The Wild West of Green Bonds

The need to mobilize capital for green causes and adaptation initiatives to follow up on the Paris climate conference is raising many questions about the verification and assurance of what qualifies as “green” and how the proceeds of these bonds are allocated.

There is a growing urgency to standardize the market mechanisms and ensure the environmental integrity of these new financial instruments. Various stakeholders, from the underwriting banks to investors, have a role to play.

The increasing attention to green bonds has already aroused criticism and scrutiny. One major theme that emerges is the higher cost of green bonds. The Cost of Being Green Barclays’ report from September 2015 claimed that investors had been paying 20 extra basis points. This is a trend that has been increasing over time, while the tranches have had the same yields as other bonds.

In addition to being concerned about the financial characteristics of these instruments, environmentalists are worried about additionality: whether unique new projects around renewable energy, transportation, and other green initiatives will come to existence and would not have been built anyway. The discussion also debates what qualifies as “green” and who tracks the proceeds of the bonds.

All the above concerns call for a bonds that can link the abundant debt capital to much-needed investments in renewable energy, energy efficiency, and sustainable means of transportation. Green bonds can also include water quality, air emissions reduction, and water conservation.

The green bonds market is an exciting topic in the fixed-income space of securities.

The recent news of a big corporate player coming in as an issuer marks a new milestone in the development of the industry. Last week, Apple announced it would issue a seven-year $1.5 billion green bond that would be biggest corporate issuance in the United States. The bond will solicit second opinion from the independent reviewer Sustainalytics and have the accountancy Ernst & Young perform annual audits on the proceeds’ allocation.

Steadily maturing from a market of multilateral banks issuing financial instruments to support green projects to a space that attracts big corporate issuers, the global green bond market saw a record volume of $41.8 billion in 2015, according to the Climate Bonds Initiative (CBI).

Forecasts for 2016 are bold and optimistic. Moody’s Investor Services expects financing for green bonds to rise to $50 billion. HSBC bank predicts between $55 billion and $80 billion of issues in 2016. This would represent growth of between 32 percent and 91 percent on last year whereas the CBI target for 2016 is for the market to reach issuance of $100 billion.

The United States bond market was estimated to be $39.5 trillion in mid-2015, according to the Securities Industry and Financial Markets Association (SIFMA).

Going forward, there is a risky “valley of death” that all relevant stakeholders need to leap over. Striking the right balance between yield, risk, environmental integrity, and public confidence in the market requires aligned incentives for all participants: banks, investors, issuers, verifiers and regulators.

“It’s a Wild West out there”

With significant pioneering efforts, aggressive marketing, and few established rules, the market is at a defining point.

Christa Clapp, head of climate finance at the Center for International Climate and Environmental Research (CICERO), said: “The state of the market can hardly continue too long without more alignment on definitions and standards.”

Currently, most issuers choose to abide by the Green Bonds Principles (GBP). These are voluntary process guidelines negotiated and approved initially in 2014 by a consortium of 13 banks that included Bank of America, Morgan Stanley, JPMorgan Chase, HSBC and Rabobank. These principles define what a labeled green bond should do.

In June 2016, an updated version of the GBP was published. The governance framework consists of an executive committee, members, observers, a drafting committee, and a secretariat.

In addition, there are standards that define what bonds are green based on the use of their proceeds. Second-party opinion providers, Moody’s, and other organizations are using these standards

These are backed up by leading investors and the major underwriting banks, among whom HSBC, Barclays, Crédit Agricole, Skandinaviska Enskilda Banken AB (SEB), and Citi. The principles touch upon the use of proceeds and the recommended reporting structures. 

“This is a good first step towards the transparency of the market,” Clapp said.

But the current GBP guidelines are very vague and lack detail.

Progress toward common ground on green bonds comes from key markets overseas as well. Securities and Exchange Board of India recently published its own sets of rules, strongly recommending third-party verification by auditors. The People’s Bank of China Green Finance Committee has devised the Green Projects Catalogue (GPC), which provides a set of standards for screening which assets and projects are eligible to be financed using green bonds.

