Responsible Investor blog: On three major risks to the market’s credibility; how standardization can help ensure that the green bonds market delivers on its potential

This month, Responsible Investor devoted their RI Insight report to Green Bonds: the future of sustainability financing. The report was prepared in association with the Climate Bonds Initiative and includes insights from: Bank of America Merrill Lynch, TIAA-CREF Asset Management, SEB, European Investment Bank, Skanska Financial Services, Oekom research, Vigeo, Sustainalytics, MSCI / Barclays, Bloomberg New Energy Finance, Länsförsäkringar AB, Actiam and the ICMA.

Responsible Investor calls the report a testament to green bonds’ three main features:  the simplicity of the green bonds concept, the ability of the bond markets to act as a rapid financing stream and the determination and gusto of its dedicated supporters

Below is the article contributed by Sean Kidney and Bridget Boulle.  Or, download the report here.

How standardization can help ensure that the green bonds market delivers on its potential

2014 has been a big year for green bonds[1]. We’ve seen the market grow very quickly and we’ve seen investor interest levels soar. We expect 2014 issuance to reach over $40bn – four times 2013 issuance.

Growth is fantastic but growth to date has to be seen as just step one. The bulk of issuance so far has involved highly creditworthy issuers repackaging assets as green bonds; the next step is to ensure that this growth has a bigger impact.

This is an opportune moment to take a step back and remember what this market is for... the market began as a tool to help investors identify financial products that shift capital towards investments that address climate change. This was the theme of the European Investment Bank, World Bank and IFC bonds, for example. Green bonds that link proceeds to particular projects or assets are a means of doing this.

This concept of shifting capital directly towards particular projects/assets is unique to bonds. The majority of SRI/ESG-related investment to date has been concerned with equities, where the analysis has been at the company-level. Thematic bonds can enable investors to shift capital more directly towards particular projects and thus the environmental analysis is more relevant at the asset-level. This new market provides new opportunities but also brings with it a few challenges.

(Note that we refer in this article only to thematic bonds that are contributing towards environmental goals –i.e. green bonds and climate bonds. There are other thematic bonds that address social challenges such as the World Bank/IFFI Vaccine bonds, Lloyds “ESG” bond or more recently BNG’s Dutch municipal “sustainability” bond. We have kept these discussions separate due to the different nature of assessing the underlying impact or benefit)

The growth that we’ve seen in the labelled green bonds market shows that there is a real chance that the market can shift substantial capital towards climate and environmental solutions. We do have a way to go: the +$32 billion we’ve seen so far in 2014 is tiny compared to the IEA estimate of $53 trillion required by 2035 to avoid “catastrophic” global warming. But the corporate market only began last year so this is just the beginning.

The important next step is to ensure that the market continues to grow and that it is genuinely contributing to solutions that have a significant impact.

The green bonds market is built on the confidence that funds will genuinely be deployed to green assets. Confidence is the key word; financial markets have a habit of evaporating when that confidence is shaken.

To maintain that confidence we need a rigorous approach to assessing the green claims of investments; it also helps if a common framework exists that allows investors to easily compare the environmental and reporting characteristics of different bonds. This will be especially important as a wider range of issuers, at lower rating levels, come to market over the coming year.

At present there is no standardised approach for the issuance of a Green Bond. More standardisation will become particularly important as issuance broadens from more obvious “green” areas such as renewable energy and we expect investors to push for more clarity on what types of projects can be defined as green. A common, science-referenced classification of what is green will also be important to the next stage of growth.

Below we identify three major risks to the market’s credibility and some description of how standards can help to reduce these.

1) Green-wash risk: the risk that the proceeds are directed towards projects that have no meaningful impact on solving an environmental challenge but serve primarily to boost the reputation of the company.

There are no examples of pure green-wash that we have identified to date – while different bonds have had different levels of impact (more on that below), from what we can gather, they all have had or will have an impact.

It’s possible that we will see greenwash in the future and standards are the obvious way to avoid this – a set of widely-accepted standards saying which assets can and can’t be included in a green bond will avoid any projects with dubious environmental credentials being financed with a green bond.

