reedsmith.com Green Bonds – how to unlock their full potential? December 2015 reedsmith.com The green bond market is presently one of the fastest growing fixed-income segments, with issuances tripling between 2013 and 2014. There is a sense of excitement and optimism surrounding the market; initially led and developed by the multilateral development banks (MDBs) and international financial institutions (IFIs) but now actively promoted, sponsored and supported by the private sector. The demand for green bonds is currently investor-led and the supply is mostly from MDBs/IFIs, corporate issuers and, to a lesser extent, banks themselves1 . If anything, at the moment, there is a lack of good corporate issuers to supply current investor demand. However, despite an estimated US $65.9 billion2 worth of green bond issuance taking place in 2015, this is merely scratching the surface for the potential growth in the green bond markets. To state the obvious, if the target to limit the increase of average global temperatures to well below 2 degrees Celsius (the 2° Target) (as envisaged in the Paris climate change agreement3 ) is to be met, this will only be possible with the use of climate finance, raised predominantly from the private sector, supporting the investments necessary to change the way in which we currently source our energy. Even on conservative estimates this amounts to a need of US $1 trillion per year by 2050 for low carbon infrastructure and an extra US $150 billion per year by 2025 for improving resilience and adaptation to climate change4 . The purpose of this paper is to examine the current state of play for green bonds and the impediments to unlocking that growth potential. For this paper, we only focus on ‘labelled’ green bonds and within that, mostly on two particular types – corporate bonds and project bonds (i.e. type 1 and 3 as described below). INTRODUCTION Labelled Green Bonds by numbers • The first green bond was issued by the EIB in 2007 • Currently, the single biggest issuance is GDF Suez’s €2.5b bond in March 2014 • The EIB is currently the largest issuer of green bonds worth €10.8b • 2015 global issuance of green bonds is estimated to be around $65b • 36% of all labeled green bonds are issued without a ‘second opinion’ • India’s YES Bank, raised $50m on a private placement new bond in August 2015 with the IFC to fund renewable projects in India 1 What is a green bond? There is no regulatory or universally accepted definition of green bonds. However, they are generally accepted to be any type of bond instrument where the proceeds will be predominantly5 applied to finance or refinance new or existing “green” activities or projects, for example, in areas such as renewable energy, energy efficiency, sustainable waste management, sustainable land use, clean transportation, climate change adaptation, etc. The list of sectors is still evolving. The broad requirement of using the proceeds of the bond for ‘greenness’ is the chief differentiator from vanilla bonds. The 2015 edition of the Green Bond Principles6 (“GBP”) categorise green bonds into four types: 1. Green corporate bonds (“use of proceeds” bonds) – standard/full recourse to the issuer backed by issuer’s balance sheet; note payments from the general corporate funds of the issuer; same credit rating applies as to the issuer’s other bonds; no risk transfer. 2. Green “use of proceeds” revenue bonds – non-recourse to issuer; the pledged cash flows of the revenue streams (e.g. fees, levies) are the collateral for the debt. 3. Green project bonds – non-recourse to issuer backed by the credit rating and cash flows of an underlying green project or portfolio of projects; recourse limited to the project’s assets and balance sheet. 4. Green securitised bond – bond collateralised by one or more specific projects; repayment from cash flows of project assets (e.g. rooftop solar PV); recourse is to the group of projects. Prior to the publication of the first version of the GBP in 2014, the definition of how and what can be labelled a green bond had been shaped by the issuances of the MDBs/IFIs. Today, the GBP is the most commonly referred basis for ensuring that bonds wishing to claim to be ‘green’ can do so by compliance with those principles. The GBP covers four main aspects of green bonds: (i) the use of proceeds, (ii) the process of project evaluation and selection, (iii) the management of the proceeds, and (iv) reporting. However, the GBP is voluntary and, therefore, not all bonds will necessarily have to comply with standards that are at least as robust as the GBP. For example, the London Stock Exchange’s dedicated green bond segment does not require that the green bonds that it lists should adhere to any specific standards such as the GBP but they do prescribe that the use of proceeds should be for an eligible category of projects and that a second opinion is required to certify the ‘green nature’ of the bond. Even