ESG Focus | Jul 12 2021
FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
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ESG focus: It’s easy being green – for now
Carbon intensity is set to emerge as the benchmark hero in the global push to create a fungible green bond market.
-The green bar is set “deceptively” low
-Standardisation is a global hot topic
-Carbon intensity to become the green common denominator
By Sarah Mills
Welcome to Part 2 of our green bond story, one of several articles on the ESG bond market.
Part 1 discussed the state of the green, sustainable and social (GSS) use-of-proceeds bond market; green bond basics and pricing; and developments in the international criminal courts. [Link below]
It notes that green bonds, in particular, have created a bridgehead for sustainability finance to transform traditional vanilla non-bond financial markets over the next two decades.
This article focuses purely on the green bond market and regulatory attempts to improve fungibility of green bonds to draw them into mainstream investment.
It’s easy being green, but not for long
At the moment, nearly any corporation and its dog can issue a green bond and expect very little scrutiny.
Failing to direct the proceeds as agreed in the loan’s terms does not trigger a default, and as long as the loan is financial, the issuer is good to go.
The International Accounting Standards Board has stated publicly that “greenwashing is rampant”.
The market’s critics cite inadequate green contractual protection for investors, poor quality of reporting metrics and transparency, greenwashing and pricing issues.
Evidence also overwhelmingly suggests that green bond issuance is not associated with falling or even comparatively low carbon emissions at the company level, and critics argue therefore green issuance has had limited impact save as a transition subsidy (at best).
Green deception, or eco-fraud as some have described it, can have serious implications for ESG-specific fund managers.
Failure of an instrument to meet a fund’s standards can result in loss of funding approval, a need to sell the bonds potentially at a loss, or, in extreme cases, dissolution of the fund.
If failed instruments are included in sustainability indices, it can also impact on the integrity of the indices, as was the case with Mexico Airport’s failed green bond, which lost its green ratings from Moody’s Investors Service and S&P Ratings.
It may also mean the taxpayer might end up subsidising a vanilla bond and result in back-ended tax benefits.
These claims are largely true.
The policing of the green bond market is loose, but that is forecast to change as certification and other credentialing improve.
Already green loans more frequently have enforceable green covenants.
Similarly, over time, penalties for non-conformance are likely to rise, and at some time in the distant future could trigger a default.
The EU, announcing its sustainable finance strategy this month, promised a crackdown on greenwashing and improved ratings systems.
Baker McKenzie suggests incorporating reporting provisions into contracts, making them actionable via an agreed put event, and introducing margin incentives as a penalty for non-compliance (which really makes them sustainability linked).
In return, the firm argues that investors should reward issuers with increased appetite and lower pricing.
Tax incentives for good performance have also been discussed
Flouting green bond agreements can incur reputational damage but at this stage, even that is fairly low.
But given primary market pricing is comparable with vanilla bonds, most issuers are doing so partly to gain credentialing for the future, most at least pay lip service.
The de-rating of Mexico Airport’s green bond has also directed efforts to ensuring a green bond remains a green bond until the end of its maturity; and this will become a requirement for issuers and a subject for due diligence, according to On Point.
What happens to the non-conformers?
So not surprising, non-conformance of bonds has attracted some attention, and steps are being taken to ramp up the reputational consequences of green “default”.
Under the Climate Board Initiative’s (CBI’s) Standard of Certification, green defaults must be declared to the CBI within one month of becoming aware of non-conformance.
The CBI may recommend corrective action but if conformance is not restored, the board can revoke its green bond certification, remove the bond from the Climate Bond listing; and inform bondholders, exchanges and other market participants of the loss of certification.
This process is discretionary and uncertain.
The CBI actions affect the issuer’s credentialing, which at present is nothing more than a slap on the wrist given pricing supplements often include express statements that a loss of certification does not constitute and event of default and bondholders cannot exercise redemption rights or take any other action.
But moves are afoot to standardise reputational and financial consequences.
Until then, investors are left holding the baby so due diligence is important, particularly for funds whose mandates require the investment to meet certain green targets.
Regulators are also expected to incorporate oversight into the supervisory process and the prudential treatment of balance sheet assets; and brown penalties may be introduced in the medium term.
Standardised measurement is a hot topic
Perhaps the biggest challenge facing the green bond market is lack of standardisation, which hampers liquidity, transparency and comparability.
Typically, green bonds are not fungible, in that they apply to different projects, in different industries from corporations or countries with different risk profiles and ratings, and for different reasons.
They are not comparable and regulators are seeking to address this issue.
According to Baker Mackenzie, on top of the above, there is no universally accepted legal and commercial definition of a green bond:
“Imitating the International Capital Market Association’s (ICMA) Green Bond Principles, elements common across many standards include:
(i) use of proceeds disclosure stating the cash raised will finance new or existing projects that have positive environmental or climate benefits;
(ii) ongoing reporting on the foregoing green use of proceeds; and
(iii) the provision of a second opinion by an independent third party reviewer certifying the green aspects of the bond.
The four main providers of green bond data tend to be the arbiters of “kosherness” and include CBI, Dealogic, Bloomberg and Environmental Finance Bond Database.
But even this data has gaps wide enough to drive a horse and cart through.
Tracking the banks’ usage of green proceeds is also hard given the fungible nature of cash and loose labelling by banks, according to Fitch ratings.
Because green bond issuance is used for standalone projects rather than company-wide emissions, this can confuse some equity investors in terms of the likely forward credentialing/rating for the issuing companies.
Not only that, projects promising carbon reductions can be offset by carbon increases elsewhere.
The thorny issue of verification
This takes us to another major challenge for the market – verification that environmental benefits are delivered.
