Stopped in its Tracks

Mandatory EU Green Bond Standard risks slowing issuance, but a voluntary approach can still drive Taxonomy-aligned volumes.

On the face of it, the market for green bonds is heading in the right direction, and fast.

Issuance has risen sharply in recent years as new products have become an established part of a rapidly broadening sustainable fixed income landscape.

Green bonds – which fund projects that foster a net-zero emissions economy, protect the environment or improve resilience and adaptation to climate change – have become more prominent as issuers meet investor demand for strategies linked to sustainability objectives.

With political pressure building for more private-sector money to help reach targets set out under the European Green Deal, the European Commission (EC) is moving forward with its plans for a European Green Bond Standard (EUGBS).

Green bond issuance has climbed a sharp trajectory since the 2015 Paris Agreement, up from around US$40 billion that year to a record US$489 billion in 2021, according to Refinitiv. Yet green bonds still account for a very small proportion of overall bond issuance, which totalled US$9 trillion in 2021, a year during which overall sustainable bond issuance collectively passed the US$1 trillion mark for the first time.

Moody’s expects green bond volumes alone to reach around US$775 billion in 2022, as more issuers build sustainability strategies into their capital market plans.

“We believe the steady growth in global issuance will continue into 2022 as an increasing number of issuers seek to finance climate mitigation and adaptation efforts and advance their net zero commitments, while more sovereign issuers expand their green bond programs,” it says.

But with the US$104 billion issued in the first quarter of 2022 being 7% below the same period 12 months earlier, according to Refinitiv, it will become clear over the coming months whether the green bond market has hit pause or reached a possible plateau.

Rapid but insufficient issuance growth to date has intensified calls for more transparency and standardisation and some argue that the EU’s proposed standards are essential if the market is to reach the next stage.

Moving the goalposts

The European standards were formally proposed in summer 2021 as part of efforts to support the EU’s transition to a net zero economy and meeting the targets set out under the European Green Deal. The EC views a green bond standard as necessary in developing the green bond market by making it easier for issuers to raise funds for climate-focused investments.

Transparency and standardisation in the green bond market are currently met primarily by the International Capital Market Association’s (ICMA) Green Bond Principles (GBPs), which set out definitions and voluntary process guidelines for green bonds (the association has also formulated similar guidelines for social and other forms of sustainable bond issuance).

Under the GBPs, issuers are required to build a green bond framework composed of four main components: use of proceeds (i.e., they must finance or refinance green projects); process for project evaluation and selection; management of proceeds; and reporting (i.e., on allocation of funds to eligible green projects).

The proposed European standards are a further step in the right direction, says Joshua Palmer, Head of Sustainable Credit Research at investment consultants WTW.

“Current market standards do not adequately ensure transparency and accountability and there is no ongoing supervision of the issuer. The EU standards take steps to address all of these issues.”

Striking a balance

The new EU principles duplicate much of the ICMA standards, but with significant additional features.

One is the linkage between European Green Bond (EUGB) proceeds and the EU Taxonomy, whereby funds raised must be used to finance assets that are either aligned with the taxonomy or contribute to a transformation towards becoming environmentally sustainable within a defined period, as set out in a taxonomy-alignment plan developed by the issuer.

Investors with EU Taxonomy alignment thresholds that they can’t go below in their portfolio will have to gravitate towards EU Taxonomy aligned bonds to ensure their threshold is met. With the introduction of Sustainable Finance Disclosures Regulation alongside the taxonomy, asset managers are required to report on the extent of taxonomy alignment of their portfolios.

But linking the EU green bond framework to the complex definitions of what is classed as “environmentally sustainable” in the taxonomy may deter some issuers, according to Palmer. “The prescriptiveness of the contents of the green bond fact sheet, pre- and post- issuance reviews, allocation reports and impact reports that are set out by templates in the legislation could be overly onerous too.”

However, initial taxonomy-related disclosures by issuers are unlikely to provide asset managers or their clients with an accurate guide to portfolio alignment, says Isobel Edwards, Green Bond Analyst at Dutch asset manager NN IP.

