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Green bonds: who is to certify ‘sustainability’?

Green bonds

Poland’s issue of a green bond earlier this month was the country’s second financing of this type, and the first ever repeat issue by a sovereign. It has revived the debate as to whether there should be a single regulatory standard to certify the environmental quality of financial assets. This will be a key issue for the EU’s sustainable finance strategy which is due to be released shortly.

Global climate targets, and in particular the Paris Agreement of 2015, have fuelled investor demand for ‘sustainable’ financial assets. This is now reinforced by the scrutiny that supervisors apply to the carbon exposures of the financial industry, and the attempt to mitigate the financial stability risks of a transition to a low-carbon economy.

As a conventional bond, a green bond is debt contracted for projects with an extended life-time, though such projects must have certain environmental qualities. By holding such assets institutional investors demonstrate their adherence to their own sustainability targets, and reduced exposure to climate-related financial risks. There are now 17 dedicated green bond funds in Europe, and the investor base increasingly comprises foundations and the treasuries or pension funds of large companies. Issuers of green bonds gain visibility with their own sustainability strategies and will access a wider investor base. This could be an important benefit when liquidity in corporate bond markets recedes, and market access becomes more uncertain.

The green bond market is, as yet, a fraction of the international debt market. Total international issuance of both public and private green bonds of $120 billion in 2017 pales in comparison to overall global bond issuance of around $21 trillion.

But growth has been very rapid in the last three years, which may explain the policy attention that the market now attracts. As the range of issuers and sustainability objectives widens, the challenge is to safeguard the reputational benefit of a green bond issue.

Disclosure must be adequate to prevent superficial labelling (‘greenwash’) and ongoing evaluation should discipline the flouting of announced sustainability targets in the use of proceeds (a ‘green default’). Unlike a project-specific bond, a municipal or sovereign issue will suffer from the inherent fungibility of proceeds within a large and complex public budget. France’s recently announced pipeline of long-term green projects likely sets a standard in this regard.

Clearly, for the green bond market to grow further, a credible common standard is needed. This should allow the investor to verify the environmental quality of the underlying assets, and account to its own beneficiaries. A common standard reduces due diligence costs compared to a process of self-certification and decentralised assessments by individual asset managers, however good the level of disclosure by the issuer. The question for the EU capital market is who should set this standard.

So far, certification has been led by the industry. The Green Bond Principles of 2014 make broad recommendations for the use of proceeds, project evaluation and reporting. The Climate Bond Initiative is more demanding, as it certifies compliance with criteria in many of the 46 sectors that it tracks. Rating agency Moody’s has designed an evaluation standard that also offers an ongoing assessment throughout the lifetime of the bond. Several EU financial centres, including the Luxembourg stock exchange, have adopted issuance standards that are based on these industry norms.

It is clear that a single EU standard could foster transparency, scale and liquidity in the market for sustainable financial assets

The opposing case for a regulatory harmonisation has now been made by the EU Expert Group on sustainable finance which released its final report last month.

In its view, a single EU standard should bring greater clarity over the underlying assets and their compatibility with sustainability goals set by the EU. At first harmonisation would be limited to stricter documentation standards and the accreditation of private-sector companies that evaluate green investment objectives. But ultimately the EU green bond label would be based on a European sustainability taxonomy. It is likely this would narrow down the objectives currently supported by private-sector labels.

The expert group also developed its proposals for so-called supporting factors in the prudential treatment of sustainable financial assets. While it is problematic to mix objectives in environmental sustainability with those in financial stability, this proposal would no doubt depend on there being a single EU-wide norm for green assets.

It is clear that a single EU standard could foster transparency, scale and liquidity in the market for sustainable financial assets. A single asset class could more easily be defined, and issuance premia and performance relative to other financial benchmarks could be tracked. Financial innovation, including structured products or securitisation, could attract additional capital.

That said, private standards have kick-started the market and have remained responsive to the issuers’ underlying portfolios, and technological change in the industry. ‘Greenness’ of projects is of course a fluid concept in a highly innovative industry. External evaluations of issuer information draw on deep industry expertise in environmental accounting (e.g. specific mitigation claims). As the Commission now prepares its sustainable finance strategy it should be cautious in imposing a single taxonomy that may not do justice to the complexity and dynamism of the industry.

-ALEXANDER LEHMANN

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