Greenpiece: The birth of green bonds

Green bonds have developed rapidly in the last decade but continues to suffer from a lack of uniformity in definitions and standards across different countries, Chloe Cho writes.

The issuance of the green bond market is expected to exceed US$100 billion by the end of 2017, though it will remain small and immature, accounting for less than one per cent of the worldwide bond market. We think green bonds can thrive as a key component of the bond market if a uniform definition is adopted and if investors keep a keen eye on the use of bond proceeds.

Is top-down government action the only way to address global environmental issues? Not at all. In fact, despite the focus on one global power’s exit from a key climate accord, a burgeoning, bottom-up movement is taking shape, with the bond market – yes, you read that right – leading the “green” charge.

For those feeling a bit “green” when it comes to sustainable finance, let us clear up definitions first: a “green bond” is a financial instrument that signifies a commitment to use the proceeds to finance or re-finance projects that deliver positive environmental impact. Green projects include, but are not limited to: renewable energy, clean transportation, sustainable land use, and energy efficiency.

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Green bonds are well-suited for large-scale sustainability projects and enable cities, states and corporations to secure large amounts of capital.

These “do-good” investments are becoming more popular as corporations and municipalities build brands around “sustainability” and as fund managers increasingly create vehicles to direct capital toward these projects. Perhaps we should not be surprised by these trends: millennials are nearly twice as likely to invest in funds that target environmental or social outcomes.1 

GOING GREEN: HOW GREEN BONDS STARTED

Green bonds have only developed in the last decade, but they have been growing at a fast pace. In 2007, the European Investment Bank issued the world’s first green bond, followed in 2008 by the World Bank. These multilateral development banks were the sole issuers of green bonds until the first corporate green bonds were issued in 2013 by EDF, Bank of America, and Vasakronan. 

Specifically labeled green bonds attract investors as the securities enable them to invest directly in sustainable projects. Corporations covet the “green” label as an opportunity to deliver sustainable narratives and to explicitly market their bonds as environmentally and socially conscious investments.

The green bond market expanded greatly in 2015 when 195 countries signed the Paris Agreement – a commitment to cut emission levels and to hold the increase in global average temperatures below 2°C above pre-industrial levels.2 

To meet the aggressive temperature goal by 2030, an estimated US$93 trillion in infrastructure investment is needed. In response, many cities and municipalities around the world turned to debt financing for low-carbon development projects, especially for renewable energy infrastructure. As of February 2016, green bonds have been issued in 23 currencies and 14 markets of the G20.3 

As a result, by the end of 2016, global green bond issuance more than doubled from one year prior, with nearly US$97 billion in fresh financing. China accounted for US$32 billion, as one of the leading countries issuing green bonds.4 

Approximately 40 per cent of the proceeds from new issuance financed clean energy, while nearly 25 per cent went to buildings and industry, and around 10 per cent to transport.5  

As for 2017, the total green bond issuance haul year-to-date (as of 5 May 2017) reached US$45 billion, putting the market on track to best its 2016 total and reach US$111 billion by year end.6 

There is a growing trend for green projects, as more institutions support initiatives aimed at preserving the environment. However, the green bond trend goes beyond recent climate initiatives. Emerging markets, in particular, face a growing need for energy-efficient and clean technology. As the cost of constructing clean tech infrastructure falls, countries are shifting towards renewable energy. 

For example, in South Korea, newly-elected President Moon temporarily shut down all coal power plants and mandated more investment in renewable energy power plants as Seoul, the country’s capital has recently become one of the world’s most polluted cities.

Some emerging markets still do not have a strong banking or capital markets foundation to help finance high-cost infrastructure projects. In the energy sector, countries with the greatest need for power plants are the ones that rely heavily on international financing. These countries issue project-specific green bonds backed by single or multiple projects to finance high-cost projects. 

For example, the Philippines financed a geothermal power plant by issuing green bonds, the first local currency green bond in the power sector. By issuing green bonds, emerging economies can enhance the growth of their debt markets and reduce the infrastructure-investment gap.

GREEN BONDS MARRY MUNICIPAL BONDS: GREEN MUNICIPAL BONDS

The U.S. lags the rest of the world when it comes to green bond issuance. Green bonds comprised a mere 0.061 per cent of the total U.S. bond market, a smaller share than that of China, India, and many European nations. 

The slow pace of development is due to relatively small offering sizes and sporadic deal flow, which leads to a lack of liquidity and stunted growth of the market. Demand also remains mostly retail driven, through SRI (Socially Responsible Investment) funds.

CHALLENGES: SHADES OF GREEN 

The overall purpose of a green bond sounds great—it facilitates financing for long-term, capital-intensive infrastructure projects and encourages people to be aware of the environment. However, at the same time, green bonds face critical challenges to enhance market transparency.

One of the market barriers is that there is no universal definition and standard for green bonds. Different countries have their distinct definitions, challenging the green bond market to conform to a common understanding.

This self-labeled “green” has broad meanings that confuse investors and put issuers at risk of “greenwashing”, which is using the proceeds from green bonds for non-green uses. China, for example, counts clean coal as “green”. For these reasons, investors should be cautious when evaluating the “greenness” of a bond.

One solution to this issue may be to prompt all countries and corporations to adopt a single, rigorous definition of a green bond. However, if it were this simple, you might think, “Why did issuers not pursue this option in the first place? Do people even want to agree to a common definition?”

Issuers face the dilemma of either having a strict or loose definition of a green bond. A specific definition could limit market growth due to selectiveness but gives clarity on the use of proceeds to investors, whereas a “loose” standard would accomplish the opposite. Even knowing the potential downside of having a strict definition, to enhance the credibility of the “greenness” of a bond, we still believe having a unified and clear definition of the green bond is needed. 

CHALLENGES: THIRD-PARTY EXTERNAL ‘REVIEW’

Currently, the market is trying its best for transparency. Rating agencies such as Moody’s have promoted green bond ratings that assist investors in understanding overall risk factors. These third-party external reviews help investors verify the requirements of the Green Bond Principles of a bond. 

However, the third-party verification process is still in its infancy. As of October 2015, only 60 per cent of total green bond issuance was officially audited by a third party.7 Also, the third-party verification process is costly, with prices that range from US$10,000 to US$100,000.8 

Ratings reviews, like green bonds themselves, bring different approaches for assessment from each rating agency. Each reviewer has her own standard and criteria, challenging investors’ ability to effectively compare and measure. 

For instance, learning from the United States’ FASB (Financial Accounting Standards Board), with its goal to improve financial accounting and reporting standards for investors, the SASB (Sustainability Accounting Standards Board), a US non-profit organisation, was founded in 2011 with a similar purpose but with a focus on material sustainability features. SASB addresses US public companies’ disclosure of material, reliable, and comparable data to investors so that they can make decisions with an awareness of environmental, social and governance (ESG) factors. This helps investors to assess a company in a comparable, rigorous way.

CLARITY BRINGS SERENITY

By 2020, it is estimated that green bonds could enable US$120 billion in incremental annual investment.

As long as there is uniformity in the definition of “green” and rigorous evaluation of the use of proceeds, green municipal bonds have a high potential for further growth and transparency, becoming more diversified across geography and credit quality while targeting a wide range of investors.

Cities and states may have their way on climate initiatives, regardless of the stance their respective federal government’s support.   

Chloe Cho is summer economic analyst at Payden & Rygel.