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How the green bond market works

By Charles Smith

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A new tool for helping the private sector green the world

Financing green investment through bond issuance is a relatively new development, with the EBRD at the forefront. Here we chart the rise of the green bond market.

In August this year, the green bond market reported another milestone when aggregate green bond issuance reached US$ 150 billion since the first bonds in 2007-08. With the heightened awareness of global environmental and climate challenges, green bonds are increasingly seen as a tool that could allow the private sector to take an active part in raising the funds needed to put our society on a more environmentally sustainable footing.

But what exactly is a green bond, and who decides whether it is green or not?

The distinguishing element of a green bond is its “use of proceeds” pledge. This earmarks the proceeds for specific projects with environmental benefits, such as a wind park or a water treatment plant. For anyone in the development finance industry this is a familiar concept, but in fixed income markets most financial instruments have traditionally been separated from the assets they fund.

Technically, most bonds fund so-called “general corporate purposes” and the only difference in documentation between a normal and a green bond is the “use of proceeds” section.

However, this relatively minor change raises a host of new issues. What are the green assets that are funded? How are they selected and what are the environmental benefits? How are the funds and projects segregated and tracked? How is all this reported to investors and other stakeholders?

What makes the green bond market particularly dynamic is the fact that it straddles two very different worlds: the capital markets and environmental development (from both a technical and policy angle). It also requires coordination of administrative functions and resources by issuers, investors and market intermediaries alike.

In 2014, a group of influential issuers, underwriters and investors agreed on a set of voluntary process guidelines called the Green Bond Principles (GBPs) in order to support communication among market participants and promote market-driven solutions to specific green bond issues.

The GBPs focus on transparency, disclosure and integrity from a process point of view. The goal is not to define what may constitute a green project, but rather to ensure enough transparency in a green bond issuance for any investor to assess the potential environmental merits.

The decision as to whether a bond is green enough therefore lies with the investor and, as in any market, the different investor focus areas and criteria promote diversity and growth. This also flexibly accommodates changing views of what constitutes green as, say, technology evolves.

The requirements for an issuer to establish a green bond programme are significant, and a good example is the depth and range of reporting that is expected. The reporting involves not just tracking the proceeds and qualitatively describing the benefits, but transparent quantitative measures are increasingly required.

The reporting is made more complicated by the broadening range of issuer types (from banks to corporates in various industries) with different green assets and operating in dissimilar regions. This makes comparing the bonds challenging to say the least, and the reputational risk for the issuer in making a mistake in the reporting could be considerable.

Whereas the US and Europe rely on voluntary guidelines and reputational incentives to retain the integrity of the market, some emerging markets (like China and India) have chosen a regulated approach, including a more prescriptive definition of what is green.

There are, however, concerns that a regulated approach, in which issuers might for instance face legal repercussions should environmental benefits not materialise as planned for any reason, could limit growth and diversity.

The GBPs have proven highly effective in promoting a transparent, diverse and flexible marketplace that is well suited for the evolving nature of the underlying assets, and that encourages growth yet also retains integrity. With continued strong growth in green bonds – and the assets they fund – this instrument will increasingly contribute to a more environmentally sustainable society.

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