The evolving green bond landscape

"Investing in green bonds is investing in our planet's future. It is a step towards ensuring that our children inherit a world that is healthy and thriving."

Mary Robinson, former President of Ireland and climate justice advocate

The green bond market has surged to unprecedented heights, hitting a landmark US$1trn in cumulative issuance by December 2020. Although the first green bond was issued by the European Investment Bank in 2007, the market truly took off in 2014. Driven by increasing regulatory support and investor demand for sustainable finance solutions, the green bond market reached US$100bn in cumulative issuance in 2015.

Figure 1: Growth in green bond market issuance

Source: Bloomberg, in US$bn

Since then, green bonds have become a mainstream financial product, crucial for climate finance and for achieving Paris Accord goals. Today, green debt instruments from more than 67 nations help to fund projects with significant environmental benefits.

According to the International Capital Markets Association (ICMA) 2018 report, green bonds are any type of bond instrument where the proceeds will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible green projects (such as renewable energy, clean transportation, climate change adaptation etc), and which are aligned with the following core components, also known as the Green Bond Principles (GBP):

1. Use of Proceeds

2. Process for Project Evaluation and Selection

3. Management of Proceeds

4. Reporting

Although this definition aids both institutional and individual investors in identifying what qualifies as a green bond, there is an important piece that we have overlooked so far. The ICMA report states that the Green Bond Principles are voluntary process guidelines, and there is no legislative power held by the agency over green bond issuers. This fact significantly complicates the instrument selection process, and potentially allows issuers to greenwash their projects and financial instruments.

To tackle this limitation, the Climate Bonds Initiative (CBI) was a pioneer in developing a classification and certification for the assets, activities, and projects needed to deliver a low-carbon economy. The resulting Climate Bonds Taxonomy (CBT) and Climate Bond Standard (CBS) are consistent with the goals of the Paris Agreement and are based on the latest climate science and the input of hundreds of technical experts from around the world. As of 2023, the following sectors (including assets, entities, sustainability-linked debt, and use of proceeds debt) are fully certified by the CBI:

The extended list of certifications, including partial, limited, and intended certifications, can be found on the Climate Bonds Initiative website.

It is worth noting, that despite the CBI’s efforts, as of 2023, certification against its standard represented only about 20% of global green bond market volumes. The lack of harmonised rules for evaluating and monitoring environmentally sustainable bonds, as well as diverging definitions of environmentally sustainable activities, make it increasingly difficult for investors to select bonds and issuers. The international nature of the green bonds market required action from governing bodies.

The European Union was among the first to develop a green bond standard – and although it only concentrates on the internal market, its actions could potentially reduce the risk of fragmentation of the external review services. The policy talks started in 2016, a year after the market reached $1bn in cumulative issuance, and the legislative standard was released in 2023.

The regulation ruled out the terms of use of ‘European Green Bond’ (EuGB) as an instrument name, and a list of requirements for the issuers should they wish to adopt this definition. For example, the issuers of green bonds must complete the European green bond factsheet, provide, until the proceeds are fully invested, an allocation report every twelve months and publicise an environmental impact report on the use of the funds. Failure to adhere to the regulation may result in administrative penalties, which include official public statements, an order to cease the conduct, prohibition from issuing EuGB in the future, and fines up to €500,000. The bonds issued for synthetic securitisation cannot be termed EuGB, however, securitised exposures may be used to finance electricity from fossil fuels or the co-generation or production of heating/cooling and power from fossil fuels, provided this meets the ‘no significant harm’ test.

It is no surprise that the EU was one of the pioneers in regulatory oversight of the green bond market, as it tends to have European bias (over US$640bn in issuance since 2014). However, the trend is slowly shifting. In 2023, the country that issued the highest value of sustainable bonds (both government and corporate) was the United States, with almost US$100bn of fixed income debt issued. China was second, with nearly US$90bn, then Germany with US$74bn.

Figure 2: Green bond issuance by region

Source: Bloomberg, in $bn. EMEA: Europe, the Middle East and Africa; AMER: AMER: North, Central, and South America; APAC: Asia and Pacific; SUPRA: supranational bonds (Supranational bonds are typically highly rated debt securities issued by international organizations like the World Bank and the European Investment Bank, backed by multiple nations and considered safe investments)

Similar to regular bonds, green bonds owners receive periodic coupons and get back their initial investment upon maturity. Compared to the aggregate bond market, green bonds on average tend to have longer duration and lower maturity, especially in the corporate sector, suggesting lower bias between the greet and conventional market.  Another key feature to keep in mind is the ‘green premium’ – green bonds tend to be priced higher than regular bonds, which can result in smaller coupon payments.

Of course, like with every financial instrument, investing in green bonds exposes their holders to various types of risk. Not only are green bonds still exposed to ‘traditional’ types of risk like geopolitics, issuer bankruptcy, or lack of liquidity on the market – there is also an array of specific risks that come with the label ‘green’. For instance, due to the absence of a globally accepted framework for issuing green bonds, some issuers may engage in ‘greenwashing’ by channeling investors’ funds into projects that are less than sustainable.

On a positive note, green bonds are often issued by governments or reputable institutions, which signals lower risk compared to other bond types. As we have discussed earlier, some of the world authorities have set regulatory reporting and overall transparency requirements for companies and governments to issue green bonds. There is also lower bias in the green bond market, suggesting it offers some protection against minute market shocks. With the green bond market maturing, and investors gaining confidence in sustainable finance, society may finally take steps to ensure that our children inherit a world that is healthy and thriving.