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In the struggle to recover from the COVID-19 economic crash, the European Union has set an ambitious target to rekindle growth via green stimulus. In early September, European leadership upped the bloc’s already ambitious green goals, aiming to cut emissions 55% by 2030 against 1990 levels, up from an earlier reduction target of 40%.
For green bonds to fulfill their promise — driving decarbonization and lowering climate risk — the finance industry must advance reliable rules to encourage long-term investments that deliver real reductions in carbon intensity.
To fund the effort, Europe mapped out plans to issue €225 billion ($267 billion) in green bonds as part of the overarching €750-billion Next Generation EU coronavirus recovery fund. Some 37% of the fund will target climate-change projects such as hydrogen power, energy-efficient building renovations, and one million electric vehicle charging points, reports The Wall Street Journal.
The program accelerates Europe’s already world-leading push to hit net-zero emissions by 2050, a goal formalized as part of the European Green Deal. As a secondary benefit, a surge of EU-backed green bonds could help transform a nascent market with increased liquidity just as the appetite is growing for long-term, stable, green-tinted investments among insurers, pension funds, endowments, and other long-term investors.
Green bonds are growing quickly, but remain a niche in global debt markets. From less than $1 billion a decade ago, issuance of green bonds eclipsed $250 billion in 2019 (chart, via The Financial Times, or FT), comprising about 3.5% of the global total of $7.15 trillion, according to a recent note from the Bank of International Settlements.
Rising appeal — and challenges
Green bonds offer a way to raise long-term, lower-cost funds for projects that target climate change and/or benefit the environment. Green bonds let companies and governments tap into rising demand for environmentally-focused investments from insurers, pension funds, ESG funds, and the like.
Yet for all their appeal, green bonds are selling a promise of sustainability that, so far, lacks the sort of rigorous rules and rating regimes that define legacy bond markets. For that reason, a bigger wave of green bonds will up the pressure to improve standards and deepen confidence in a financial tool that could help firms and governments alike mobilize trillions of dollars of capital to fund climate-related transformation.
As green bond volumes rise, so too has scrutiny. In 2019, a top executive at Japan’s Government Pension Investment Fund — the world’s biggest pension fund — expressed concerns over the space. He told the FT that, without greater volume and higher confidence in selection standards, the asset class risks becoming “a passing fad.” Such doubts could slow green bonds’ growth.
In the wider bond market, where tiny differentials in risk and yield can rapidly redirect huge capital flows, green bonds’ smaller market size, relative immaturity, and rising popularity can lead to unexpected outcomes. For instance, in 2019, Verizon issued $1 billion in green bonds that were oversubscribed eight fold. This led to a yield that was lower than the company’s conventional bonds.
Verizon’s successful listing, albeit anecdotal, suggests that green bonds may benefit from the sort of investor enthusiasm that has already lifted flows into green equity markets. Stock funds focused on environmental, social, and governance (ESG) factors have outperformed conventional investments over the past decade. To be sure, green bonds are subject to different market dynamics, yet both asset types could benefit from rising public sentiment.
Cultivating greener standards
Debt markets could see similar gains unfold in green bonds but are more reliant on an ecosystem of regulated ratings processes and investment standards. Hence, the need for more evolved rules around — and understanding of — what qualifies as “green” in a bond, and why it should thus merit different pricing and risk consideration.
Specialized green standards are emerging, and Europe is taking the lead. In 2019, the EU approved a set of guidelines (see the April 2020 EU technical report on sustainable finance here) better defining what counts as a sustainable investment. The new rules are “a clear signal to the financial markets that sustainable investment should become the new mainstream,” Bas Eickhout, a Green MEP told the FT.
These extend a foundation of green bond certifications and standards developed by private rating agencies. Issuers can get a green label if individual projects are in line with standards set out by the Green Bond Principles (GBPs) of the International Capital Market Association (ICMA).
To widen these criteria, Torsten Ehlers, Benoit Mojon, and Frank Packer at the Bank of International Settlements have endorsed an approach that would create firm-level ratings based on carbon intensity (carbon emissions relative to revenue) that would complement project-level bond assessments.
Their proposal addresses another concern in the nascent market, where green bonds are not yet generating measurable carbon reductions for their issuers: “green bond projects have not necessarily translated into comparatively low or falling carbon emissions at the firm level.”
When factored into project-based bond issuances, a firm-wide measure of carbon intensity could help would-be buyers and rating agencies better assess the overall climate impact of a green bond offering.
By this logic, automaker ABC Co. with an all-electric fleet would be rated somewhat higher on a green bond to fund a new EV plant compared with legacy car company XYZ Inc. issuing a similar bond to build its first EV factory. Such a system could reward ABC Co. with a lower cost of debt, thereby incenting long-term, systemic commitments to a low-carbon strategy.
This is a helpful reminder that, for all of the necessary minutiae around green bond ratings and standards, the higher goal is to fund investments that cut carbon.
Indeed, vital as energy innovations are –– from high-output wind turbines to low-cost batteries — to solving the climate crisis, markets face a related urgency to advance the technology behind the financial instruments needed to efficiently fund the decarbonization of energy systems. Accordingly, financial instruments that advance environmental sustainability are a growing priority for asset managers, corporate debt issuers, and governments alike.
Financial innovation sits at the heart of the 2015 Paris climate goals. The accord includes language committing signatories to make “finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development.”
By this logic, the imperative is clear. For green bonds to fulfill their promise — to drive decarbonization and lower climate risk — the finance industry must advance reliable rules to incent long-term investments that begin to deliver real reductions in carbon intensity.
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