where the GBP is used, many of its principles are (intentionally) broad and not highly prescriptive. This leaves a lot of latitude for issuers to operate within the margins of the GBP and still claim compliance with it. MDBs/ IFIs also will often have their own principles and approach in terms of defining the ‘greenness’ of their bonds. From an investor perspective, it is very hard at present to assess the ‘green’ credentials of one labelled green bond, subscribing to one set of principles, as compared to another green bond that subscribes to a different set. This makes the development of a liquid secondary market in green bonds harder and raises the echo of past comments about green bonds not yet being ‘mainstream’. As such, this leads to the discussion on whether a more prescriptive or standardised approach toward defining the labelled green market should be introduced. 2 Should the green bond market be regulated? The entry of big corporations into the green bond market in 2013 has raised questions regarding whether the bonds are actually ‘green’. A recent ‘social impact bond’ issued by Lloyds Bank was seized upon by the broadsheets after Lloyds admitted that it was just a repackaging of loans that were already on its balance sheet. Questions arising in the aftermath of the Volkswagen emissions scandal have caused the EIB to clarify that its loan to Volkswagen was not financed via its Climate Awareness Bond program. To date, although the market has avoided any real scandals of ‘green-washing’, the impact of any scandal could be a significant set-back to the scaling up of the market. There has also been a parallel argument from environmental groups regarding the need for bonds to be ‘additional’ (a concept imported from the carbon markets)7 . This has raised questions about whether such bond issuances are just “green-washing”? Additionality is not currently a requisite part of green bonds and, if it were, it would likely to have an adverse impact on the growth prospects of the green bond market. Bonds have a significant role to play as a tool for refinancing. In pursuit of the 2º Target, many larger infrastructure projects will have longer term debt structures that, inevitably, will need to be refinanced after the initial financing period. Green bonds will have a significant role to play in supporting that process and to impose a constraining ‘additionality’ test on green bonds would ultimately be counterproductive to achieving the ambition of the 2º Target. Many market commentators believe that although the market is not yet ready for standardisation of product, it may be ready for standardisation of approach. For example, the requirement for a ‘second opinion’ document that certifies the ‘green’ nature of the bond at the point of issuance is now accepted as the norm in the context of corporate green bond issuances in Europe but not necessarily so in the context of equivalent issuances in Asia or the United States. The value lies in having a suitably qualified, independent, third party analyse whether the issuer’s green bond framework is well aligned with a low carbon future that is supported by the issuer’s policies and strategies. Confirming this analysis via its opinion (including commentary on the transparency of the process) is key to enhancing investor confidence in the product. Active EU market second opinion providers include DNV and CICERO. Second opinions are not the panacea to all issues. For example, the second opinion providers assess the potential for environmental benefits and not actual benefits. Their assessment is done without having to subscribe to a common form of opinion or a common analytical approach for the assessment (although many opinion providers will use the GBP as the basis of their assessment). In short, although the use of second opinions is now the norm in Europe, it has not yet evolved into a transparent, commonly accepted criterion in the style adopted by rating agencies as part of their credit analysis of risk-transfer debt instruments.8 The question: is it yet necessary to establish that standardisation of due diligence for the green bond sector? Most commentators say that it is too soon as the concept is still an evolving one and issuers are still getting used to the idea of developing a program of environmentally sustainable activities to fund via the capital markets. Another commentator, writing in the Financial Times, has gone so far as to say “…The convergence of these factors will either move us towards a standardised approach to Should the green bond market be regulated? 