Policy Solution Green Bonds

23 July 2020
Climate Analytics



Climate change poses one of the major challenges of our times imposing threats and opportunities that significantly affect the economy and the financial sector in Europe and across the globe. Achieving the transformation towards a 1.5°C world requires a major shift in investment patterns, among other initiatives (de Coninck et al., 2018). The alignment of the financial sector towards 1.5°C pathways would require significant upscaling in climate-aligned finance and a major reallocation of the investment portfolio (Rogelj et al., 2018). The need to redirect financial resources towards low-carbon pathways is even more relevant in the current context. The COVID-19 pandemic is presenting unprecedented challenges for every sector, institution and government. At the same time, one of the few silver linings from this crisis is that it opens the opportunity to rethink the way we develop our economies.

The necessary investments and portfolio reallocation towards 1.5°C pathways would require encouraging new potential sources of finance and new financial tools, that bring the necessary resources, both from public and private sources, to drive the transformation across all economic sectors towards low-carbon development. Green bonds have emerged as a relatively novel financial and environmental instrument capable to raise capital for green projects that are being financed or refinanced while obtaining positive financial returns and environmental impacts. However, green bonds also face some challenges and risks of not delivering the expected environmental and economic positive outcomes

Green bonds are debt security instruments in a form of fixed-income investments issued by any organization with bonding authority, such as any other bond, except that proceeds are exclusively applied to finance or re-finance green projects or assets (ICMA, 2018). A green bond can be issued by governments (national, states, or provinces and municipalities); supranational entities such as multilateral development banks (MDBs), and corporate entities or private companies and organizations. Investors or debt holders loan money to the issuer at a fixed interest rate (coupon) for a defined period (maturity). One characteristic of a green bond is that issuers must disclose financial information to regulators, rating agencies, and investors on how the money invested is allocated in green projects (WB, 2015). As with regular bonds, green bonds can be publicly traded or traded over the counter depending on the type of market (primary vs secondary) and the liquidity of the bond. The primary market refers to the market where securities are created, while the secondary market is one in which they are traded among investors once the bond was purchased from the issuer (Weber & Saravade, 2019).


Different narratives surrounding green bonds


We have identified four categories of main narratives that represent a specific rationale and in which two narratives are embedded.

Financial narratives

Under these narratives, green bonds are defined as a financial product that must bring positive financial returns and portfolio diversity as well as additional reputational features that can benefit primarily the investors and the issuers. Under this category the main rationale is profit maximization, therefore financial performance and risk associated with green bonds in comparison to their classical counterparts are the two main narratives for green bonds to succeed in the financial markets. We found that there is no conclusive evidence that green bonds have a lower financial return when they are issued in the primary market and pricing differences in the secondary market are not always significant and still associated strongly with the issuer’s credit rating. With regards to risk, green bonds are a standardized asset class that carries both environmental and financial risks in a particular manner and its risk “infrastructure” presents particular challenges of risk and how it is originated, partitioned, distributed as additional actors are involved in comparison with traditional regular bonds.


Environmental narratives

Under these narratives, green bonds are assessed according to their potential to generate genuine positive environmental impacts regardless of their financial performance. The risk of greenwashing is often cited since there are historical precedents in the green bond market that when the market was left unchecked, self-regulation, at times, proved insufficient to ensure the integrity of green projects or projects that were genuinely green presented social and environmental controversies such as land use rights conflicts and biodiversity trade-offs. Other environmental narratives focus on measuring the direct environmental impact of green bond investments. We found that despite recent efforts in setting a harmonized impact framework, impact reporting still shows strong limitations. On one hand, there is just consensus about measuring and reporting the project’s emission reductions. Additional information about other benefits or trade-offs in projects still shows a significative difference in methodologies, approaches, interpretations, and sector-specific and project-specific criteria that render comparability extremely difficult. Furthermore, some environmental impacts are difficult to assess such as biodiversity where there is a lack of consensus on definitions and impact measurement methodologies. On the other, green bonds have shown low capacity to finance projects targeting intangible assets such as regulating ecosystem services where markets are not developed. It is important to mention that the EU-GBS considers additional criteria in impact reporting such as the “do not significantly harm” (DNSH) principle that allows a more comprehensive impact assessment.


