Since the launch of the first green bond (labeled a “Climate Awareness Bond”) on July 4, 2007, by the Luxembourg-based European Investment Bank, green bonds have seen many breakthroughs, but challenges remain. One challenge has been defining what constitutes a green bond or a green investment. External review processes such as certifications and second opinions have developed to address this issue.
Given the short history and dynamic state of the green bond market, wide variation exists in external review processes — based on regions, frameworks and evaluation parameters. Differences also exist in how these processes are perceived in terms of their roles, importance and value addition. A wide range of issuers are using labeling and certification schemes in their green bond issuances. While renewables and low carbon buildings and transport dominate, conservation organizations are also using second-party opinions — such as The Conservation Fund, a partner of CBEY’s, in its recent issuance focusing on land conservation and working forest protection.
The green bond external reviews and certification landscape received a boost with the introduction of the Green Bond Principles by the International Capital Market Association in 2014, according to Bank of International Settlements analysts Torsten Ehlers and Frank Packer. They write that there has been rapid growth in issuances in the wake of this change, an increasing number of sectors being covered under the international Climate Bonds Standard and Certification Scheme, national guidelines being developed across the globe and the introduction of several green bond indices.
The year 2019 (PDF) saw the issuance of 1,788 green bonds from 496 issuers, with a majority from energy, buildings, transport and water. The value of these bonds was $257.7 billion, a massive improvement from $41.8 billion in 2015.
An encouraging development has been the entry of 250 new issuers in the landscape in 2019. Ehlers and Packer point towards issuers recognizing the utility of green bond certification and labeling schemes in diversifying investor base, market signaling and responding to investor demands. Investors also place a higher value on labeled and certified bonds.
2014 also saw the launch of two major green bond indices — Bloomberg MSCI and S&P Green Bond. Both have incorporated ICMA’s Green Bond Principles as their core element and track the development in the green bond markets through stringent investment and performance standards.
The green bonds market is expected to continue its strong growth in the future. Reports from Moody’s and Climate Bonds Initiative predict growth of 24 percent — 55 percent in issuance value in 2020. We spoke to green bond stakeholders including issuers and external review providers about the growth of external review and certification processes, and the role they are playing in helping green bonds move from a niche to a mainstream instrument for a greener future.
The value of the global outstanding bond market in 2018 was $102.8 trillion, 38 percent more than the global equity market capitalization (PDF). The bond market offers advantages for companies in terms of interest rate, operating freedom and lender diversity. The Organization for Economic Co-operation and Development estimates a minimum requirement of $4.3 trillion in annual green investment (PDF) to limit global warming to 2 degrees Celsius by 2035. Do green bonds offer a potential path towards reaching this target, and what are the challenges?
Over the years, the green bond market has seen growing diversity in issuer type, with more national, municipal and corporate entities joining early-adopting supranational organizations. However, in the 12 years since the first green bond launch, cumulative green bond issuance has grown only to $825 billion, a small part of the $100-trillion-plus outstanding bond market.
As climate action and risk become increasingly central to public policy-making and corporate strategy, institutional investors are also increasing their focus on environmental governance practices, management systems and investment criteria. This translates to strong demand for green debt instruments, which remains unmatched on the supply side.
“Supply-side constraints stem from two sources,” said Christa Clapp, climate finance lead at Norway’s Center for International Climate and Environmental Research (CICERO). “First, a lack of clarity among issuers and underwriters on what activities qualify for a green bond, and second, complexities in transitioning from non-green to green activities.” Clapp said that it can be particularly challenging for companies and industries without strong environmental track records to enter the green bond market.
That uncertainty comes in part from the absence of widely accepted definitions and standards in the green bond universe. This lack of clarity opens green bonds to criticism for greenwashing at worst and stretching the boundaries of what constitutes a green investment at best.
In 2019, for example, China issued green bonds to finance coal-based power projects under the “clean coal” label in the name of energy security. In another instance, a green bond issuance by Teekay Shuttle Tanker in October received pushback and failed to raise its targeted amount. The company, which owns one of the largest fleets of ships to transport oil from offshore drilling sites, was going to use these proceeds to build fuel-efficient tankers. The Financial Times called the use of green bonds to enable future fossil-fuel shipments “oxymoronic.”
Despite the accountability and transparency issues, investors see merit in green bond investments and this led to the emergence of numerous tools to bring about acceptable standards and criteria to enable market growth.
Supply-side constraints stem from a lack of clarity among issuers and underwriters on what activities qualify for a green bond and from complexities in transitioning from non-green to green activities.
Evaluating green bonds: a diversity of tools
Green bond issuers take the plunge for a variety of reasons. Experts across the board agreed that green bonds provide an opportunity to diversify an investor base by attracting impact-driven and socially responsible groups; help corporations market-signal and communicate with the public on vision and goals; help respond to investor-driven pressure; and achieve regulatory compliance.
Given the increasing demand for green bonds and the gaps mentioned above, the market responded with a variety of options. Significant milestones during this journey were the development of Green Bond Principles, Climate Bonds Initiative Standards and Certification Schemes and efforts by national governments globally.