3 “green due diligence”, or kill the green bond movement and relegate lending for environmental benefit to the purview of governments.”9 Even if this statement is viewed as overstating the concern, it does nonetheless invite serious consideration of the alternative (i.e. a regulated and standardised approach to green bonds). Green bonds currently have the same regulatory status as equivalent vanilla bonds. That said, it is not a market driven by regulation but by principles. Some countries, such as China, do intend to regulate their green bond markets. The State Council of China announced plans in 2013 to grow a corporate green bond market as part of meeting the objectives of the 12th Five-Year Plan to assist the transition to a low-carbon-green economy. The promotion of green finance to facilitate the development of the low-carbon-green economy and the reform of China’s bond market are all expected to be reinforced as major focuses of the 13th Five-Year Plan which is intended to serve as the roadmap for the development of China’s economy between 2016 and 2020. In a paper co-sponsored by the People’s Bank of China (PBOC) on ‘Establishing China’s Green Financial System’, the Green Finance Task Force recommendation for green bonds was to “develop the … market by issuing industry guidelines, permitting and encouraging banks and enterprises to issue green bonds and providing incentives”. The report recommends incentives such as allowing commercial banks to exclude loans backed by green bonds from the calculation of its loan-deposit ratio, to allow stronger financial institutions to have access to 75 percent preferential risk weighting and capital regulation requirements, to allow institutional investors to benefit from the same tax exemption policy as treasury bonds, to allow corporate investors to be exempted from corporate income tax on coupon on green bonds, etc. The primary purpose of regulating the green bond market is to use it to facilitate a targeted approach to China’s transformation of its economy and, therefore, to use policy as a key driver to achieving this ambition . Of course, China is slightly unique in the way that its market operates and therefore may not be a suitable analogy for the rest of the world. However, a coordinated and focused policy measure, such as the Chinese green bond guidelines, may have a more direct and immediate impact in scaling up green bond issuance in China than the alternative ad hoc approach adopted by the rest of the world. As China has demonstrated, when it does something, it usually does it ‘big’. A question may be asked: at what stage will the market outgrow self- regulation and require greater top-down intervention to achieve its potential? That point in time may be when, in the interest of achieving the 2° Target, incentives and policy measures, applied via regulation, are needed to accelerate the raising of climate finance via green bonds. 4 How will the green bonds market scale up? Whilst national and international regulation may well have an important role to play in the growth of the green bonds market in the near future, arguably the market is not yet at critical mass to justify significant regulatory intervention. Indeed, more red tape at this stage could discourage new issuers from entering the market, thereby inhibiting growth. Regional efforts, such as the inclusion of green bonds in the agenda of the EU’s Capital Markets Union, may have a role to play in promoting further EU standardisation of green bonds. The biggest challenge, however, is ensuring traditional investors, including pension funds, insurance companies and sovereign wealth funds managers, view green bonds as a financially credible alternative investment and not just a subcomponent of their ESG mandates. The success of scaling up will be measured by how much of that market segment, green bonds have been able to attract. To achieve this, the reporting element of the green bond market will need to be tackled. At present, there is no validation of whether the promises of greenness, made at issuance, are actually kept. There are no sanctions for non-performance and equally no gatekeepers. The GBP does advocate annual reporting (at least), to cover expected environmentally sustainable impacts of the disbursed funds but accepts that there are no established standards for impact reporting. The MDBs/IFIs have picked up on this gap and have, in December 2015, published a framework document titled “Green Bonds – Working towards a harmonized framework for impact reporting”. At present, the scope of its indicators and templates are limited to energy efficiency and renewable energy but the intention is to develop additional indicators for other project types. Further progress along these lines and the adoption of similar reporting requirements by all issuers will help build the appeal in green bonds to a wider investor market. Other developments include the ratings agencies progressing towards their own standardisation of due diligence for environmental impact; investors becoming increasingly discerning about green bonds and less concerned about “green washing”, the greater adoption of certification standards such as the Climate Bond Standard and the use of its climate bonds taxonomy, and the development of green indices, such as