Complementary and competing policies narratives

From these narratives standpoint, policies are crucial for the green bond market to develop. They can create the appropriate incentive framework to trigger the market or, on the contrary, they have the potential to impose barriers and bottlenecks. On one hand, complementary policies can address directly the green bond market establishing incentives that go in line with the nature of the transaction between issuers and investors. We explored three direct policies that the EU can set in place: Direct subsidy bonds, where bond issuers receive cash rebates from the government to subsidize their net interest payments; tax credit bonds, where bond investors receive tax credits instead of interest payments and tax-exempt bonds. And finally, additional policies such as carbon price can have a positive effect on green bonds as it discourages investments in carbon-intensive capital assets and facilitates low-carbon investments by making them relatively cheaper. On the other hand, some policies can set barriers to the green bond market to develop. One key competing policy is fossil fuel subsidies. The EU still supports fossil fuel subsidies with approximately €112 billion on average per year. This is one of the main sources of policy inconsistency with global climate goals entailing negative socio-economic and environmental effects. It is urgent to address the numerous mechanisms in the EU that have facilitated the support for fossil fuels which include financing facilities, funds, and policy tools since removing subsidies may be equally essential as providing direct support to the green bond markets (Rudebusch, 2019).


Transformational narratives

Under these narratives green bonds have the potential to be a powerful instrument to catalyse the necessary transformation in the financial sector and allocate resources into low-carbon projects/economy that, additionally, accelerate decarbonization strategies in the political, social and technological spheres. The potential of green bonds in transforming the financial sector or in making a real contribution in the investment needs towards a 1.5°C global pathway would depend on their capacity to enable additional new capital to flow to green assets and projects that would not otherwise get financed. We explored three types of additionality: First, if finance allows projects to overcome high initial cost burdens. Second, if the projects are directly financing untested technology and third, projects that could be commercially viable but the high political risks in the region/country deter private investors. Green bonds have shown a limited potential to finance projects under the first two types of additionality, however, we observed some evidence of the third type of additionality as green bonds have served to finance projects in developed countries with relatively higher risk and emerging economies.


Are green bonds feasible, desirable and viable at a large scale?


Following a Quantitative Storytelling framework, we analysed if green bonds are feasible, viable, and desirable at a large scale in their relation with WEF nexus. Our results are as follows:

Green bonds are feasible but face two main limitations. First, the green bond market and its scale-up can be affected by past and present investment decisions allocated in assets or projects that are not consistent with climate target goals. These investments would create stranded assets increasing the cost of the necessary transition towards 1.5°C pathways and affecting the available financial resources that could be potentially directed towards green bonds issuance or investment. Second, the green bond market is embedded in financial systems with a high degree of complexity as they are interdependent and interconnected systems. This complexity can trigger processes that develop outside of human control such as some of the past economic crises. These two feasibility limitations can be somewhat addressed through an effective regulation and governance that supports a full scope alignment of the financial sector towards 1.5°C pathways.

Green bonds are viable under the condition that governance regimes ensure input and output legitimacy. We analysed different governance regimes in the green bond market according to their prescriptiveness and inclusiveness since studies found a correlation between these two features and input and output legitimacy in governance regimes. We found that the EU-GBS emerges as the most inclusive and prescriptive governance regime, however, it is fundamental for the viability of the EU-GBS to address two main concerns. First, it must act as an umbrella governance framework to avoid market fragmentation that may lead to incoherent or conflicting regulatory mandates, uncertainty among market participants, decreasing levels of compliance and high levels of competition between different governance regimes. Second, additional activities under the EU-GBS such as mandatory verification will add significant additional costs and it could trigger a “race to the bottom” for issuers incentivizing the adoption of a “cheaper” option for certification unless complementary policies such the ones explored in this deliverable are set in place. Furthermore, green bonds are viable under circumstances where they can overcome key economic and technical barriers such as the lack of green projects and unbalanced regional development where green bonds show viability limitations in high-risk financial markets and low-income countries as their local debt markets are still underdeveloped. Additionally, green bonds show limited viability to finance projects outside the renewable energy and energy efficiency, transport and building sectors due to the difficulties to turn intangible assets such as ecosystem services and biodiversity into a commodified form.