Another framework that is slowly making progress is the Climate Bonds Standard, developed by the Climate Bonds Initiative. Along with its very vocal efforts to raise awareness about the market, the UK-based think tank is proposing a tool that will have sector-specific eligibility criteria and will also track the bonds’ proceeds continuously over time. 

“Who says what is green?”

Independent review of the suggested use of proceeds of a green bond is increasingly popular. The so-called “second opinions” are mostly provided by research engines and advisory companies, among whom leaders are CICERO, Sustainalytics and DNV GL.

Approximately 60 percent of total green bond issuance to date has solicited a second-party review.

Some forward-looking banks, such as HSBC and SEB, have moved toward underwriting only bonds that provide a second opinion, Clapp said that “other underwriting banks in the United States seem less concerned with environmental due diligence.”  

Barclay’s research confirms there is more investor demand for the bonds that provide high-quality information about the environmental benefits of the underwritten projects. While independent reviews and impact reporting are evidently improving investor’s confidence, the service adds cost to the bond issuance.

“Taken into a cost-benefit ratio though, this additional cost is negligible,” Clapp said.

 “In CICERO’s experience, many issuers have shared that issuing a second opinion has been a very educational experience on the environmental practices of the company,” Clapp said. “In most cases, the process improves internal dialogue. Investors… value the issuers’ transparency. Some sophisticated investors in Scandinavia, for example, would not ever buy a green bond if it does not have a second opinion.” 

As gatekeepers to bond issuances, the banks can take a leadership role in tracking proceeds’ use and set more stringent rules on the necessity to provide independent verification. With the volume and leverage that the financial institutions have, they could potentially lower the soft costs for issuers.

Realistically “banks will need a strong incentive to facilitate the process of independent verification,” said John Wilson, head of corporate governance, engagement and research at Cornerstone Capital Group.

“They are asking for concrete results”

Analysts Ryan Preclaw and Anthony Bakshi, authors of the Barclays’ research report, said, “Green-mandate portfolio managers suggest that they have a bias toward green issues, but only when they receive risk-adjusted compensation that is equivalent to conventional investments.”

“Every portfolio manager has to comply with their fiduciary duty in considering an asset,” Wilson said. “Green bonds have to meet certain financial criteria to be considered investable. No one would buy them only because they are interested in the greenness.”

While the green fixed-income product can sometimes be challenged to fulfill simultaneously an environmental benefit with adequate financial gain, it has been proven that the more investors know about a certain bond, the more confident and willing to take on the bet they are.

“Investors have made statements that are calling for a stronger stand on transparency. They are asking for impact reporting. They are asking for concrete results,” Clapp said.

One clear example is Ceres’ statement on investor expectations, issued by the Investor Network on Climate Risk, which is cumulatively managing more than $13 trillion in assets.

“The biggest risk is failing to preserve the environmental integrity”

All stakeholders need to be alert of “the real threat of green-washing,” Clapp said. “The biggest risk is failing to preserve the environmental integrity of the market. Banks are limited in what they require and how they shape the market, unless investors are requiring more disclosure and transparency.”

Debt financing has a true potential to move the needle on sustainability, clean energy, and infrastructure that combats climate change.

Two recent announcements hint that the future of the market of it might be closer to mainstream than ever.

The credit rating agency Moody's has revealed plans for its own methodology to assess the environmental credentials of issuers, which it expects to be ready by the end of March 2016.

Bloomberg will start collecting more information on green bonds under categories: management of proceeds, reporting and assurance.  

This bid from standard market players to help boost transparency is a positive sign that green bonds will continue growing in an environmentally sound and financially responsible manner.

The responsibility to bring green debt to the next level of asset maturity lies with all stakeholders, vigilant banks and demanding investors, as much as dedicated issuers and truthful verifiers and assurers.

Note: A paragraph that describes the GBP was corrected on 6/27/2016. The subsequent paragraph was added on that date.

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