The voluntary Green Bond Principles from the International Capital Market Association are widely accepted. These provide the issuers a fundamental set of conventions on which to base their green bond issuance. They also look to help investors understand how a given project fits within broader green investment criteria, the use of proceeds, and plan to achieve the stated environmental objectives. And they guide accounting, allocation, auditing and communication processes across eligible green project categories, including land use, terrestrial and aquatic biodiversity conservation, and management of living natural resources.
External reviews, which come in many forms, look to provide a layer of assurance of the “greenness” of green bonds. They can take the form of certifications, second-party opinions, verification and ratings. Additionally, there exist standards or guidelines developed or supported by national governments such as the green bond guidelines issued by the Securities and Exchange Board of India, the regulator of the securities market in the country.
The Climate Bonds Standard and Certification Scheme run by the nonprofit Climate Bonds Initiative (CBI) is an international certification scheme for green bonds. The initiative provides 12 sectoral criteria ranging from forestry and agriculture to renewables and low-carbon buildings. Second-party opinions, the most common form of external review, take place under a variety of processes and standards. Independent institutions with environmental expertise provide these opinions, and typically review the bonds’ alignment with the Green Bond Principles.
CICERO is a leading global provider of second opinions and follows a color-coded grading approach in labeling green bonds. This allows it to avoid the binary nature of certification and indices, highlighted as a challenge by the Bank of International Settlements. CICERO recently provided a second opinion on a green bond issued by Mowi ASA, the world’s largest salmon producer, for sustainable aquaculture, water and wastewater management. ADIF-Alta Velocidad, a state-owned corporation in Spain, recently was awarded a “dark green” opinion by CICERO (its highest grade) for financing clean transportation.
The percentage of issued green bonds receiving an external review increased from 65 percent in 2015 to 82 percent in 2017. The share of CBI-certified bonds among these was just 11 percent in 2017, up from 4 percent in 2015. “The robust and comprehensive standards make sure that only those projects which entail low emission and a climate-resilient vision of the future get certified,” said Carman Mak, certifications officer at CBI. “For instance, off-grid solar projects which use fossil fuels beyond 15 percent become ineligible.” Mak is also confident these numbers will increase as more sector-specific criteria are added to the standard.
Challenges facing external review processes
Certification and other forms of external review systems face a set of challenges, according to interviewees. The plethora of options available make it difficult to create a consistent set of standards. Lack of information is a common concern as issuers and underwriters struggle to understand the trade-offs between different external review processes, as well as their corresponding pricing or distribution advantages.
There is also a view among issuers that given the information gap, investors are not differentiating among green bonds based on whether it is certified or whether it has a second-party opinion. Rather, the focus is on the issuing companies that have a known history in positively dealing with environmental, social and governance issues.
Todd Gartner, head of the Natural Infrastructure Initiative at the World Resources Institute, sees “supply-demand mismatch as the primary reason for low certification levels, with a lot of investors showing willingness to purchase non-certified bonds.” Gartner theorizes that issuers “are currently not seeing advantages in basis-point benefit and low interest rates for a certified bond vis-à-vis non-certified one.”
The absence of a certification premium becomes important as certification costs — ranging from $10,000 to $150,000 — may be construed as unwarranted. Gartner, however, perceives this as “a short-sighted approach as the market may see an influx of non-certified green bonds.” This may result in a high volume of green bonds issued, but with questionable green labeling and usage claims that create skepticism among investors and the public.
In terms of pricing, no clear indication of a pricing difference exists between green bonds and traditional bond offerings. However, some experts, such as Agustin Martin, head of European credit research at BBVA, expect this to change and a “green premium” to develop.
The future of green bonds and certification
Despite the current lack of financial benefit, certification and standards compliance provide a platform for an organization to communicate its green agenda and have the potential to bring in recognition and newer partnerships. Clapp of the Center for International Climate and Environmental Research sees “green bond issuance as a natural alignment with the larger move towards sustainable products and processes within organizations.”
The future bodes more damages resulting from climate change and instruments such as green bonds may come under increasing scrutiny. There may arise a need and demand to bring in stricter regulatory, auditing and accounting frameworks for green bonds.
The European Union is already taking steps on these lines. In its 2018 Financing a Sustainable European Economy report, the EU’s High-Level Expert Group on Sustainable Finance stressed the need to introduce a common sustainable finance taxonomy. Articulated sustainability standards, they wrote, would ensure market consistency and clarity, and guide more capital towards green investments.
The Expert Group proposes an official EU green bond standard as a key component of reporting and verification. The standard would be more obligatory and demanding than the existing Green Bond Principles. The group argues, however, that the standard would not be disruptive as it would be based on existing market practices.
On the other hand, the nascent green bond market is still developing. Having a single set of standards and certification criteria globally may restrict its development — particularly in emerging markets. Some observers say that the market is too young for standardization, and perhaps that move might never happen.
“Existence of different standards is advantageous as different markets are at varied stages of development, and regional or governmental-level differences in green vs non-green thresholds vary,” CBI’s Carman Mak said.
Having multiple sets of transparency, reporting and management standards makes it simpler to enter the market. He argued that in the future, we might see market consolidation of standards in a manner similar to the ratings system in the mainstream bond market.