debts by Alexander Hamilton to current treasury orthodoxies. According to these orthodoxies, a sovereign’s ability to borrow is at its best when it is able to make use of a free flowing, fungible, single treasury account where funds are drawn from many sources to a central point. 

This represents a return to earmarking in a reverse manner with respect to the SGrB framework. Instead of using earmarked revenues to support debt payments, the sovereign issuer is essentially providing their overall creditworthiness but covenants themselves that the funds raised will be used solely for verified eligible green expenditures supporting climate and environmental objectives. Upon the issuance of the Ministry of Finance of the Government of India’s initial tranches of Sovereign Green Bonds in January and February 2023, India became part of a rapidly evolving international market of sovereign green debt.

Green debt issued by governments cannot be viewed as simply an environmental policy statement. It is primarily a type of fixed income investment which operates according to price-setting principles of asset pricing, liquidity risks and fiscal structures. The primary economic decision faced by managers of public debt is whether the instrument provides quantifiable advantages over traditional instruments regarding the structure of public debt. Specifically whether it results in lower costs at auctions referred to as the ‘greenium’, or if its mechanism for allocating capital can overcome the inherent problem associated with treasuries due to fungibility.

Background

The Indian government formally launched its debt raising initiative with the Sovereign Green Bond Framework that was established in November 2022 by the Ministry of Finance. The framework is based on the principles for green bonds of the International Capital Market Association (ICMA), which are divided into four key areas: 

1. Use of Proceeds: The money raised through the issuance must be used to fund eligible “green” projects that will provide tangible environmental value.
2. Process for Project Evaluation and Selection: The process by which issuers evaluate and select the “green” projects in order to receive financing from the market is as follows; issuers are required to disclose their environmental goals/objectives and what they consider to be an “eligible” project.
3. Management of Proceeds: After funds have been raised and the proceeds (net) have been placed into the “green” account, tracking of those net proceeds must be done and then credited to a separate sub-account or investment portfolio.
4. Reporting: Issuers are required to report current status and progress of utilization of the funds received and the positive impacts associated with each “green” project selected for funding.

Constitutional Cash Unity and Treasury Reconciliation

The SGrB’s structure is subject to constraints related to the political nature of its issuer, specifically, constitutional cash unity. In parliamentary democracies, the ability of a government to issue new forms of domestic debt that do not fall under a unified cash pool is limited due to provisions in their constitutions.

Under article 266(1) of the Indian constitution, any monies which have been raised by the Government of India are required to be credited to the Consolidated Fund of India. Therefore, the creation of separate financial tools such as an offshore escrow account, or a ring-fenced commercial sinking fund to isolate proceeds from green bonds would both be contrary to the spirit and letter of that provision concerning constitutional cash unity.

In order to address the potential conflict created by the constitutional provision limiting the flexibility available to a government to issue debt in a manner which is segregated from other sources of revenue, the Ministry of Finance has provided an administrative reconciliation process for managing green bond receipts. Specifically:

• All gross proceeds generated by the primary auctions of the Reserve Bank of India (RBI) held for the purpose of issuing SGrB are immediately deposited into the Consolidated Fund of India (CFI).
• The Public Debt Management Cell (PDMC) maintains an additional accounting register known as the “Green Register”, which records all inflows and outflows associated with the SGrB program. 
• Drawdowns are made from the Green Register based upon a schedule outlining eligible green expenditures. This schedule also provides a 24 month time frame during which expenditures can be drawn down. 

This allows for financing of expenditures previously incurred no sooner than twelve months before the date of issuance.

Figure 1: Sovereign Green Bond (SGrB) Eligibility Taxonomy: Qualifying vs. Excluded Sectors. (Source: Framework for Sovereign Green Bonds, Ministry of Finance, Government of India, 2022)

Union Budget (2023–24) documents (specifically Statement 15A of the Expenditure Profile, Union Budget) reveal the empirical distribution of allocated proceeds:

Table 1: Allocation of Sovereign Green Bond Proceeds across Ministries and Capital Schemes (Source: Statement 15A, Expenditure Profile, Union Budget 2023–24) 

The Reality of Debt Allocation Through Accounting

The accounting process functions mainly as a financing substitute for refinancing. Due to the relatively small size of SGrB issue volume (₹16,000 to ₹ 20,000 crores per annum) in comparison to the total amount borrowed in the Indian government’s gross market borrowing (exceeds ₹14 lakh crores), the Ministry of Finance has limited its selection to high-confidence, capital intensive lines item, which have been previously screened in the Union Budget.