the S&P Green Bond Index and the S&P Green Project Bond Index to help track the market performance of debt issued dedicated to various green projects. Most importantly, there will also be the ‘Paris Agreement effect’, which will place the private sector, and the green bonds market in particular, front and centre in global efforts to scale-up financing to tackle climate change. The need to scale up the green bonds market to tackle climate change was highlighted in October in a UN investment report11, which notes that “Green bonds offer an attractive way to access institutional investor capital as the risk and returns of the bonds are typically determined by the issuer’s full balance sheet, not just the green assets.” This is true of corporate bonds, but not of project bonds, and serves to demonstrates the need to differentiate between types of green bond when evaluating what role they have to play and what needs to happen to scale-up the market. 5 Green corporate bonds Private sector investment in the green corporate bond market has been largely driven by ESG investors, which reflects the (now less prevalent) perception that green bonds do not offer equivalence to or advantages over non-green vanilla bonds. The comparable returns offered by green bonds to vanilla bonds are beginning to attract investment beyond mere fulfilment of ESG quotas. Faced with similar returns as those offered by vanilla bonds, with a “green” bonus feature (particularly in the current climate of low and negative yields), it is no surprise that green bonds are appealing from an investor perspective. The fact that green bonds are trading at a premium on the secondary markets would suggest that investors are beginning to cotton on to this. The increase in the number of companies signing up to and complying with global principles, such as the UN’s Principles for Responsible Investment (PRI), may also explain the rise in demand. According to the PRI’s 2015 report, it now has 1,250 signatories in 50 countries. These companies have USD $59 trillion worth of assets under their management. However, it is notable in their findings that “while 63% of professionally managed assets are managed by PRI signatory investment managers, just 19% of assets are held by PRI signatory asset owners (and 75% of this is European asset owners)”. This suggests further growth prospects for green bonds from the asset owning side of the market once they sign up to PRI or other similar principles. From an issuer’s perspective, the choice of borrowing from cheaper capital markets, relative to the banking markets, is an easy one. What is not so easy for the issuer is to have available a sizable portfolio of investment programs that meet the eligibility criteria for green bonds (i.e. bankable projects). This requires investors to have a company ethos around sustainability and a forward looking program of investment in carbon resilient infrastructure, energy efficiency (e.g. retrofits and green buildings), low carbon energy (e.g. solar, renewables, storage), adaptation (infrastructure to deal with increased heat stress, sea-barriers), etc. This turns on the climate awareness and preparedness of the company in question as well as its priorities and localised government incentives. The banks that have issued green bonds have often benefited from the fact that they already have a pipeline of green projects that they have been financing via their lending business. This is certainly true of the MDBs/IFIs but also of the recent private sector banks such as Credit Agricole CIB. With the impact of regulatory capital pressures forcing banks to restrict their longer term lending ability for project finance work, the ability to finance or refinance eligible projects via the green bond market is an invaluable route to ensuring the continued support of lending to such longer-term projects. Because repayments of green corporate bonds are from the issuer’s general corporate funds, the bonds receive the same credit rating as other non-green bonds from the same issuer. As a result, there is no transfer to the buyer of the project risk associated with the underlying projects to which the proceeds are applied. Absent such risk transfer, the rating agencies have less of a role to play in this segment of the market. That is not to say the role of rating agencies, in the context of climate change risk, is not relevant. Increasingly, rating agencies such as S&P analyse the effect of carbon price risk on a company’s creditworthiness, by considering “the direct and indirect effect of exposure thought continued on page 6 ››› 6 the profitability, asset and liability valuation, and cash flow.”12 S&P also considers the ESG risk of companies as a component of its “Management and Governance Credit Factors for Corporate Entities and Insurers”13. The analysis considers ratings impacts, among others, of climate change, pollution, resource depletion, adherence to legal and