CAPITAL MARKETS GREEN BOND CHALLENGES CAPITAL MARKETS GREEN BOND CHALLENGES Critical challenges facing the Green bonds’ growing pains green bond market Green bonds are now in the mainstream. But the lack of contractual

Green bonds are now in the mainstream. But the lack of contractual protections, as well as issues with reporting metrics and transparency, risk protections, as well as issues with reporting metrics and transparency, risk undermining the market and the broader sustainable finance project undermining the market and the broader sustainable finance project

n the space of barely a decade, green bonds have gone from the periphery of the capital markets to being one of its fastest-growing n the space of barely a decade, green bonds have gone from the MINUTE segments. Green bonds are now used globally as a financing periphery of the capital markets to being one of its fastest-growing sIource for a wide range of issuers including green renewable energy MINUTE segments. Green bonds are now used globally as a financing READ sIource for a wide range of issuers including green renewable energy companies, sovereigns and supranationals, and brown corporate issuers READ In 10 years green bonds have seeking to transition some or all of their business operations. companies, sovereigns and supranationals, and brown corporate issuers 1gone from being an esoteric In 10 years green bonds have seeking to transition some or all of their business operations. Global green bond issuance in 2019 is projected to hit $200 billion 1gone from being an esoteric fringe product to being (against $167.3 billion in 2018). Green features have also expanded Global green bond issuance in 2019 is projected to hit $200 billion accepted and used in the across the asset class from vanilla corporate bonds to project bonds, fringe product to being (against $167.3 billion in 2018). Green features have also expanded mainstream of the international asset-backed bonds and covered bonds, with 2018 witnessing the first accepted and used in the across the asset class from vanilla corporate bonds to project bonds, capital markets. These green commercial paper programme. With the Paris Agreement and mainstream of the international asset-backed bonds and covered bonds, with 2018 witnessing the first instruments are critical in UN Sustainable Development Goals as the compelling double catalyst, capital markets. These green commercial paper programme. With the Paris Agreement and helping to bridge the massive and the UN stating that the world needs $90 trillion in climate instruments are critical in UN Sustainable Development Goals as the compelling double catalyst, investment gap required to investment by 2030 to achieve these, there should be no limit on the helping to bridge the massive and the UN stating that the world needs $90 trillion in climate meet the targets set out in the rise and use of green bonds. investment gap required to investment by 2030 to achieve these, there should be no limit on the 2016 Paris Agreement on However, there remain significant challenges and risks to the meet the targets set out in the rise and use of green bonds. Climate Change and the 2015 continued use and growth of the green bond market. These include 2016 Paris Agreement on However, there remain significant challenges and risks to the UN Sustainable Development inadequate green contractual protection for investors, the quality of Climate Change and the 2015 continued use and growth of the green bond market. These include Goals (see figure 1). However, reporting metrics and transparency, issuer confusion and fatigue, UN Sustainable Development inadequate green contractual protection for investors, the quality of there are several concerns greenwashing, and pricing. We describe these challenges below, and Goals (see figure 1). However, reporting metrics and transparency, issuer confusion and fatigue, which could undermine the suggest ways in which the green bond market can evolve to safeguard there are several concerns greenwashing, and pricing. We describe these challenges below, and credibility and evolution of the integrity of the asset class, make the instrument more robust from which could undermine the suggest ways in which the green bond market can evolve to safeguard green bonds as a much- an investor perspective, and enhance product transparency and credibility and evolution of the integrity of the asset class, make the instrument more robust from needed market product. These discipline for all market participants. green bonds as a much- an investor perspective, and enhance product transparency and include a surprising lack of needed market product. These discipline for all market participants. green contractual protection for include a surprising lack of investors, so-called Common terms and actionable rights green contractual protection for greenwashing, the quality of investors, so-called Common terms and actionable rights reporting metrics and There is no universally accepted legal and commercial definition of a greenwashing, the quality of transparency, issuer confusion green bond. Imitating the International Capital Market Association's reporting metrics and There is no universally accepted legal and commercial definition of a and fatigue, and a perceived (ICMA) Green Bond Principles, elements common across many transparency, issuer confusion green bond. Imitating the International Capital Market Association's lack of pricing incentives for standards include: (i) use of proceeds disclosure stating the cash raised and fatigue, and a perceived (ICMA) Green Bond Principles, elements common across many issuers. This article by Baker will finance new or existing projects that have positive environmental lack of pricing incentives for standards include: (i) use of proceeds disclosure stating the cash raised McKenzie lawyers discusses or climate benefits; (ii) ongoing reporting on the foregoing green use issuers. This article by Baker will finance new or existing projects that have positive environmental these concerns and presents of proceeds and (iii) the provision of a second opinion by an McKenzie lawyers discusses or climate benefits; (ii) ongoing reporting on the foregoing green use potential solutions. independent third party reviewer certifying the green aspects of the these concerns and presents of proceeds and (iii) the provision of a second opinion by an bond (see figure 2). potential solutions. independent third party reviewer certifying the green aspects of the bond (see figure 2).

