Climate Risk for Investors

Channels: Green Bonds

Companies: CICERO

People: Christa Clapp

Contributed article

Green bonds are contributing to increased awareness of climate change, despite being a small portion of the bond market.

Treasurers and sustainability experts are sitting in the same room, in some cases for the first time, as issuers prepare for green project selection and reporting. Investors are asking questions about the environmental impacts of their investments. Investors with a sustainability profile are buying bonds from issuers not previously in their portfolio. Yet to ensure that 'green' translates to a positive environmental impact, we need independent environmental due diligence.

Increasing awareness of climate change risk

From a risk perspective, investors are becoming more aware of climate change exposure. How well are their portfolios and assets aligned to avoid 'stranded assets' from shifting carbon policies and preferences? Are their portfolios positioned to protect against risks and take advantage of opportunities revealed by changing physical climate and weather patterns?

Extreme weather events, flooding and heat waves are more often in the news today connected to financial losses, and their frequency and severity is expected to increase with climate change. Sea level rise is impacting coastal city infrastructure today, while heat waves are impacting agriculture production and worker productivity. Global damages as a result of eight extreme weather events in 2011 were valued at $148 million, with insured losses of more than $55 billion1. At the same time, changes in resource availability also create opportunities for businesses.

On the policy side, signals of international cooperation and domestic carbon policy implementation have been getting stronger: the Paris Agreement, which entered into force on 4 November, covers more than 55% of global greenhouse gas emissions. More than 90 countries have included proposals for pricing carbon initiatives in their national plans for the Paris Agreement, and 40 countries are already putting a price on carbon.

There is much work to be done to bring better granularity on climate science to support smart investment decisions. To complement ongoing work in this area, CICERO launched the Climate Finance Center to bring climate scientists and institutional investors together to improve communication and tailored information on climate risk.

Green bonds can be part of a pro-active investment strategy in the face of climate risk. Mark Carney has pointed out that green bonds are "an opportunity to advance a low-carbon future while raising global investment and spurring growth"2. Yet to contribute actively to a climate change solution, we need a better understanding of what is green. CICERO Second Opinions are a first step toward disclosing climate and environmental risk of green bonds to investors.

Environmental due diligence

In today's green bond market, just about everyone is a self-proclaimed 'expert' on green. Green is trendy, but if we don't take care to ensure the environmental impacts are positive, we could be left with possibilities for 'greenwashing'. There is a wide range of quality and competence in due diligence on environmental risk...and even more troubling is that nearly half of the market has no external review at all (Figure 1).

Figure 1: Green bonds and External Reviews. Cumulative from 2008 by number of issuers reviewed, from CBI and CICERO data

In this confusing green landscape, some issuers are deciding themselves what constitutes green. Others incorporate independent reviews of potential environmental impacts. Index providers must determine which bonds are eligible for their green indices, while securities exchanges must decide which bonds to include in their green bond listings. Some, such as the Oslo Stock Exchange, require publicly available second opinions.

As a first step, the Green Bond Principles provides voluntary guidance to issuers on disclosure and due diligence in the market. The 2016 edition outlines broad areas for use of proceeds, and recommends external review.

However, to consider how green a bond is, a more thorough environmental consideration is needed. Do the project categories align well with a low-carbon, climate-resilient future? How can the selection process can influence environmental outcomes? How does the issuer measure and report impacts?

External reviews by independent environmental experts can analyse these questions in an unbiased manner.

The Green Bond Principles note a range of categories of external reviewers, including consultants that establish frameworks, certifiers, verifiers and rating agencies.

We should carefully distinguish between different types of reviewers. Independent experts can provide a second opinion or certify the bond against a standard at the time of issue. Either approach provides due diligence on environmental integrity, although the level of scientific expertise and the thoroughness of the review varies.

Second opinions can also be complementary to standards, offering a more nuanced review alongside standard certification. Finally, project-level examiners can verify the environmental impacts after the issuance.

At this moment, given the relative infancy of the green bond market, due diligence in the form of independent second opinions at the time of issuance is critical. Over time, second opinions against agreed definitions or certification against standards may become more widespread. Impact reporting is becoming more common, and ex-post verification could follow. To encourage more green bond issuance, we need a balance between keeping impact reporting and measurement simple and meaningful.

But environmental due diligence needs to cover the breadth of the market - even 'pure play' renewables companies need second opinions for full disclosure. Investors should be informed about environmental impacts associated with supply chain or contractors in the production line. Management structures can also influence project selection and how local environmental impacts are taken into account. Perhaps a 'fast track' second opinion for pure plays could be developed, recognising that they may require less scrutiny. Independent disclosure of potential environmental impacts on pure play issuers allows for full transparency and a way for investors to compare across all green bonds.

