The EU Sustainable Finance Strategy also supports the achievement of Paris Agreement’s ambitious goals and the European Green Deal, but authentic impact investors must take heed. While benefits and advantages exist, so do loopholes and risks. Find out our thoughts on the so-called ‘gold standard’ for green bonds.
Benefits and advantages
In our opinion, there are three clear benefits of the European Green Bond Standard.
- Clearer definitions
Clear definition and a common standard for green bonds are provided. Currently, the market for green bonds is self-regulatory and any issuer can label a bond as green. The current commonly used standards, the ICMA Green Bond Principles and the Climate Bonds Standard, do not share an agreed definition. By linking the EU’s Green Bond Standard to the EU Taxonomy Regulation an asset class with a clearly defined set of activities is created.
- No more window dressing
The risk of window-dressing will be mitigated because a pre-issuance and post-issuance review by an independent party is necessary. Proceeds will no longer be able to finance non-green activities, unlike the current situation where the proceeds of some green bonds are used to finance fossil-fuel infrastructure. Another upside is that evidence suggests externally reviewed green bonds can realise larger reductions in carbon emissions.
- Improved comparability
A fixed template for reporting is proposed. This will help investors assess reports more efficiently and improve the comparability between (the impact of) bonds.
Loopholes and risks
As currently drafted the Green Bond Standard has several loopholes and risks that authentic impact investors should pay close attention to when making investment decisions.
- Potential lack of impact
A feature of the EU Green Bond Standard is that issuers must provide information about how the green bond aligns with their broader environmental strategy. This means that the green bond only contributes to positive change when it improves the issuers' environmental performance. However, this obligation is not specific enough and as a result, there is no guarantee that the proceeds of the bond(s) will create their intended impact. This loophole could be corrected by requiring the issuer to use the proceeds to help green its main activities.
- Risk of zero-sum game
As currently proposed, the Green Bond Standard creates the risk of a zero-sum game, where the environmental benefits generated by the green bonds are offset by other parts of the issuer's business, or 'impact' pockets. This risk could be overcome by applying minimum requirements for the issuer in terms of environmental performance (improvement).
- Risk of lack of additionality
Green bond proceeds can be used to finance existing (old) projects, so the green bonds are merely a cheap re-financing tool and the issuer's balance sheet doesn't become any greener. This could be overcome if the Standard specifies a maximum lookback period (preferably less than 24 months) for eligible projects. For investors who want to minimise this risk, the reporting requirements are also not helpful. Issuers are not required to specify the finance versus refinance ratio of projects and (financial) issuers that apply a portfolio approach need only provide limited information about the developments of their portfolio. As a minimum requirement, the reporting should provide full transparency on the finance versus refinance ratio.
- Lengthy look-forward period - Interestingly, the proposed Standard allows a period of five years for the proceeds to be fully allocated and even longer if the issuer provides justification. It only needs to specify how the unallocated proceeds will not affect the delivery of environmental objectives, which means that for as long as the proceeds are not allocated, no positive impact can be realised. This look-forward period is too long because in practice, issuers start building a portfolio of projects before issuing a green bond to ensure that the proceeds can be quickly allocated. A maximum look forward period of one year would provide sufficient flexibility.
Investors should stay alert
Overall, the proposed EU Green Bond Standard is a step in the right direction. There are benefits, however if the bonds are issued without authentic intention there are risks to investors of investing in greenwashed bonds. Investors, particularly those who want to create positive impact and a more sustainable economy will need to continue to carefully assess (the quality of) green bonds beyond the EU Green Bond Standard.
Also read Rosl's article about the EU taxonomy, or the interview with Hadewych Kuiper about the EU Sustainable Finance Disclosure Regulation.