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Figure 1 specifically highlight that no event of default Figure 2 Timeline of major developments or put event will be caused if the use of ICMA Green Bond Principles in the green bond market proceeds or reporting referred to elsewhere in the disclosure document are not complied • Published in 2014 and last updated in • 2007 EIB and World Bank issue first with. See figure 3 for an example of such June 2018 green / climate awareness bonds language. • Aim of the GBP was to strengthen the • 2010 The Climate Bond Initiative This provokes a dilemma. Bondholders integrity of the Green Bond market launches the Climate Bond Standard who are still being paid interest and principal • Voluntary market guidelines: not law or and Certification Scheme on time per the terms of the green bonds may regulation • 2014 ICMA publishes the ICMA Green be unable to show loss, and so may be unable • The GBP have four components: Bond Principles to have effective redress. A bondholder who is 1. Use of proceeds Typically similar to • 2015 UN Sustainable Development placed in breach of its own investment criteria “to finance and/or refinance, in whole Goals and 2030 Agenda for may be obliged to promptly sell in the or in part, eligible green projects” Sustainable Development secondary market and in so doing may incur 2. Process for project evaluation • 2016 Paris Agreement on Climate a loss. In the absence of express contractual and selection Varies based on Change – ratified by 170 countries provisions, sustaining a claim for that loss may individual nature of projects and • 2018 Green bond issuance hits $167.3 prove difficult. While clearly there are selection criteria billion reputational motivations to dissuade against 3. Management of proceeds In • 2018 EU Commission publishes action deliberate mis-selling by issuers, the fact some cases ringfenced into separate plan on financing sustainable growth remains that there is no contractual stick to accounts • 2019 Green bond issuance estimated to ensure that bonds sold as green remain green 4. Reporting Using external third-party be over $200 billion for their lifetime. This risks potential abuse, verifier, or can be self-reporting. • 2019 As part of EU action plan critical which could severely undermine the Generally reports published at least papers are published: credibility of the green bond market. An annually (e.g. on website of issuer). • guidelines on corporate climate- example of things going badly wrong for related information reporting investors is the high-profile case of the Mexico • classification system –taxonomy – Airport green bonds (see figure 4). for environmentally-sustainable Figure 3 economic activities Sample risk factor from a green • a voluntary EU green bond standard Reporting standards, metrics and bond prospectus for a bank • EU climate benchmarks and transparency issuer benchmarks' ESG disclosures Green bond reporting is built on two simple “Although the Issuer may agree at the pillars: (i) the pre-issuance use of proceeds Issue Date to allocate the net proceeds disclosure (which sits alongside and aligns of the issue of the Green Bonds However, the green bond market has with the second opinion report) used to sell towards the financing and/or developed in such a way that none of the the green bonds, and (ii) the also disclosed refinancing of Eligible Green Assets in above product-critical elements confer post-issuance ongoing reporting on the actual accordance with certain prescribed actionable rights on bondholders. This may use of proceeds. eligibility criteria as described under the have been understandable as the product's The ICMA Green Bond Principles do not Green Bond Framework of the Bank, it first steps were relatively non-confrontational outline what use of proceeds will be would not be an event of default under (and so easy for issuers to digest) to encourage considered green. This analysis is left to the the Green Bonds if (i) the Issuer were market growth. But as the market matures, issuer, its advisers, and the second opinion to fail to comply with such obligations or problems have arisen. Use of proceeds, reviewer. The current practice is to aver were to fail to use the proceeds in the ongoing maintenance or withdrawal of the compliance with a rather broad category of manner specified in this Offering published (and relied upon) second opinion published ‘eligible green projects’, confirmed Circular and/or (ii) the Second Party review and annual reporting are not often by the second opinion review as green. The Opinion issued in connection with the included as direct covenants in the terms and issuer then determines specific usage of the Green Bonds Framework were to be conditions of green bonds. Failures to use the cash proceeds raised. Issuers have their own withdrawn... ” bond proceeds for stated green projects (or criteria or definitions of an eligible green deliberate use for non-green purposes) and project, with varying levels of specificity and inadequate annual reporting (or simple non- detail. This results in maximum room to the EU Commission published a detailed compliance) are accordingly not events of manoeuvre for the issuer, with the investor taxonomy for environmentally-sustainable default or put events that would enable the then looking to the post-issuance reporting to economic activities which will assist issuers in noteholders to accelerate or redeem their see what its money was in fact used for. That describing their eligible green projects (which bonds in the event of breach. Nor are they is rather opaque, and can be a dissuading will be used in the voluntary, non-legislative step-up events, which trigger an increase in factor for an investor concerned that the use EU green bond standard – see the June 2019 the coupon payable by an issuer. Indeed, risk of proceeds does in fact match with their own EU Technical Expert Group on Sustainable factors in listed green bonds will often investment guidelines. While in June 2019 Finance Report on Green Bond Standard), it

