Andrew Mason, responsible investment analyst, Standard Life Investments warns of inconsistencies in measuring the sustainability of green bonds.
As the latest controversy surrounding refereeing decisions during the Rugby World Cup has shown, regulating human endeavour, whether it be sporting or financial, is fraught with challenges. This is certainly the case in new areas such as the green bond market. This sector has continued to grow at a rapid rate over recent years, creating tensions between scale, quality and acknowledged standards. There are no universally accepted governance mechanisms in the market and current conventions to accredit ‘green bonds’ are lagging behind the complexity, geographical make up and range of the bonds being issued.
Green bonds originated with multinational development banks (MDBs) and a drive to source funding for projects which could address the challenges of climate change. The European Investment Bank (EIB) brought the first green bond to market in 2007 with AAA-rated investment grade issuance. This was in response to the EU’s Energy
Action Plan and the EIB is now one of the largest issuers of green bonds with circa €10 billion raised to date. Green bonds remained largely within the sphere of MDBs until 2013. A turning point for the market occurred with sale of a USD1 billion green bond – sold within an hour of issue – by the IFC in March 2013 closely followed by the first corporate issuance of green bonds by companies such as EDF and Bank of America. Since then the growth of green bonds has increased rapidly, offering investors an opportunity to fund green projects that meet the Environmental Social and Governance (ESG) factors which more and more investors are applying to their processes.
A total of USD36.6bn of green bonds were issued in 2014, three times the USD11bn issued in 2013. The Climate Bonds Initiative estimates that this figure will reach $70 billion by the end of 2015 with a stretch target of USD100bn. The rapid growth in size of the market is mirrored by the breadth or range of green bond issuers. Data from HSBC highlights that in addition to MDBs, green bonds are being issued by commercial banks, as well as the utility, transport and waste sectors. There is also significant growth within the US municipal green bond market, particularly to support the creation of green buildings.
In addition to green bonds we have also seen the rapid growth of unlabeled climatealigned bonds. These are bonds that have been issued by companies which the climate bond taxonomy classifies as having an environmental focus and are currently estimated at over USD530bn.There is some correlation between this growth and the number of investors considering ESG criteria within their investment processes. The number of signatories of the Principles for Responsible Investment (PRI) has increased by 16% and the assets under management of those signatories has almost doubled since 2013, growing from USD34trnto USD59trn in 2015 .
So what exactly is a green bond and how can investors ensure that investments are meeting defined objectives? Although there is some variance in opinion, green bonds can be defined as any bond instrument which will be exclusively applied to finance or re-financing of a new or existing project which tackles environmental issues, such as promoting renewable energy. This year the International Capital Markets Association (ICMA) published the Green Bond Principles (GBP) a voluntary set of guidelines which assesses green bonds relative to four components:
- Use of Proceeds: the utilization of proceeds should be described in the legal documentation for the security and clear environmental benefits should be defined assesses and quantified by the issuer
- Process for Project Evaluation and Selection: mechanisms should be in place to clearly define the eligibility of a project as green including a level of assurance
- Managements of Proceeds: the net proceeds of green bonds should be credited to a sub-account and allocation of funds should be assigned solely to the green project
- Reporting: the use of funds and the positive climate outcomes of the project should be reported upon subject to confidentiality and/or competitive considerations
This is a positive step by the ICMA. The creation of indices tracking green bond performance, individual reporting from issuers and climate bond standards for different sectors such as solar and wind are also supporting the market. However, without an established governing body a number of issues remain. One issue to monitor is ‘Greenwashing’ which may lead to inappropriate bonds being labelled green. It could also be the case that the core operations of a company have negative environmental impacts and only a small percentage of its business has a green focus.
Such greenwashing could undermine the credibility of the market and lead to a loss of green status for a number of bonds as the use of proceeds becomes clearer. We believe that it is important also to consider the social impacts linked to projects and it is not our intention to invest in green projects which are detrimental to other aspects, such as large scale hydroelectric dams which can have negative impacts on local communities. The differing types of bonds coming to market also presents an issue and the inclusion of unlabelled climate aligned bonds adds to the uncertainty of which bond to invest in. These areas must be considered prior to investment and although a number of green bonds offer lower risk it is important to recognise that a green label can also add an additional element of risk. In future projects which do not produce the defined environmental outputs or appropriate use of proceeds could potentially lose green status.