Shades of green

CICERO, Norway's foremost institute for interdisciplinary climate research, is the leading provider of second opinions3. We are distinguished by being the only non-profit scientific research institution in the market. We have produced over 60 second opinions since the beginning of the green bond market for a range of issuer types including development banks, municipalities, and corporations. To broaden our regional expertise and global reach, CICERO established the Expert Network on Second Opinions to collaborate with other academic institutions on second opinions4.

Building on the Green Bond Principles, CICERO's approach takes a starting point in climate science. We focus on environmental aspects of the project categories, project selection, reporting and transparency. As we draft a second opinion, we ask tailored questions to the issuer to clarify any issues that could have a negative environmental impact.

Recognising that a range of solutions is necessary to reach a low-carbon, climate-resilient future, we developed the CICERO Shades of Green (figure 2). This rating system for second opinions gives a clear indication to investors of the potential environmental impacts. It also allows for more nuanced considerations about what is green, in contrast to a black-and-white standard approach.

Dark green Projects and solutions that already realise the long-term vision of a low-carbon and climate-resilient future. Typically, this will entail zero-emission solutions and governance structures that integrate environmental concerns into all activities. Example projects include renewable energy projects such as solar or wind.

Medium green Projects and solutions that represent steps towards the long-term vision, but are not quite there yet. Example projects include sustainable buildings with good (but not excellent) energy efficiency ratings.

Light green Projects and solutions that are environmentally friendly but are not by themselves a part of the long-term vision. Example projects include energy efficiency improvements in fossil-based industry that result in short-term reductions of greenhouse gas emissions, and diesel-fueled buses.

Brown Projects that are in opposition to the long-term vision of a low carbon and climate-resilient future.

Figure 2: CICERO Shades of Green

From almost a decade of experience in reviewing green bonds, CICERO has identified best practice for various sectors. The best renewable energy projects consider local environmental impacts, e.g. by incorporating life cycle analysis. For transportation, we have seen issuers moving towards public transport fuelled by renewable energy and improved cycling and pedestrian conditions. Sustainable buildings are aiming for passive energy use, with building standards supplemented by energy efficiency improvement targets and programs to reduce tenants' environmental footprint. Forestry projects should adhere to international standards and consider local biodiversity and community impacts. Best practice in waste includes a focus on recycling and bioenergy from local organic matter. Water management and adaptation should be considered holistically to control against flooding, supply disruptions, and biodiversity impacts.

As external reviewers, we also look for management structure that supports good environmental decision-making under the green bond framework. An issuer's climate goals can help provide guidance to project selection under the framework. Lifecycle analysis and supply chain management can be valuable in understanding the full environmental impacts of financed projects. Integrated mitigation and adaptation or resiliency planning can help issuers prioritise projects that take into account climate risk. Annual reports on green bond projects are becoming the norm, with some issuers moving forward on impact reporting.

Having a thorough second opinion does not need to add much to transaction costs – no more than an engineering feasibility study, for example. In fact, several issuers have noted that issuing a green bond with a second opinion has attracted new investors. Importantly, the process of obtaining a second opinion also improves issuers' internal dialogue between financial and environmental experts.

A green future

Looking ahead, we will most likely see some harmonization of green definitions and approaches to second opinions. However, it is difficult to imagine a single international green standard, given the different regional approaches. China has adopted a top-down approach to defining green bond categories, whereas in the US second opinions are not standard practice yet.

Despite some regional variations, an increasing focus on green and climate risk-proofed investments seems inevitable. Climate change is leaving its impact on natural capital and financial assets. The Paris Agreement gives a strong signal on tightening climate policies and measures. Investors are asking more questions about how businesses are managing climate risk. Green bonds may be the first step towards a significant green capital shift.

Christa Clapp is head of climate finance at CICERO. Contact

  1. Gardiner, D., et al., (2011). Physical Risks from Climate Change. Oxfam America, Calvert Investments and Ceres.
  2. Carney, Mark (2016). Resolving the Climate Paradox. Arthur Burns Memorial Lecture, 22 September 2016.
  3. As recognised in a contribution to the G20 Green Finance Study Group by Bank for International Settlements, 24 August 2016.
  4. Including: Basque Center for Climate Change, Stockholm Environment Institute, International Institute for Sustainable Development, and Tsinghua University's Institute for Energy, Environment and Economy.