By doing so, this method does away with programmatic execution risk and allows for 100% fund disbursement into the project at the earliest possible time (within the first 2 years as defined by the Framework Rules). However, this is also evidence that SGrB proceeds are primarily used to replace the general borrowing cost rather than expand the entire fiscal capital envelope. Therefore, the primary economic justification for this instrument lies solely on the basis of reducing the cost of debt and creating a long-term greenium. 

Pricing Mechanism: Calculating the Sovereign “Greenium”

In sovereign fixed income markets, the greenium (Δy) can be described as the negative yield spread between a green bond (Y _green) and a comparable conventional sovereign bond (Y_conv) issued by the same sovereign entity with the same credit quality term and currency characteristics:

Greenium = Y_green— Y_conv < 0

A “negative” spread is indicative of a discount/price advantage obtained by the government to its own issuers when issuing bonds with environmental protection covenants: in other words, investors agree to buy a higher-priced paper with a lower interest rate (yield) because it has been issued as a “green” asset-backed bond.

Measurement Methodologies

There are several econometric methodologies used in academic literature (for example, research from the Harvard School, Columbia University, and the Bank for International Settlements) to estimate the spread (in basis points) between yields of conventional government securities and their associated yield curves.

• Synthetic Matching Methodology 

Synthetic Yield Curve Spline: Fitting a zero-coupon sovereign yield curve (with a Nelson-Siegel-Svensson model) using all current market available conventional government securities. Calculate the difference in basis-points between the primary yield of the Green Bond issue and the synthetic yield calculated at exactly that same time horizon/maturity for an equivalent maturity conventional government security.

• Direct Matched Pair 

Spread Methodology: Matching the green bond directly to a comparable on-the-run or liquid off-the-run conventional government security with nearly identical tenor/duration characteristics; adjust for remaining differences in tenor characteristics through linear interpolation.

Empirical Auction Evidence: The Indian Curve

The RBI initiated the SGrB Program by issuing two 8,000 Crore Rupee Tranches of securities dated January 25th & February 9th with equal allocation to both 5 years & 10 years Tenure Securities:

Table 2: Primary Issuance Auction Results and Realized Sovereign Greenium (January–February 2023) (Source: Reserve Bank of India Auction Press Releases, 2023)

The first set of auctions for primary issuance in January of 2023 confirmed the existence of a very clear, greenium premium (approximately 5-6 bps) for all maturities. There was significant demand from domestic institutional investors who have strong commitments to Environmental Social Governance (ESG) through their mandates as public sector banks, life insurance companies, and pension fund managers. As such, these investors were able to significantly compress the price that they paid for each issue relative to traditional Government Securities (G-Secs) bonds.

Structural Degradation of the Greenium

The liquidity risk premium offset was demonstrated by subsequent market activity for G-SecS in FY24 & FY25 which showed the greenium is unstable and very susceptible to the level of liquidity in the secondary markets. Frequently in the secondary markets, the SGrB discount to Benchmark on-the-run G-secS diminished and traded either at or above those benchmarks. This demonstrates the liquidity risk premium offset:

Y_observed = Y _risk-free + Risk Premium – Greenium + Illiquidity Premium 

The high volume of secondary trading activity surrounding a country’s long-term “benchmark” 10-year bond enables efficient repo financing which allows for effective hedging against interest rate changes using interest rate futures (IRFs) and provides a platform for clearing all trades through the Clearing Corp. of India Ltd. (CCIL). 

In contrast, the vast majority of Indian Sovereign Green Bonds were purchased as buy-and-hold investments by large institutional investors that are subject to statutory liquidity ratios (SLRs) in order to meet their SLR obligations. As such, they did not participate in subsequent secondary market trading activities. Since these institutional investors held nearly all of the outstanding stock of SGrBs, there was essentially no secondary market floating supply of SGrBs available for subsequent purchase and sale. Therefore, an illiquidity premium became a factor. 

If this illiquidity premium becomes greater than the intrinsic “greenium”  

P _illiquid > | Greenium |

The participants in the  primary auctions will require higher yields for purchasing SGrBs at auction relative to their counterparts’ participation in G-Sec auctions. Thus, the sovereign debt manager loses its price benefit. A vivid example of this was seen during FY25 when some of the SGrB auctions faced resistance from primary dealers who would not absorb additional green paper unless it was priced similarly to traditional G-Secs.

Way Forward

The structural changes to enable the Ministry of Finance to transform SGrBs from an ad hoc funding tool into a permanent solution for lowering India’s sovereign borrowing cost.

To take advantage of international ESG capital pools (such as Article 8 and 9 funds under Europe’s SFDR framework), India needs to access those capital pools using SGrBs issued under the FAR program with no FPI statutory caps. The global pool of ESG and sustainable investing funds is estimated to be managing tens of trillions in AUM (which includes EU SFDR Article 8 and 9 products) which will create significant structural demand for sovereign issuers.

