The Economist explains

What makes bonds “green”?

Simply using the proceeds for environmentally friendly investments is not enough

By K.K.

THE market in “green” bonds, which tie the capital raised in bond issues to environmentally friendly investments, is growing. A decade ago total issuance from municipalities and multilateral development banks was worth just a few hundred million dollars annually. In 2016 issuance reached $97bn according to SEB, a Swedish bank. This year, it says, that number could hit $125bn. Green-bonds issuers now range from banks and companies to sovereign states. On the demand side, various sorts of investors, like asset managers and insurers, are buying such bonds. Some are setting up dedicated funds to invest in them. What makes a bond green?

The incomplete answer is that green bonds are green because the proceeds are used to fund green projects such as clean energy (financing construction of a wind park, for example) or transport (financing a new tram line that will take cars off the road). But definitions of what counts as “green” vary. In the market’s early days, the judgement was left to the issuers themselves. So the World Bank’s environment department ruled on projects financed by the green bonds it issued. Even some of the first private issues, like one from Toyota in 2014, were self-declared as green.

As the market grew, self-reporting was no longer tenable. Now, bonds are accepted as green if, within certain broad rules, an external reviewer has signed off on the bond issue in question. Over 140 of the world’s largest banks and asset managers have signed up to the Green Bond Principles, broad guidelines that provide a common definition of greenness, stipulate reporting on the use of funds raised and recommend external review. The Centre for International Climate and Environmental Research in Oslo (CICERO), a Norwegian climate research institute, is one of the largest providers of external review on green bonds; certification by the Climate Bonds Initiative (CBI), an NGO, is another option. Second opinions from private firms, such as environmental consultancies or large auditors, have also grown more popular. The criteria are often very narrow: for example, some geothermal plants can release as much carbon dioxide as coal-fired ones, from CO2 dissolved in the water itself or freed from the rock in the drilling process; the CBI therefore only certifies geothermal plants that mitigate this problem.

The current set-up still has flaws. One is that standards are proliferating: China’s central bank, for instance, has drawn up its own standards for the Chinese market that differ from international ones, and India is working on its own rules. The Principles are vague, and external review methodologies vary greatly. But perhaps most significantly, the external review process is blind to nuance, providing binary yes/no judgements. That is starting to change. Credit-rating agencies such as S&P Global and Moody’s have recently launched green-evaluation services that grade bonds on a scale of greenness, like their conventional credit ratings. Such a system, if it wins market share, should help environmentally friendly investors better decide how to allocate their money.

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