2 A low-impact market

This is the risk that the market becomes a very “pale” green one – where the lowest possible hurdle rates/standards have been used to determine ‘green-ness’ and the market becomes pool of bonds with low environmental impact and high PR value.

For example, a river clean-up that cleans the water a bit but doesn’t make it drinkable; a climate investment that reduces energy consumption a little but still doesn’t make the building/factory/company in line with requirements for a 2 degree world.

This is the biggest risk to the market.

It’s not pure green-wash as there is some environmental benefit, but the opportunity to use this market to shift large amounts of capital towards environmental/climate solutions would be missed.

The best way to avoid this risk would be to ensure that rigorous standards are in place that support a bigger-picture perspective to environmental challenges – i.e. that benchmark an environmental benefits to what is required from a global perspective.

This doesn’t mean measuring impact alone (although this will certainly be a part of it) but rather linking this measurement to what is required. E.g. if buildings need to reduce carbon emissions by 40% then a building which does so by 5% isn’t sufficient.

Similarly, tonnes of CO2 reduced is meaningless without a benchmark – is 100t a lot or is greater ambition needed? Such standards may seem ambitious but they’re also necessary. The Climate Bonds Initiative is working with others to make this happen (see below).

3 Misuse of proceeds post issuance.

This is the risk that the bond doesn’t end up financing the types of projects that it set out to at the point of issuance.

We haven’t seen this yet in the case of labelled green bonds but it is a concern that investors have raised. At the moment, we believe that reputational impact is sufficient to discourage any misuse of proceeds.

However, if there becomes a point in time where there is a high risk of misuse of proceeds, standards could go some way to mitigating this concern. Investors could: a) require legal bond documentation to specify the commitment to use of proceeds, so that it becomes legally binding (in the USA SEC filings perhaps serve this purpose), b) specifying a minimum reporting period for issuers to report to investors on allocation of funds towards projects; c) requiring issuers to provide some sort of recourse to investors in the case of misallocation of proceeds..

Common standards are a pivotal part of credible green bond market growth. In the short term, they may be difficult to attain as they require a great deal of collaboration between potentially-competing organisations. In the long term, we believe that the interests of multiple parties will converge towards a set of common standards.

For investors, who will demand the standards, the benefit will be a means of making quick decisions knowing that common criteria have been applied across different bonds; due diligence on one set of standards reduces due diligence effort on individual bonds.

For underwriting banks, a common set of standards will provide an easy-to-use tool to identify qualifying assets within clients. This will also give external credibility to their advice to clients.

For issuers, standards help them to easily identify qualifying investments.

For ratings agencies, common standards will reduce the potential for conflicts of interests from the issuer paying for a review and thus provide further credibility to them. It will also ensure less-reputable agencies do not make inroads to the market by certifying just anything. In time, certain agencies will gain a reputation for their expertise in particular areas or geographies allowing them to differentiate themselves despite using common standards.

The Climate Bonds Initiative publishes open access guidelines for which climate-related investments that could be associated with green bonds. Guidelines, or "Climate Bonds Taxonomy", are developed by international expert committees made up dozens of academic and industry experts. The guidelines are a free resource for independent reviewers and others as a basis for determining eligible investments.


See also articles by other contributors to the report: 
download the report here

Bank of America Merrill Lynch: The coming of green bonds

TIAA-CREF Asset Management: The future of green bonds

SEB: What is a green bond? and why does it work?

European Investment Bank: Green bonds - the role of public finance

Skanska Financial Services: Skanska Green Bond

oekom research: Corporate green bonds: challenges for a real contribution to sustainability

Vigeo: Drawing the line: why second party opinion and verification provide an important and useful guiding line for the success of the burgeoning green bond market

Sustainalytics: Key considerations for navigating green bond issuances

MSCI/Barclays: Catalyzing change Defining a benchmark index for the green bond market

Bloomberg New Energy Finance: Growth of the project bond market

Länsförsäkringar AB: Green bonds are great investments but be aware of green washing

Actiam: The climate bonds market in need of standards – maybe even a small range of them?

ICMA: The Green Bonds Principles


[1] The generic term “green bonds” refers to bonds marketed around their environmental credentials. They may be labeled “green”, “climate” or other terms.