Green bonds – the state of play

Green bonds have been a hot topic in recent times for capital markets lawyers and environmental lawyers alike. Green bond issuance exceeded $47bn in 2015 and, if this year’s trends continue, 2016 could potentially reach upwards of $60bn.

As the market continues to grow, so too will demand for lawyers with specialist green bonds expertise.

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The rapid growth of the green bond market might in part be down to the ‘Paris Agreement effect’. History was made in December 2015 when, for the first time, 195 nations agreed to take collective action to limit the increase of average global temperatures to well below 2 degrees Celsius (the ‘2° Target’).

Meeting the 2° Target is expected to cost more than $12 trillion over 25 years according to a report by Bloomberg New Energy Finance and Ceres (“Mapping the Gap: The Road from Paris“, January 2016). Climate finance and green bonds in particular are expected to play a crucial role in scaling up private sector investment to meet this cost.

What is a green bond?

There is no regulatory or universally accepted definition of green bonds. However, they are generally accepted to be any type of bond instrument where the proceeds will be predominantly applied to finance or refinance new or existing ‘green’ activities or projects, e.g. in areas such as renewable energy, energy efficiency, sustainable waste management, sustainable land use, clean transportation, climate change adaptation, etc. The list of sectors is still evolving. The broad requirement of using the bond proceeds for ‘green’ ends is the chief differentiator from ordinary bonds.

Although there are many type of bonds, green bonds broadly fall into two categories: green corporate (‘use of proceeds’) bonds, which are not linked to particular green projects, give full recourse to the corporate issuer and are backed by the issuer’s balance sheet; and green project bonds, which are non-recourse to the issuer and are backed by the credit rating and cash flows of an underlying green project or portfolio of projects.

The opportunities and risks vary between these two types. Green corporate bonds are generally seen a less risky from an investor perspective, but arguably there is greater opportunity now in the green project bonds sector.

What are the current market trends?

There is currently a real sense of momentum and optimism in the global green bond market; initially led and developed by the multilateral development banks (MDBs) and international financial institutions (IFIs) but now actively promoted, sponsored and supported by the private sector. The demand for green bonds is currently investor-led and the supply is mostly from MDBs/IFIs, corporate issuers and, to a lesser extent, banks themselves. If anything, at the moment, there is a lack of good corporate issuers to supply current investor demand.

2015 saw a number of high profile issuances, including the $1.5bn Apple corporate green bond issuance, dedicated to financing clean energy projects across its global operations. This has continued in 2016, with issuances by Toyota to fund consumer purchases and leases of energy efficient vehicles (£1.6bn), and by the manufacturer of London’s black cabs, to finance the development of zero emission vehicles ($400m).

China has been particularly active in 2016 following market reforms to develop its domestic green bond market, with RMB 34 billion of issuance in the first quarter alone, (against a target of RMB 300 billion annually).

What are the current challenges for the green bond market?

One key challenge is the divergent interpretations as to how ‘green’ is defined. In response to this lingering lack of concrete definition, third party groups have emerged to track issuers for the life of green projects and initiatives, thus keeping them accountable for certain standards. Further, financial services firms acting as underwriters have drafted and supported the Green Bond Principles, which serve as voluntary guidelines encouraging increased transparency and disclosure.

From an investor perspective, it is very hard at present to assess the ‘green’ credentials of one green bond, subscribing to one set of principles, as compared to another green bond that subscribes to a different set. This makes the development of a liquid secondary market in green bonds harder and raises the echo of past comments about green bonds not yet being ‘mainstream’.

This has led some to call for a more standardised approach toward defining the green market to be adopted. It remains to be seen whether this will happen through regulation or through voluntary standards, as has been the case to date.

Despite the challenges, it will be interesting to watch the market continue to grow and evolve, and to see if green bonds really can play a pivotal role in bridging the climate financing gap to meet the 2° Target.

Peter Zaman is a partner and Adam Hedley is a senior associate at Reed Smith.