regulatory requirements, etc. The recognition by companies of the weight given to these factors by rating agencies may also act as a driver for the increase for the pipeline of green projects needed to support additional green bond issuance. The points raised above, regarding making further progress towards standardisation of approach to ‘greenness’ and increasing transparency and measurability as to the application of the proceeds (via reporting), will be important factors in enabling investors to better assess the ‘green’ benefit of one project against another. This should also lead to the pricing of ‘greenness’ as an element of the overall pricing of the bond. As demand for green corporate bonds grows, it is important that supply is not outstripped. Clear policy statements and incentive programs from governments may help to counter this. With 187 countries each committing to some form of climate change related effort via their intended national determined contribution (INDC) under the Paris Agreement, it will no doubt enable green bond opportunities for corporate issuers to materialise not just in developed countries but in developing countries as well. Green project bonds For issuers, project bonds offer a key advantage in that they essentially transfer the risk to investors. Credit ratings for project bonds tend to be lower (being based on the project-specific risk) and the structures tend to be more complicated. This generally means that project bonds are more expensive to issue than corporate bonds and harder to market without the benefit of credit enhancement. Some investors, such as European insurance companies, may not be attracted to a green project bond with a long-term debt rating lower than “A” because of the capital that will be required to set aside under its regulatory capital treatment. On the investor side therefore, the corporate bond market is attractive because it allows investment in green projects through the balance sheet of highly rated corporates. continued on page 7 ››› 7 The fact that the green project bond market is relatively small compared with the corporate bond market indicates that higher risk, non-recourse instruments have yet to catch on in the market. Arguably, infrastructure type projects (which would include many green adaptation projects) may be a better fit for the equity investor model. The key question is who will lead the way with green project bonds? The green corporate bond market was trail-blazed by MDBs/IFIs and it remained largely their territory until 2013 when issuances by the EDF and Bank of America Merrill Lynch signalled the arrival of the private sector. Moving forward, the corporate bond market is now set to be dominated and driven by the private sector. The same now needs to happen with green project bonds. Some of the characteristics of green project bonds include: (i) their size (e.g. issuance in excess of €100 million is needed to justify the greater complexity), (ii) the limited investor pool (mostly insurance companies and sovereign wealth funds with longer term investment mandates), (iii) the cost (higher legal fees to meet regulatory requirements, cost of getting the issue rated, additional service provides, etc.), (iv) bankability (i.e. some infrastructure projects don’t get financed without credit enhancement either because they lack a stable revenue stream or are just not creditworthy), and (v) time (it takes longer to get a green project bond issued because of the input required from the rating agencies, underwriters and listing authorities). These characteristics mean that the project needs to be big enough to justify the time and effort required to get it off the ground. But the key obstacle is risk. Apart from the fact that many investors will not have the experience in assessing project risk (e.g. construction risk) there are other risks that will cause them pause such as placement risk and negative carry concerns. In many instances, due to the higher risk associated with these projects, there often needs to be a degree of first loss risk absorbance by the issuer. For obvious reasons the private sector banks have no appetite or mandate for this and nor do any (if not most) of the MDB/s/IFIs. Therefore, the market will increasingly look to governments and organisations such as the Green Investment Bank in the UK or internationally to the Green Climate Fund (GCF) to act as market makers or credit enhancers. The GCF is certainly alive to the crucial role it will play regarding green bonds. It proposes to work through various private and public sector entities accredited by it to issue, underwrite and make a market for project-specific bonds. The GCF will add value by injecting credit or enhancements such as first or second loss mechanisms. Ratings agencies will also have an important role to play in the development of the green project bond market, given the need to assign risk ratings to particular projects. If