Lastly, in terms of desirability, we found that green bonds are desirable for society at large if they do not jeopardize or impose trade-offs in the water-food-energy nexus. In general, green bonds have shown positive environmental and social impacts; however, some projects financed via green bonds, have presented important controversies that should be assessed, especially in developing countries and/or in emerging economies. Finally, as a financial instrument, green bonds are desirable to the extent that they become a transformative factor of the financial system towards the 1.5°C pathway, this requires green bonds to generate profit enough to be competitive with similar financial instruments, as financial markets are driven by a “positive return” rationale.


Results and conclusions


We found that there is no concrete evidence that green bonds are a less attractive financial instrument in terms of their financial performance. We found mixed results about yields and the existence of a premium in the green bond issuance. There is evidence that the demand for green bonds is increasing as investors are oversubscribing green bonds. Additionally, green bonds have a particular risk structure where additional actors (compared to conventional bonds) are involved.

We found that as some projects show potential risk of greenwashing there is a lack of clearness on what activities enable the transition towards climate neutrality could lead, on one hand, to the exclusion of brown assets to phase-out more promptly and, on the other, to incremental changes on efficiency and delay the transformation. Additionally, we found that the particular risk structure of the green bond market can unfold potential risk of greenwashing from risk transfer and partition between verifiers and issuers since they are business model stewards, incentives in the “issuer-pays” business model represent a potential conflict of interest, where verifiers are driven to retain issuer-clients in order to gain market share rather than comply with the reporting/verifying mandates. Finally, we found that the environmental impacts of green bond projects are not standardised showing a significative difference in methodologies, approaches, interpretations, and sector-specific and project-specific criteria that render comparability extremely difficult. Despite recent efforts to create a harmonized impact framework reporting, there is just consensus about measuring and reporting project’s emission reductions.

Complementary policies are necessary for the success of green bonds. Direct policy interventions in the green bond market can be applied either to the demand side or the supply side of the green bonds. Additionally, we explored complementarities with carbon price as they set the right incentives to allocate investments into green projects. From the competing policies side, we found that mainly incoherence between climate goals and fossil fuel subsidies as they discourage investments in carbon-neutral technologies lowering the cost of carbon-intensive technologies, influencing investors’ behaviours and expectations, and preventing them to correctly price risks and returns associated to different energy technologies and investments.

Green bonds have shown additionality in projects that could be commercially viable but the high political risks in the region/country deter private investors, mainly in emerging economies with B risk categories such as India, Mexico, Turkey and Brazil and developed countries with comparatively higher risk such as Spain and Greece. In terms of the financial system alignment to article 2.1(c) of the PA, we found that the recent EU-GBS expands its scope considering activities that do not significantly harm other environmental objectives, however, the full scope of the financial system alignment still incomplete.

With regards the recent EU developments in the green bond market, we found that the EU is one step ahead in the green bond market with its EU Sustainable Action Plan, and two key actions the Taxonomy and the EU-GBS as they address two main concerns in the EU green bond market. First, it will clarify and provide a standardized definition of what is green. Second, it will enhance the harmonization of the varying quality and extent of external reviews with a centralised accreditation scheme for external verifiers (EU Technical Expert Group on Sustainable Finance, 2020).

However, there are still challenges reviewed in this deliverable to effectively adopt and scale-up this instrument. First, the EU-GBS must act as an umbrella governance framework to avoid market fragmentation that may lead to incoherent or conflicting regulatory mandates and higher uncertainty among market participants, decreasing levels of compliance and high levels of competition between different governance regimes. Second, it must ensure that additional activities such as mandatory verification do not add significant additional costs in order to avoid a “race to the bottom” for issuers incentivizing the adoption of a “cheaper” option for certification.


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