Sovereign issuers may also benefit from price premiums (“greenium”) created in sovereign issuances due to this demand, resulting in sovereign issuers earning a lower yield on their sovereign debt than comparable non-ESG benchmarked sovereign debt. The result would be a reduction in the sovereign issuer’s cost of capital.

There are two ways the DMO/PDMC can create liquidity benchmarks for a given SGrB line:

• Execute multiple re-openings (tap issues) of the same green line over time: To provide sufficient liquidity to qualify for high-turnover repo eligibility and lower the illiquidity premium charged by primary market underwriters, a minimum of ₹30,000 to ₹40,000 crore of SGrB must exist outstanding.(This is estimated as per RBI’s empirical threshold for benchmark G-Sec line sizing and secondary market liquidity)
• Use repeat issuances of multiple tranches of the same green line: Each tranche would need to be large enough (approximately ₹10,000 crore+) to also meet the requirements for high-turnover repo eligibility.

Conclusion 

The sovereign green bond represents a new form of development in the history of earmarking for sovereign lending. Early parliamentary states used liquor taxes to give creditors assurance that the government would be able to repay debts, but today the modern sovereign uses transparent tracking of green capital to gain access to niche global liquidity.

The Ministry of Finance’s Sovereign Green Bond Framework has demonstrated the potential for sovereign greenium in the Indian marketplace with a 2 to 6 basis point pricing discount on its first few issuances. However, the post-issue data regarding this new asset class illustrate an unchanging truth about sovereign debt. 

No matter how much a country may emphasize or provide evidence of the “sustainability” characteristics of their Bonds. They will eventually suffer from the same friction that all fixed income markets experience: illiquidity. As long as there are limited sources of secondary liquidity and most of the funds raised through primary issues come from captive domestic accounts, the illiquidity premium will consume the greenium.

As signaling mechanisms and tools for developing countries, sovereign green debt can create a reference pricing curve for domestic non-sovereign borrowers (e.g., state owned entities such as IREDA and REC, municipal corporations, and private sector investors who wish to develop infrastructure). The Government of India will have to find ways to increase participation by foreign investors, concentrate secondary market liquidity and demonstrate verifiable additionality if it wishes to retain the financial benefits provided by the framework. Thereby allowing green sovereign debt to achieve its full economic potential by providing structural reductions in the cost of capital for the sovereign while simultaneously funding its transition architecture.

References

Baker, M. P., Bergstresser, D. B., Serafeim, G., & Wurgler, J. A. (2018). Financing the response to climate change: The pricing and ownership of U.S. green bonds. SSRN Electronic Journal. https://doi.org/10.2139/ssrn.3275327 

Government of India, Ministry of Finance. (2022). Framework for sovereign green bonds. Department of Economic Affairs, Budget Division. https://dea.gov.in/sites/default/files/Framework%20for%20Sovereign%20Green%20Bonds.pdf

International Capital Market Association. (2021). Green bond principles: Voluntary process guidelines for issuing green bonds. ICMA. https://www.icmagroup.org/sustainable-finance/the-principles-guidelines-and-handbooks/green-bond-principles-gbp/

Larcker, D. F., & Watts, E. M. (2020). Where’s the greenium? Journal of Accounting and Economics, 69(2–3), Article 101312. https://doi.org/10.1016/j.jaecon.2020.101312 

Ministry of Finance. (2023). Statement 15A: Statement of allocation of proceeds of Sovereign Green Bond (SGrB) (Expenditure Profile 2023–2024). Union Budget of India. https://www.indiabudget.gov.in/budget2023-24/doc/eb/stat15a.pdf

Reserve Bank of India. (2023, January 25). Sovereign green bonds: Full auction results (Press Release 2022-2023/1605). https://www.rbi.org.in/Scripts/BS_PressReleaseDisplay.aspx?prid=55107

Zerbib, O. D. (2019). The effect of pro-environmental preferences on bond prices: Evidence from green bonds. Journal of Banking & Finance, 98, 39–60. https://doi.org/10.1016/j.jbankfin.2018.10.012 

About The Contributor

Anushree Khare is a Research & Editorial Intern at the Impact and Policy Research Institute (IMPRI). She holds a B.A (Hons) degree in Economics with Research. Her academic and professional interests lie in the domains of finance, quantitative research, data-driven policy analysis, and business strategy.

Acknowledgement

The author extends sincere gratitude to the IMPRI team for their guidance and support along with the reviewers  Ms. Ninchen Tamang and Ms. Mannat Abbot for their valuable feedback and insights.

Disclaimer

All views expressed in the article belong solely to the author and not necessarily to the organization

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