When it comes to certification, the Climate Bond Standard aims to establish a platform for assessing climate-friendly attributes of projects but doesn’t try to assess the credit worthiness of the instrument, nor compliance with laws or other environmental obligations. This is up to the investor to determine.
Sustainable Finance Disclosure Regulation (SFDR) and Non-Financial Reporting Directive (NFDR) are expected to step in to the breach, requiring institutions to disclose the extent to which they are taxonomy-aligned and the strength of their green asset ratio.
The green certification platform is preparing to include enforceable contractual arrangements protecting investors from “green” default.
According to Corrs Chambers Westgarth, these may include:
– “an assurance process during the tenor of the green bond with regular reporting required to be made available to investors;
– “requirements for application of proceeds to the intended green purposes;
– “the ring-fencing of proceeds into a separate account so that any unallocated issuance proceeds form a green tranche are not applied to other non-green purposes;
– “linking green failures to put events to enable bondholders to accelerate or redeem their bonds, or linking green failures to a margin ratchet requiring the issuer to pay an increased coupon if there is green non-compliance.
“With these arrangements, we expect margin ratchets will be the most popular. This is due to the clarity margin ratchets provide green bond investors and issuers with respect to enforcement … ;
– “the green bond market may further evolve to include a full “green default” regime and rights recourse. However, at this stage, the market is not ready.”
Carbon intensity – the green common denominator
So the push is on to create a ratings system for green project issuance based on an issuer's total group carbon emissions, using carbon intensity as the common denominator for all issuance.
This will increase pressure on green issuers to publish standardised impact reports.
Carbon intensity is favoured as a benchmark because of its relative ease of measurement and ease of verification.
Carbon-intensity performance is measured as emissions relative to revenue.
According to the Bank for International Settlements (BIS), there is no evidence that green bond issuance is associated with any reduction in carbon intensities over time at the firm level.
In fact, about half of green bond issuers have the highest carbon intensity (and are usually energy producers).
Trucost data shows that while carbon intensities fell on average in the two years after issuance, carbon intensities rose afterwards.
According to BIS, Scope 1 green issuers post a 60% fall in intensity after three years but only 30% firm-wide for Scope 1-3 emissions (see previous article for Scope 1, 2 and 3 definitions).
Median changes across firm before and after are minimal. Also, results are not statistically significant so no clear pattern emerges.
But the BIS believes that carbon intensity can be used to create fungibility by classifying green bonds into “buckets” – a concept already well understood in the industry.
For example, the bonds could be sorted according to project types within industry buckets based on a carbon-intensity ratings systems.
BIS has this to say:
“A firm-level (organisational level) green rating system should have three high-level objectives:”
– It should provide extra incentives for the rated companies to contribute to the attainment of climate goals;
– It should help investors in their decision-making processes, particularly those investors without resources to conduct their own green due diligence; and
– The system should allow investors and other stakeholders such as auditors, regulators and policymakers, to check an organisation’s improvement and verify that the desired climate mitigation effects are achieve.
By rating an organisation, rather than the bond, on its overall carbon intensity, it also encourages the organisation to increase its carbon efficiency; and help investors sort the wheat from the chaff in the quest for the sustainability premium.
It would also provide extra incentives for large carbon emitters to battle climate change.
We will offer an edited version of BIS’s free complementary musings on the subject in a separate article for real enthusiasts.
Green bond certification for treasury bonds on cards
Denmark’s central bank, Nationalbank, and the Danish Ministry of Finance announced in May that they were considering a new model for sovereign green bonds that separates financial commitments from green commitments.
Denmark has the fifth-lowest government debt-to-GDP in the EU and the central bank notes that green bond issuance drains liquidity from pre-existing bond series, raising the cost of funds.
Under the proposed model, the Danish government’s “green” bonds would be traditional vanilla bonds, complemented by a green certificate.
This certificate separates the commitment to provide a coupon payment and the principle on maturity from the use-of-proceeds commitment.
In essence, the bonds can be issued in the primary market alongside traditional bonds, but the green certificates can be traded separately (a zero-coupon bond with zero redemption at maturity).
“Owning both the conventional government bond and the green certificate is equivalent to owning a sovereign green bond,” according to the Danish central bank.
Denmark’s liquidity problem is one faced by many other small sovereign issuers and, if successful, could be adopted more widely with interesting broader market consequences.
According to IP, four of Denmark’s biggest pension funds have said they are receptive to the idea.
While experimental, it is just one example of the potential for innovation in the green bond market and the likely augur of many new instruments to come.
The EU will likely be entertaining many options given its ambitious 2050 targets are off to a slow start.
The challenge for investors
As noted, green bonds don’t always come from the most carbon-efficient firms, creating challenges for investors.
On the fixed-income side, backing the wrong carbon horse could cause investors to lose bang for buck.
Failure could also affect the green credentials and financial positions of investment funds, resulting in fund re-ratings, forced sales and possible dissolution.
But once regulations tighten, investors may gain a financial windfall from step-up rates and penalties, adding some reward into the equation.
On the equity side, if investors conflate green issuance with green credentialing, they may invest in a company that is on a losing rather than a winning carbon streak.
Those with hedged portfolios will be seeing the best performers regardless as this is where the long-term investment sweet spot lies.
There are those that suggest that true “green” intent is as good a barometer as any financial litmus test, given it is likely to guide investors with a moral barometer towards the most ethical choices in the absence of proper regulation and financial metrics.
As with most ESG investment, the best GSS bonds are likely to be forward looking, as leaning into impact during a period of dramatic change is being pitched as safer than sitting on the edges.
In the words of the transition architects, it’s a game of “Who Cares Wins”.
It's Easy Being Green — For Now (Part 1): (https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/)
FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/
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