01 August 2018
Green bonds are facing criticism from some very loud voices to prove their additionality and, by extension, their right to exist, comments Peter Cripps
An example of this noisy criticism comes from Stan Dupre, CEO of NGO 2° Investing Initiative. As part of a debate on 'what is the point of green bonds' at our Green Bonds Europe conference, he dismissed green bonds as "shooting for the moon in a hot air balloon". By this, he meant that they are the wrong vehicle to help meet the Paris climate goals, they are a distraction from meaningful activities, and are nothing but hot air.
At the core of the criticism lie concerns that green bonds are not going far enough in terms of additionality – ie. moving the needle away from business as usual, and helping to channel additional flows of capital into green projects that will help meet the goals of the Paris climate agreement, or other environmental objectives.
People who have been following the green bond market for years will know that this is not a new debate. This has long been flagged as a problem that needs to be addressed.
Proving additionality for an asset class that is primarily used for refinancing has proved difficult. The market has generally been fixated on growth – moving from billions to trillions – with the hope that the bar could be raised at a later date, or that reaching scale would help lower the cost of capital, thereby incentivising new projects.
Generally, NGOs have been delighted to have 'big business' at the table, discussing climate change and taking it seriously as a business risk and opportunity. (The green bond market can claim to have brought mainstream investors and corporates to the table, often for the first time.)
In a comment piece earlier this year, I outlined some of the many benefits that green bonds bring, but I also highlighted that additionality is a thorny issue for green bonds and one that needs to be addressed.
So, while the arguments presented by Dupre are not new, the push for a higher level of ambition is welcome. As I argued in my closing comments at our recent Green Bonds Europe conference, green bonds were themselves an innovation about a decade ago (particularly the inclusion of dedicated use of proceeds), and the market needs to keep evolving and innovating.
I clearly don't have all the answers, but in this piece I offer a few thoughts about the evolution of the market so far, and where it might head.
1. More targeted labels, scenarios and strategies
The term 'green bond' is broad. Deliberately so. The Green Bond Principles (GBPs) do not opine on what is green, they instead provide a long, but not exclusive, list of suggested eligible project types.
As a result, a market has evolved with a spectrum of green bonds – different types of issuers, different types of projects, different reasons for investors to buy them. This diversity has been important for encouraging the growth of the market.
More sub-labels could be created to provide a clearer sense of purpose. Many in the market will be hissing at this suggestion, fearing that it will fragment and slow the growth of the market.
But green bonds are currently guilty of being too vague – as well as addressing climate mitigation they can also address climate adaptation, water, waste or biodiversity, for example.
A more specific set of labels, sub-labels or objectives could help to create clearer outcomes, and better connect investors with the kind of bonds that meet their intended outcomes.
How about a climate risk mitigation bond, a 2°C-aligned bond, or an NDC-aligned bond, for example? This would also help differentiate climate bonds from other types of green bonds such as water or waste.
Having clearer labels or outcomes may also make it easier to set targets and report impacts. For example, a 2°C-aligned bond could use a 2°C scenario to demonstrate whether the issuer is on a 2°C trajectory and present a strategy to show how its business model is aligning itself with this scenario.
It may be, however, that a central scenario needs to be agreed by a body such as the GBPs.
I suggest that what climate-focused green bond investors typically want is an indication that the activities or projects being financed are in line with the Paris Agreement (2°C or lower), or perhaps there is a commitment that the issuer is demonstrably changing behaviour away from business as usual and towards a 2°C trajectory.
Adding more rigour into the process of showing how the green bond is part of a long-term climate strategy would help to allay concerns that "green bonds are a fig leaf for the worst corporate polluters", as one NGO described them.
2. Green bonds as climate risk mitigation tools
The main innovation of the green bond market – dedicated use of proceeds – opened the market up to a wide universe of potential issuers. That innovation is both its genius and its limitation.
On one hand, it effectively means that any company with some form of green capex can issue a green bond. But on the other hand, for the typical 'use of proceeds green bond' (which accounts for the bulk of the market), the credit risk of the bond remains with the issuing entity rather than the assets.
For the most part, investors buy green bonds to demonstrate their support for green finance and action to mitigate climate change (or some other environmental benefit).
However, they are unlikely to pay more for a green bond than for a comparable non-green bond from the same issuer, because the credit risk is the same.
But there is potential for green bonds, which may be considered to have less exposure to physical or transition climate risks, to be used as a climate risk mitigation tool.