the rating agencies can use the established and comprehensive methodology that MDBs/IFIs and private sector banks use in assessing project finance risk and convert it into a rating system to support green project bonds, which are, in turn, supported by the appropriate credit enhancement tools, this will go a long way in helping investors get comfortable with the project risk concerns in investing in green project bonds. continued on page 7 ››› 8 CONCLUSIONS The prospects that green bonds provide in supporting the global transition to a low carbon, climate resilient economy within the 2° Target is obvious. The signal arising from the Paris Agreement is very much a ‘call to arms’. In the first instance, the most immediate growth will be in the corporate bond side with parallel but slower growth following on the green project bond side. The scope for growth in green corporate bonds will be aided as new issuers (both corporate and banks) recognise the opportunity and the value placed on their ESG credentials and activities. Board level recognition of having a forward-looking climate risk strategy can only aid this. Initiatives such as the PRI will further increase this awareness in Asia (especially, China and India), Latin and North America. The aviation sector may see the opportunities when they commit to an international market based mechanism under ICAO in 2016 and, as already highlighted, there is more to be done to sign up the asset owning-side of the market to PRI type principles. However, in terms of growing the share of the green bond market as well as achieving a greater climate impact, the biggest (as well as the harder) opportunities lie in the green project bond side. The MDBs/IFIs must lead in this area and development of new credit enhancing tools should be a priority of government policy and organisations such as the GCF. Therein lies the secret to public sector funds being used appropriately and efficiently to leverage funding from the private sector. 9 NOTES/REFERENCES 1 HSBC Holdings Plc. issued its first green bond, raising 500 million euros in November 2015. ING Bank N.V. issued its inaugural green bond, issued in two tranches, totaling more than $1 billion in November 2015. 2 Bonds and Climate Change: The State of the Markets in 2015 – prepared by the Green Bonds Initiative 3 The Paris Agreement was adopted on 12 December 2015 by the 196 countries participating in the 21st Meeting of the Parties to the United Nations Framework Convention on Climate Change. 4 UNEP (2014) ‘The Adaptation Gap Report: A Preliminary Assessment’. 5 Currently the Green Bond Principles require the use to be “exclusively” 6 The Green Bond Principles are a set of voluntary guidelines agreed by a consortium of investment banks, with its drafting led by Bank of America Merrill Lynch, Citi, Credit Agricole CIB and JP Morgan Chase with the International Capital Market Association, serving as its secretariat. 7 The debate on “additionality” is whether, to be considered truly “green”, should only green projects that would not otherwise be financed qualify? The argument goes that if a project would have gone ahead anyway, or the bond is simply refinancing an existing project, the additional “green” impact of the bond is nullified. 8 At present, regulatory restrictions apply preventing credit rating agencies from providing opinions in relation to anything other than the creditworthiness of the issuer’s debt or their debt instrument. 9 “’Green’ finance environmental impact is hard to measure” – by Todd Cart and Cary Krosinsky, the Financial Times, 4 November 2015. 10 At present, the PBOC is inviting commentary on draft guidelines for green bonds. 11 “Trends in Private Sector Climate Finance”, 9 October 2015 12 Corporate Carbon Risks Go Well Beyond Regulated Liabilities - S&P, 22 May 2014 published in Ratings Direct. 13 M&G, published by S&P on 13 November 2012. Peter Zaman Partner, London +44 (0)20 3116 3686 firstname.lastname@example.org Ranajoy Basu Partner, London +44 (0) 20 3116 2827 email@example.com Claude Brown Partner, London +44 (0)20 3116 3662 firstname.lastname@example.org Gábor Felsen Associate, London +44 (0)20 3116 3542 email@example.com Adam Hedley Associate, London +44 (0)20 3116 3746 firstname.lastname@example.org Nathan S. Menon Associate, London +44 (0)20 3116 2924 email@example.com OUR TEAM About Reed Smith Reed Smith is a global relationship law firm with more than 1,800 lawyers in 26 offices throughout the United States, Europe, Asia and the Middle East. Founded in 1877, the firm represents leading international businesses, from Fortune 100 corporations to mid-market and emerging enterprises. Its lawyers provide litigation and other dispute resolution services in multi-jurisdictional and other highstakes matters; deliver regulatory counsel; and execute the full range of strategic domestic and crossborder transactions. 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