“Since the other EU Taxonomy objectives are not finished and the companies have yet to be mandated to release their EU Taxonomy alignment this means that the investors are putting together their portfolio alignment numbers based on their own research, without the company’s official figures.”

The EC also proposes that issuers are subject to (pre- and post-issuance) disclosures to ensure full transparency on the allocation of proceeds and the environmental impact of the bond.

In addition, issuer disclosures should be assessed by external reviewers to ensure compliance.

Issuers identified by annual reviews to have missed interim targets could then lose the EUBG designation. However, clarity is needed on whether national competent authorities (NCAs) have the necessary powers to repeal the EUGBS where issuers have fallen short.

Nudge or push?

But the biggest debate concerns the question as to whether the EUGBS should be mandatory for all issues, or voluntary. The EC has proposed an initial voluntary period followed by a phased-in approach towards the standard eventually being mandatory. It believes a mandated EUGBS would help align the expectations of investors and issuers and improve the impact of green bond investments.

There has been considerable pushback here, however. This has focused mainly on the risk of excluding issuers from the market, particularly smaller operators that would struggle to meet the level of reporting and disclosures required. As it stands, just half the euro-denominated corporate and sovereign bond market is eligible for the EUGBS, according to Commerzbank.

“If the standards are made compulsory, they may be too onerous for some smaller issuers with less resources and therefore reduce access,” says Palmer. “Greenwashing concerns and additional credibility could be achieved by investors doing thorough due diligence on the green bonds.”

The ICMA warns that mandatory requirements would “lead to an unsustainable level of additional cost and liability for issuers, which would hinder the uptake of the label”.

A mandatory framework also lacks “any form of incentive to counterbalance the additional cost and liability being required from issuers”, the ICMA continues, resulting in some issuers turning instead to “other sources of European market or bank finance, or access sustainable finance from other jurisdictions”.

That would cause a contraction of the European sustainable bond market and “effectively end the current undisputed leadership of the EU in the international sustainable capital markets,” it concluded.

There is a clear trade-off here. While the EUGBS is designed to promote both issuer and investor confidence, Palmer warns that mandatory gold standards ultimately risk disincentivising engagement, noting that some issuers may be able to transition over time.

Supply and demand

The effect of the proposed EUGBS on issuance and take-up of green bonds will be shaped to some extent on the final rules, particularly in areas such as disclosures and reporting. The European Council agreed its position on proposals in April and “is ready to start negotiations” with the European Parliament on a final version of the text. Consultation is also ongoing with bodies including the European Central Bank, meaning final approval is unlikely before summer 2023.

The additional information already coming into the market will help to improve transparency and confidence in green bonds, says Edwards.

“From a green bond perspective, this will mean that aligned activities within green bonds will automatically be a preference if we are coming close to our portfolio threshold at any point,” Edwards points out.

In other words, investors will naturally lean towards EU Taxonomy-aligned activities even if the EUGBS remained optional.

The existence of a widely-recognised EU standard framework will make it easier for issuers to meet the requirements to issue green bonds, leading to greater issuance volumes, says Palmer.

“There is potentially a large number of companies who could issue green bonds but haven’t been able to do so yet due to a lack of agreement on what is required with regard to reporting and what counts as green economic activity.”

In particular, the linkage between the proposed standards and the EU Taxonomy may lead to some sectors coming to the market having previously been hesitant, according to Edwards.

“We already saw some manufacturing issuers coming to the market last year which met the EU Taxonomy climate mitigation objective’s technical screening criteria,” she explains.

“This isn’t a common sector for issuing green bonds, so we imagine that more of the same might occur with the advent of the EU Taxonomy and EUGBS.”

The EUGBS will also stimulate greater appetite among investors as they grow more comfortable with the standards, the reports, and a greater understanding of the environmental quality of the projects they are used to finance, says Palmer.

The success (or otherwise) of the EUGBS will be dictated not only by the rules, but by investors requesting EU Taxonomy information from green bond issuers to the point that they are able to meet the EUGBS before it is even set up, according to Edwards.

“We have found that the more we request it, the more issuers are coming to the market with EU Taxonomy assessments already done pre-issuance in their green bond financing frameworks or second party opinions.”

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