What's the true impact of green bonds?

The transportation system overhaul in Sao Paolo, Brazil, which includes a heightened focus on water options, is one of dozens of projects earmarked for the green bonds tracked by the World Bank.

One major stumbling block for implementation of the Paris Agreement (PDF) remains one of financing, particularly the opportunity for developing countries to catch up. In this environment, green bonds have emerged as one of the simplest solutions for raising money.

To some, this financing vehicle is almost a panacea: Issue green bonds and the problem will be solved.

But the link between issuance and impact is not automatic. How green, really, is the project financed by a green bond? Most progress indicators are stated in terms of green financing made available, such as the Green Pledge, which calls for $1 trillion of green bonds to be issued during 2020. But most don’t measure the impact of the projects financed.

There is the issue of additionality, i.e. do new green bonds represent additional financing that otherwise would not be available? Take the example of France, which issued 7 billion euros in bonds labeled "green" to finance items related to the achievement of the Paris Agreement goals. These projects have been and can be financed by regular Treasury debt, but by bundling those activities around a green bond issue, the debt can be called the "the largest sovereign green bond" and boast of leadership.

Then there is the issue of labeling and greenwashing. Traditional hydropower finance is now called green finance. Even a transmission line, if it carries renewable and other sources of energy, is labeled as green financed.

To be sure, green bond issues must comply with certain requirements, the most commonly used being those of the International Capital Markets Association (ICMA), although there are many others, including those of countries or groups of countries and, in the near future, those of the European Union.

The ICMA’s Green Bond Principles (PDF) (GBPS) require issuers to comply with requirements that pertain to use of funds, evaluation and selection of projects, funds management and reports.

In theory, these principles cover all aspects deemed necessary to assure that green bonds are green. The problem lies in the implementation and verification of compliance with the stated (promised?) goals. Here’s where potential gaps lie:

  1. Bond framework or prospectus: These documents state how the issue intends to comply with the GBPs, but the vast majority include generalities, the minimum necessary to comply. The priority seems to be to maintain operational flexibility, to avoid having to disclose more information than necessary, to avoid potential reputational and, especially, to avoid legal risks. Many just state the general types of projects or activities to be undertaken without specifying details. With very few exceptions, they do not state how the projects or activities will contribute to the greening of the environment and society. 
  2. Verification: The compliance of the framework or prospectus with the GBP is verified by a third party, issuing "a second opinion" based on "limited assurance" as opposed to "reasonable assurance." This opinion is limited to the verification that all four principles are addressed in the document, i.e. the documents states where the funds are to be used, how the projects will be selected, the governance of the issue and the reports offered.
  3. Rating: Some issuers obtain a rating of the bond regarding compliance with the GBPs on some aspects (transparency, governance, projects proposed, reporting, etc.). S&P and Moody’s have developed methodologies. These ratings do add a level of rigor to the limited assurance of the prospectus as they evaluate the potential effectiveness of the proposed compliance, not only if the GBP requirements are described. But this is still an ex-ante evaluation, based on promises in the prospectus or framework.
  4. Monitoring: Here is where the largest gaps can occur. The same third parties can be called on to assess the content of the issuer’s reports. These limited assessments evaluate if the report includes what the prospectus stated it would include (see KPMG on Unilever (PDF)). There also are assessments of progress in the implementation of the issue, but the monitoring is limited to assessing if procedures outlined in the framework or prospectus were followed.

In all of these stages, there is no guarantee that the green bonds actually led to green projects.

Closing the gaps

The single most effective tool to ensure alignment of intentions with having impact is the social responsibility of the issuer itself.

If we wanted to regulate all the phases so that there would be guarantees of effectiveness and impact, the regulations would have to be so detailed as to be unyielding, very expensive for all and all flexibility would be lost. But this does not mean that the current ones cannot be tightened and still be manageable.

The GBPs should be tightened to avoid generalities, verifications should include assessment of potential impacts of the projects and activities must be compulsory not optional, and the monitoring must go beyond stating that the processes were followed. Some of the gaps identified above could be tightened by:

  • Including a justification that the funds are tapping a market that would not be available to non-green projects, that it is not just a change in denomination. This can be speculative but, combined with the assurance below, would lend credibility to the green finance market.
  • Including detailed criteria for project/activity selection based on expected impacts, not just on its vague "green" characterization, as it is currently done in most cases.
  • Include a description of the expected impacts of the activities/projects based on agreed upon indicators (for example, those of the Sustainability Accounting Standards Board). For instance, if it is energy efficiency, what are the quantitative goals?
  • Requiring a rating of the issue or a second opinion of "reasonable assurance" that includes an assessment of the compliance of the processes proposed with the detailed selection criteria (PDF) and an assessment of their potential to achieve the proposed impact of the projects, not only a limited assurance that that content of the framework aligns with the GBP.
  • For the project monitoring reports, require also a "reasonable assurance" that GBP have been complied with, that the use of the funds has been effective and the extent to which the impacts are being achieved, beyond what is the currently the case of assessing only if the resources were used in the projects and activities proposed, which could have been very general. Currently a typical statement concludes: "nothing has been called to our attention that the resources were not used for the intended purposes" (DNV-GL on Unilever Green bond). As the explosion of the market has been so recent, there are very few examples of impact assessment (see below).

Additionally, the principle issuers (ICMA, European Union and others) and the green finance industry should seek to promote the expertise and involvement of civil society organizations in the monitoring of green bond prospectus issues and projects.

This is, with some variations, what the oldest (first issue in 2007 for $800 million) and largest non-sovereign issuer of green bonds ($18 billion in 10 years), the European Investment Bank (EIB), is doing. It no doubt would increase the costs of the issues, but as they usually are in the hundreds of millions of dollars, the increase would be small in relative terms and the gain in credibility high. 

Credibility and impact, not just quantity

All of this is not to imply that green bonds are not an effective and legitimate tool to promote green development. But it highlights the potential gap between issuance and impact — the potential for traditional forms of financing to be labeled "green" and for projects to slip through that may not be as green as alleged. The GBPs, while a big step forward, could increase the potential for greenwashing and for ineffectiveness.

The emphasis on the amounts of green bond issues is misplaced and can lead to the impression that amounts are synonymous with transformation. It distracts from what should be the real concern: the impact of projects completed. Unfortunately, memory is very short, and the media is dominated by those that profit from quantity of issues (investment banks, consulting firms, assurance companies, even the companies that exploit the publicity) and not from results achieved (society).

At some point the emphasis will move towards quality, not quantity, of issues. As socially responsible investors demand that companies demonstrate proof of corporate social responsibility goals and seek more accountability beyond simplistic exclusionary criteria (no arms, no vices), the green finance industry must move beyond financing projects/activities that are labeled green to backing those that are demonstrably green.