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Figure 4 Figure 5 Mexico Airports: the green bond Post-issuance reporting that wasn't Reporting scope UoP Impact Both reporting reporting • Mexico City Airport Trust issued $6 billion of green bonds in 2016 and 2017 to finance the construction of a new Number of issuers Reporting 251 194 172 airport Non-reporting 116 173 195 • Exemplary green credentials: • Met ICMA GBP % reporting 68% 53% 47% • Second party opinion obtained from Number of bonds Sustainalytics Reporting 715 1,514 501 • Green instrument evaluations from Non-reporting 1,190 391 1,404 rating agencies Moody’s and S&P • In October 2018 the new government % reporting 38% 79% 25% halts construction of the partially-built Amount issued (USDbn) Reporting 223 219 186 airport, following a public referendum • Government launched a buyback Non-reporting 58 62 95 package, capped at $1.8 billion • Moody’s lowered its green bond % reporting 79% 78% 66% assessment from GB5 (highest) to GB1 Source: Climate Bond Initiative Study, March 2019 (lowest). S&P withdrew its green evaluation report. • Remaining outstanding bonds are “greenwashing is rampant” – and while this reviewers, disclosure reporting guidance, still technically labelled green, with was a reference to the corporate environment certifiers, index providers, industry bodies sustainability use of proceeds generally, green bonds are potentially tainted such as ICMA and the Climate Bond wording. by this. Some bonds are described as green Initiative and the increasing phalanx of active despite not actually following commonly buyside industry groupings focused on accepted use of proceeds/reporting sustainability). Many issuers are confused and remains to be seen whether this will have the requirements for green bonds, as outlined fatigued – especially those in the EU which intended effect of increasing transparency. above. With no single global standard or now have the entirely new overlay of the EU The strength of the second pillar reflects recognised legal definition, and the market action plan and a new EU Green Bond any weakness inherent in the first. While criteria based on voluntary compliance, it is Standard. Faced with this and the lack of another core limb of the ICMA Green Bond difficult to conclusively say if some bonds are demonstrable reward in improved pricing as Principles, post-issuance ongoing reporting is green or not, or indeed to assess their level of described below, it is understandable that not an area free of problems. Market practice greenness; hence the growing scepticism some issuers opt not to use the product, on frequency, the actual level of detailed around the greenness of green bonds. Is a despite its societal good and manifest public reporting disclosed, and statements of non- bond green because (a) the issuer asserts relations advantages. compliance all vary. A recent Climate Bond compliance with the ICMA Green Bond Initiative study (March 2019) found that only Principles, (b) it is included in a green bond 68% of green bonds in their study benefited index and/or (c) it has been confirmed as Pricing benefits of going green? from regular post-issuance reporting, with green by a third party independent second only 53% providing reporting on allocation / opinion expert review? As described further An increasing amount of institutional impact metrics (see figure 5) . While these above, the lack of direct investor protective investors have clear and established figures are significantly higher when the issuer provisions which make a bond green in the green/sustainable investment guidelines. This committed in its pre-issuance disclosure to eyes of the market leads to a significant risk of will only increase, especially for investors in providing ongoing reporting at a given greenwashing or related issues. the EU as buyside-directed regulation (such standard, it nonetheless illustrates the extent as reforms of the Alternative Investment Fund of the problem facing this market. Managers Directive and UCITS Directive Issuer fatigue and confusion proposed by the EU Commission) come into force. This considerable and growing buyside Greenwashing This essentially simple product is seen as demand has not yet clearly translated into overly complex to many issuers given the clear pricing differentials for green bonds Greenwashing, as a concept, refers to the multiplicity of criteria, the apparently versus equivalent non-green plain vanilla deceptive promotion of the perception that an overlapping roles of some market players, and bonds of the same issuer. Anecdotal market organisation's products, aims or policies are the dizzying and ever-increasing sets of rules, evidence suggests that any such primary environmentally friendly. In April 2019, the disclosure reporting guidelines and standards market discounts at issuance are marginal at head of the International Accounting with which they may need to comply (stock best. There appears to be a premium in the Standards Board stated publicly that exchanges, rating agencies, second party secondary market for green bonds versus