These could be highly valuable to investors, who are being urged by the Task Force on Climate-related Financial Disclosures (TCFD) to wake up to climate risks, both physical and transitional.
My frustration with the green bond market at present is that use of proceeds green bonds can rarely be used to help mitigate these risks.
Yes, there is an argument that issuing a green bond is an indication that a company's governance of environmental risks and opportunities is strong, thereby indicating a lower risk across the company.
But, surely, as climate risks become pressing investors will begin to demand more green bonds whose credit risk is tied directly to green assets, such as asset-backed securities, project bonds, mortgage-backed securities and covered bonds. These have recourse to assets and so, generally, could have lower transition climate risks than non-green bonds.
As a result, investors may consider paying up for these kinds of bonds, if they consider them less risky. And having bonds that are less risky would make authorities more likely to lower capital charges.
However, creating green bonds as climate risk mitigation tools will take a greater level of sophistication and thought than merely structuring them with a link to assets. A bond backed by green assets does not necessarily have lower climate risk.
It is possible to have a green project that is still risky. A green building could be located in an area more likely to flood as climate change bites, for example. So, for green bonds to be a climate risk mitigation tool, they will need to consider both physical and transition climate risks.
3. Covenants to help commit to do more green financing
One of the characteristics of bonds is that they tend to be used to refinance existing projects rather than finance the construction of new projects.
This creates problems when it comes to proving additionality. But what if green bonds had covenants that meant that the issuer promised to take any capital freed up by the refinancing and spend it on green projects, and report on that capital reallocation just as it reports on the allocation of the use of proceeds in the first place? I think that would kill off most criticism about additionality.
Plans for a Paris Climate Bond, which would be used to refinance projects registered under mechanisms of the UNFCCC, include a number of green covenants that allow contractual enforcement of the climate outcomes. These include a specific covenant that requires the 'liberated' funding from the refinancing to be reinvested into greenfield qualifying PCB projects.
Perhaps this could be explored in other areas.
Most of the criticism fired at the market can be summarised as: 'The projects were going to get built anyway, the bonds were going to get issued anyway, so what has the market achieved?'
Johanna Koeb of Zurich Insurance Group argued at one of our conferences last year that it is unfair to ask additionality from the green bond market. Can the issuer of a bond really prove that a project would or would not have happened, particularly when bonds are principally a refinancing tool?
But we can still ask: "What is the market trying to achieve?" Is it trying to help finance the energy transition (as well as other environmental problems)? Or is it trying to help investors future-proof their portfolios by backing the companies of the future?
What do we want the green bond market to do? To demonstrate best practice, to support additional capital flows and a shift away from business as usual, or to be a climate risk mitigation tool?
What are investors' motivations for buying? To do good, or as part of a risk mitigation process?
I think more structure and some more clearly defined outcomes are called for.
I can see that the green bond market will come under increasing scrutiny. It is going to come under increasing pressure to show how it is playing a useful role in the energy transition.
It would be a crying shame to see it swamped by a deluge of righteous criticism. A much better alternative would be to build on the decade of blood, sweat and tears that has gone into creating the market, use the existing infrastructure, and upgrade it.
After all, the bond market has a critical role to play in the energy transition. We are going to need to enlist the deep pools of capital in the bond market, if we are to mobilise the $90 trillion between 2015 and 2030 to finance the infrastructure needed to meet the Paris climate targets.
I think it was telling that Dupre, for all his vocal criticism of the market, accepted that the green bond market was needed.
So, after a decade of market building, it is time for the market to shift gears and raise its level of ambition and build to the next level. Onwards and upwards!
Peter Cripps is editor of Environmental Finance
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First of all, great job on summarizing the position of Stan and the challenges that face the planet as it copes with financing the energy transition and other environmental needs.
I understand where Stan is coming from and his sense of urgency. However, I think he is too dismissive of the benefits of green bonds, as you point out.
My ambition for ISO 14030 is that it serve as a framework for a multitude of approaches. The standard allows for different green bond "scheme owners" (or program operators) to add labeling and certification on top of verification. This can foster the "thousand flowers blooming" approach that you suggest. We can have climate bonds, 2 degree bonds, conservation and biodiversity bonds, etc. all under the green bond umbrella.
I would like to think that at some point in the not-too-distant future issuers of all types of debt obligations pass their decisions and priorities through a green screen.
John Shideler, NSF International