Should green bonds be regulated?

The emergence of green bonds as a mainstream instrument has sparked fears that some issuers might be cutting corners on environmental investments


As discussions of mitigating climate change gather pace, so too do studies into the costs of not doing so. Support for the shift to a low-carbon economy has spread to consumers in all corners of the globe, and – predictably – investors have rushed to cash in on what new opportunities have emerged in the environmentally responsible investment space.

One report released earlier this year by the International Energy Agency puts the estimated costs of switching to low-carbon technologies through 2050 at $44trn, whereas another by the IPCC claims stabilising greenhouse gas emissions requires $13trn in investments before 2030. The headline figures at first appear unworkable, especially in an era of austerity and expansionary stimulus. However, with the appropriate mechanisms in place, there exists an opportunity for willing investors to prevent the damage from being done and take part in the turnaround.

“Institutional investors are increasingly concerned about sustainability issues and ESG issues,” says Sean Kidney, CEO and co-founder of the Climate Bonds Initiative (CBI). “An indicator of this is that investors representing some $42trn of assets under management are now members of the Principles for Responsible Investment, and investors representing $22.5trn are members of the Global Investor Coalition on Climate Change.”

The green bonds climate
The staggering costs – financial or otherwise – associated with climate change, and the alleviation thereof, have caused a spike in demand for environmentally responsible investments, not least in the green bonds market, which has grown by extraordinary degrees in recent years. Used to finance environmentally responsible projects, green bonds – or climate bonds – represent a vast share of the $100trn bond market and a significant step on the way to a low-carbon economy.

The consequences of investing in a bond that might not uphold the green end of the bargain serve only to compound exposure to dirty industries

Research from the non-profit CBI also predicts that the market for green bonds will reach $40bn this year, and expand by another $100bn the year after – far and above the $10.9bn issued in 2013, which was then three times the issuance of any year previous. Further estimates show the total value of climate-themed bonds outstanding to be $502.6bn, as of July 2014, again representing a sizeable increase on the $346bn total in March 2013.

Made up of close to 1,900 bonds from approximately 280 issuers, the sub-sector is dominated by investments in transport ($358.4bn), energy ($74.7bn) and finance ($50.1bn), with the rest spread thin across industry, agriculture, waste and water-related projects.

Beginning at a meagre $3bn in 2012, the market for the instrument has since exploded beyond all expectations, and so too has the capital allocated to suitably responsible projects. Beginning as a niche product, the sub sector in its current form, looks capable even of increasing the flow of capital to low-carbon development and shifting the focus away from fossil fuels among the investment community.

However, as demand for green bonds increases, the instrument’s legitimacy could well suffer and the intended environmental benefits wain, without the right measures in place to ensure the capital is correctly allocated. “The Green Bonds era has begun,” says CBI, and many analysts are inclined to agree that the market has migrated from its beginnings as a niche product and into the mainstream; though at what cost to its green credentials remains to be seen.

As is often the case with so-called environmentally responsible investments, there is a danger that the market could be subjected to ‘greenwashing’ as it grows in popularity. The concept – otherwise referred to as ‘green sheen’ – makes specific reference to parties guilty of marketing products or services as ‘green’ when in reality the environmental benefits are exaggerated or in some instances entirely fabricated. And while the market for green bonds is yet to be tarnished in this way, the risks will likely remain for as long as there is no consistent regulatory framework to keep issuers in check.

Guidelines published earlier this year by a consortium of major banking names, including Bank of America, Citigroup, JPMorgan and Crédit Agricole, make clear the properties and principles of green bonds, with a view to arriving at a unified governance framework. The Green Bond Principles (GBP) include guidelines for use of proceeds, process for project evaluation and selection, management of proceeds and reporting, though stop short of setting out concrete rules and punishments for failing to comply with the recommendations.

“The GBP are intended for broad use by the market,” according to the authors. “They provide issuers guidance on the key components involved in launching a credible Green Bond; they aid investors by ensuring availability of information necessary to evaluate the environmental impact of their Green Bond investments; and they assist underwriters by moving the market towards standard disclosures which will facilitate transactions.”

One key area that the GBP fail to address, however, is the much-talked-about issue of environmental targets, and whether issuers need necessarily comply with specific emissions targets before a bond is labeled green. Without clarifying this point, corporate issuers in particular could take it as license to push the parameters of what constitutes green and exploit what is fast emerging as a hot investment trend.

“We think that clear guidelines are needed as to “what is green”, to both make it easier for issuers and to allow investors to compare apples with apples,” says Kidney.

“Our investor board believes that an expert committee approach that brings together key people such as academics and relevant agencies in a sector to determine eligibility criteria is the way to do it – a science-based approach. That reduces the need to have the independent reviewers assess from scratch the environmental qualifications of the bond, and means they just have to confirm it complies with published standards – an important change to allow the market to scale up quickly, as it’ll allow many more reviewer to participate.”

Whereas originally the World Bank’s environmental department decided on green bond criteria and assigned the tag accordingly, the introduction of multiple issuers to the subsector has since given rise to discrepancies, without anything close to a governing authority to answer to. The circumstances here are indicative of a wholesale shift in the green bond market, away from agencies like the World Bank and closer to corporate and banking names, which are growing increasingly eager to join the party.

Corporate overhaul
Until 2013 the green bond space was populated exclusively by AAA-rated development banks, with the World Bank, European investment Bank, European Bank for Reconstruction and Development and the African Development Bank occupying a sizeable share of the market. Once corporate players caught wind of the investment trend, however, many more diverse names rushed to cash in on the green bond rush.

Beginning with EDF, Vasakronan and Bank of America Merrill Lynch, corporate names brought with them a number of changes to the green market, namely increased liquidity and demand. Whereas in 2012 the average bond size was $96m, the introduction of new market entrants pushed the average up to $430m only a year later. The increase in size has continued on since, and some multi-billion dollar issuances are large enough even to appear in general bond indices.

Michael Wilkins, Managing Director at S&P’s Ratings Services told Utility Week that he expects global corporate issuances to reach $20bn this year, double last year’s total and half the projected total for 2014. The figures also fall in line with corporate activity so far this year, in that corporate parties have issued $10.2bn in the first half of 2014, representing 55 percent of the total and comparing favourably with the $3bn equivalent figure last year.

In June, French energy company GDF Suez issued the largest green bond to date, indicating both the rate at which the market has grown and the prominent role European utilities are playing in the subsector’s development. At $3.4bn, the Suez issue dwarfs the previous record of $1.9bn, held by Electricite France, and reveals the appetite for environmentally responsible investment that exists today.

The introduction of new market players has also raised the question of whether voluntary standards are adequate enough a deterrent to protect against the credibility of green bonds, and whether they are in fact ‘green’. One potential solution is to threaten an interest rate spike, should an issuer fail to comply with standards, although most are agreed that the reputational costs of issuing a sub-standard green bond are enough of a deterrent at present to protect against non-compliance.

The vast majority of those investing in green bonds to date are doing so for legitimate reasons – often for the purpose of offsetting exposure to climate risks. As such, the consequences of investing in a bond that might not uphold the green end of the bargain serve only to compound exposure to dirty industries. Greenwashing, therefore, is an unviable strategy for most issuers, that is, until the subsector attracts investors interested only in boosting their surface-level green credentials.

It’s perhaps too much to say right now that the market for green bonds is in need of a regulatory overhaul. However, what is important for the sub sector is that issuers abide by a uniform framework and work together to ensure the legitimacy of green bonds is upheld.

Given that issuers are transparent about their assessment criteria, the emergence of green bonds looks a decisive step on the road to a low-carbon economy.