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equivalent plain vanilla issuer debt – however, would be ideal role models in incorporating that for sovereign bonds). Again, here, this is of little benefit to issuers who need the express green provisions in green bond advantageous risk weighting could be tied discount to be applied on the primary sale in contractual documentation. Professor directly to actionable green terms. In the EU order for them to reap any upside. This lack Rodrigo Olivares-Caminal of Queen Mary this could be implemented via amendments of obvious pricing benefit is not helpful for University of London notes: to the Capital Requirements Regulation issuers who are contemplating green bond "Public sector entities in many case (Regulation (EU) 575/2013). issuance but are daunted by the new process, have longer investment horizons than the new external parties involved, changes to short-term commercial issuers, often have their regular documentation platform, plus all political or explicit mandates to "do good" Buyside industry and activist the related expense. as well as achieve commercially viable groupings financing and benefit from connections to policy-makers". Industry bodies and investor action groups Improving the product: some core Once one or two such pioneering issuers such as Climate Action 100+, as well as large suggestions adopt these new best documentation market investors such as sovereign wealth practices, it is easier for others to adopt them funds and pension funds, are in a strong Given the urgent imperative of addressing as well – or look less green by comparison. position to drive development of this market. the Paris Agreement limits on global Investor recognition and the reward of good warming, it is our view that much can be green corporate citizens would strengthen done to ensure the ongoing success of green Product incentivisation green bonds as a dynamic capital markets bonds as a product (while not compromising product supporting genuine economic and their commercial and financial feasibility). Tax societal needs. To that end, we would suggest that as flagged above, options to strengthen the green bond Given the clear and urgent public policy market include: (i) incorporating the green imperatives issues at play, there has been Next steps use of proceeds and/or reporting provisions some discussion of policymakers providing directly into the terms and conditions of the clear tax incentivisation for green bond Time is short. Real concerns impacting green bonds, (ii) accordingly making them issuers and/or investors (aside from any tax bond credibility risk compromising the actionable via an agreed put event (we considerations at the level of the eligible sustainable finance project more generally, recognise that a related event of default will green projects). To date this has not come to with potentially serious consequences for all. be seen as too draconian and face too much fruition in any major jurisdiction, though Issuers who readily endorse the Paris resistance) and/ or (iii) introducing margin some related initiatives are extant in Agreement and the UN’s 2030 Sustainable incentives as a penalty for non-compliance. Singapore and Malaysia. Interestingly, one Development Goals (and recognise and reap Actionable green obligations will be more argument raised against such tax the positive public relations value of doing contractually onerous on issuers, who as incentivisation is precisely the fact that so) should be bold. This is a dynamic and highlighted above are already weary of bonds which are labelled green do not have evolving market. Embracing product conflicting and overlapping green bond any actionable contractual rights ensuring innovation and development with increased criteria and standards. However, the carrot that the proceeds will be applied in the investor rights, and supporting broader and in exchange for the right of action stick is disclosed green fashion. Thus the taxpayer deeper product incentivisation, works for all. that the investor community, which is may inadvertently end up subsidising a plain Issuers, investors, underwriters, regulators increasingly focused on green and sustainable vanilla bond. and governments/policymakers should all be investments, should reward issuers with This argument is easily surmountable by key players in moving the green bond market increased appetite and therefore lower providing tax incentives only in respect of in this direction. It is in everyone's collective pricing for such actionable green bonds. those bonds with clear actionable green- interest. If adopted, such a green bond would not focused legal terms or, alternatively, by constitute the first time that green provisions having back-ended tax benefits when the were made contractually operative in the bond is at maturity and its greenness and sustainable finance space. Green loans more compliance with its disclosed purpose can be frequently have enforceable green covenants evidenced. This would have the dual effects – and a substantial number of green loans of bolstering the green bond market and Michael Doran reward the borrower with improved margins helping to support clear public policy Partner if the borrower can prove it has met certain objectives (i.e. practical implementation of Baker McKenzie, London objectives linked to green or sustainable the objectives of the Paris Agreement). michael.doran@ principles. bakermckenzie.com As with any capital markets innovation, prospective corporate issuers may be Investor risk weighting James Tanner understandably reluctant to be first movers. Senior associate But governments, supranationals and Investor-friendly reforms have been posited Baker McKenzie, London sovereign wealth funds (many of whom have in the area of bond risk weighting to james.tanner@ already embraced green bond financing) advantage green bond investors (mimicking bakermckenzie.com

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