09 January 2018
Everyone seems to have an opinion on what is green. The Green Bond Principles (GBPs) provide a loose voluntary framework for potential green projects. Index providers and stock exchanges are also weighing in when deciding which green bonds to include. External reviews, recommended by the GBPs, can mean many different approaches to what is green. Ultimately, the investors weigh in with their appetite for different green bonds. By Christa Clapp
This flexibility and the lack of agreed definitions may have contributed to the rapid and creative evolution of the green bond market to date. The market is characterized by a diverse set of issuers, distinct growth in emerging markets and use of proceeds for creative green solutions.
Yet it is critical to get the green labelling right for the green bond evolution to translate to a real climate revolution. For the moment, most green bonds support refinancing of existing projects to some degree. However, if we are robust in ensuring that green really means green, then issuers should be able to identify and direct financing to new green projects in the future.
Getting the green label right means doing our due diligence on climate risk. Climate risk is financial risk, as Mark Carney at the Bank of England and the Financial Stability Board's Task Force on Climate-Related Financial Disclosure (TCFD) have highlighted. Climate risk encompasses not only transition risks associated with policies and technologies, but also the risk of physical impacts from climate-related events such as extreme weather and flooding.
Taking climate risk seriously
The green bond market is the ideal pilot arena for fine-tuning our climate risk due diligence. Demand is high, while investors and regulators have an increasing focus on harmonizing green definitions and considering standards. This is our opportunity to move beyond a bottom-up approach to identifying green projects, and establish a labelling and ratings scheme that focuses on what is truly important in shifting to a low carbon and climate resilient future.
At CICERO, we use our Shades of Green method to rate bonds Light, Medium and Dark Green to offer investors better insight into the climate risk and the environmental quality of green bonds. We follow the GBPs, while also assessing the use of proceeds with a climate risk lens. We review how the issuer is selecting and evaluating appropriate green projects for the bond. The three levels of green allow investors to compare how well various bonds align with a low-carbon, climate-resilient future. This provides transparency on climate risk for investors, and a simple identification for high-quality green bonds.
We need a range of robust green projects, spanning from Light Green to Dark Green, in the transition to a low-carbon, climate-resilient society. Light Green bonds take short-term steps in the right direction, whereas Dark Green bonds have the possibility to make a transformational shift (see diagram above).
Having provided second opinions for the past decade, CICERO has contributed to diversifying the green bond market. We reviewed the first green bond for the World Bank, the first city (Gothenburg), the first corporate (Vasakronan) and recently the first green sukuk (Tadau Energy). We have been working with all types of issuers from small municipalities to the world's largest financial institutions. Across 70 second opinions, our methodology has proved both flexible and robust.
Getting the labelling right
To control for potential mislabelling, there are two key loopholes that should be addressed in the green bond market:
- Self-labelled green bonds. Some bonds are called green simply because the issuer says so. Self-labelled bonds comprise approximately 20% of the green bond market in 2017, according to Climate Bonds Initiative data. By not having an external check on the environmental quality, these bonds are risking the reputation of the green bond label.
One way to address this challenge would be to require external reviews. Some stock exchanges already require this for green bonds to be listed (e.g. Oslo B¿rs, London Stock Exchange, and Luxemburg Stock Exchange). The GBPs recommend external reviews, but do not mandate them.
- A wide discrepancy in approaches and quality of external reviews. Although the GBPs recommend external review, this could mean anything from a consultant developing a green bond framework, to having an independent review or rating at the time of issuance or an ex-post verification of environmental impacts. Some reviewers' methodologies could even give a 'green' label to a bond that uses up to half of its proceeds on a coal power plant. There is also a potential conflict of interest when organizations that consult on developing green bond frameworks are also issuing independent reviews of the framework.
One way to address this could be via an accreditation process for external reviewers, either via stock exchanges or the GBPs. External reviewers should be independent, avoid potential conflicts of interest, and have a high standing of environmental credibility.
Harmonizing green approaches
Given the confusing range of external reviews, a harmonization of green bond definitions and review approaches could help provide clarity for new issuers and investors alike. Both in Asia and Europe, legislators are taking steps to develop common definitions, taxonomies and standards for green bonds.
But what is meant by taxonomies or standards? These terms mean different things to different actors. It is important to step back and consider what goal we are trying to achieve in this push towards standards.
The overarching aim should be to improve transparency on climate risk while encouraging new issuers to come to market to meet increasing demand. Based on CICERO's 10 years of experience in the green bond market, we propose three principles for harmonizing green approaches:
1. Allow for creative solutions and technological development. Environmental technologies are evolving quickly. One of the most positive elements of the green bond market to date has been the flexibility and creativity. We need to create a common language to discuss green amongst issuers, reviewers, and investors - but with a flexible approach. Almost every green bond that CICERO has reviewed is different and many projects do not fit well within a traditional taxonomy. A fixed taxonomy approach is also ill-suited to capturing new technological developments. For example, battery development for electric cars, which is critical for transitioning to a low carbon future, does not fit easily within a traditional list of sustainable transport solutions. Taxonomies and standards reflect a snapshot in time, and would need to be updated continually to reflect evolving best practice.
2. Reflect exposure to climate risk. There is more to climate risk than just considering separate pools of mitigation and adaptation projects. For example, to be fully transparent on the climate risk of a building, it is not sufficient to report on its emissions, but one also needs to consider urban planning including public transport access and resiliency to flooding and extreme weather. A binary checkbox exercise does not reflect the overlap between transition risk and physical risk, nor does it account for the relative levels of risk for each region, sector and company. A grading system is more appropriate in providing transparency on the relative levels of climate risk.
3. Keep transaction costs low. To meet the growing demand for green bonds, we should encourage new issuers and make it simple for them to come to market. Therefore, it is important to keep the monetary costs for environmental due diligence low, while also providing clear and concise steps for new issuers to enter the green bond market.
If we want to apply the TCFD's recommendations, we should be transparent on climate risk for all financial products. Let's use the green bond market as a great opportunity to get the green labelling right, reflect climate risk, and encourage new issuers to shift finance to low-carbon, climate-resilient solutions. Hopefully, this can provide inspiration for the rest of the financial markets.