Green Bonds Standards – Creating a Market for Green Lemons?

by | Jan 2, 2018 | Uncategorized

Editor’s note: We were privileged to have Andrew Zaduban working at Autocase for the last 8 months. Andrew is a student at Wilfrid Laurier University enrolled in the Master of Arts in Business Economics (MABE) program and he has just returned to complete his degree. Andrew wrote this guest blog:

In 1970, George Akerlof published a paper called “Market for Lemons: Quality Uncertainty and the Market Mechanism” where Akerlof challenged the market for used cars. Akerlof analyzed a scenario where a buyer wants a used car, but cannot distinguish between a lemon (a poor-quality car that won’t last long) and a peach (a good quality car that will last long) – however, the seller can distinguish the quality of their car. In short, due to the buyer’s willingness to only offer the average value of both car types (lemons and peaches) the peaches will slowly exit the market as they are not offered a fair value until there are only lemons left. Could the same effect happen in the green bond market?

In 2015, the Province of Ontario committed $13.5 billion for rail improvements through the GO system, known as the Regional Express Rail (RER) program. RER was selected as a green project to receive funding from Ontario’s second Green Bond issue.

Global green bond standards, such as the Green Bond Principles and Climate Bond Initiative certification, if applied as a one-size-fits-all minimum checklist, will have the same effect as a good paint job on a lemon car… green investors will have no view into the real inner-workings of the green investment, will only want to pay the same for a peach as a lemon, and will potentially drive green projects with higher cost, but greater environmental return, out of the market.

How could such an seemingly attractive and fast-growing market suffer this problem? A little background on green markets will help to explain.

Growing Green Bonds

Green bonds are fixed income securities whose proceeds pay for projects that have social and environmental objectives. From the investor’s side, these fixed income securities provide a hedge against investments that may perform poorly as a result of climate related damages. For issuers, green bonds attract a wider investor pool from non-traditional investors, helping issuers raise more capital as green bonds serve as a philanthropic medium for environmental, social and governance (ESG) investors to reach corporations looking to push a sustainable agenda.

Market growth reflects both strong demand and supply for green bonds. The first issuance was in 2007 by the European Investment Bank (EIB) and World Bank. There was not much attention paid until the first corporate green bond was issued by the International Finance Corporation (IFC)- an offering which sold out within an hour in March, 2013. Over US$100 billion in green bond issuances have already been issued in 2017. This is a considerable, five-fold growth from less than US$20 billion in 2013.

Clearly the green bond market is receiving a lot of investor attention. The Climate Bond Initiative (CBI) found that, from January 2016 to May 2017, green bonds had a smaller bid-ask spread than other corporate bonds – a reflection of the supply and demand. In addition, green bonds performed well on the immediate secondary market by outperforming the market within the first 28 days of issuance. Ehlers and Packer (2016) find similar results in their analysis of green bond indices’ risk-adjusted financial performance over a comparable broad bond market index.

Green Train

The market seems to be on a never-ending path of growth. This growth could be attributed to the attention typically received by a new financial instrument, however, the rhetoric is clearly changing from the investor side. Global holding of assets characterized by their responsible investment strategies has increased by 25% since 2014. Almost all issuances to date have been oversubscribed, which is a testament to green bond demand. Investors want more out of their investments than financial returns.

However, in order to signal to investors that they really are investing in debt that is being used for sustainable/green investments, the market needs regulation. Regulation in this case is to avoid what is coined in the industry as “greenwashing”.

Greenwashing Produces Green Lemons

In short, greenwashing is when you claim something is green – when it is not – in order to collect the benefits of being green. How might greenwashing may play out in the green bond market? An issuer claims to be green so that they can tap into the wider investor pool and potentially raise more than they would had they not claimed to be green, but without spending their raised debt on green investments. This type of greenwashing is more likely to be seen in our current interest rate climate. With tighter prices and lower yields, there’s even more incentive for issuers to greenwash. The last thing the market needs is concerns about the credibility of the environmental benefits that are at the heart of the market incentive.

Green Waste, Waste that is Green, or a Waste of Green?

To add even more layers, greenwashing does not have to be black or white. A good example is set out in The Economist where China issued a green bond for “green coal”. How can any form of coal be considered green? Or can it be regarded as a green investment against the base case of regular coal? Those are trivial questions. That’s why the market needs guidance as to what constitutes a green investment.

Global standards (namely, Green Bond Principles and Climate Bond Initiative certification) are widely adopted and enforce due diligence within the market, however, the standards are not granular enough. These standards are only a “paint job” checklist of what constitutes a green investment.

What these rigid standards do is create a market for green lemons. Issuers don’t have incentive to be greener than the checklist requires. Issuers who are more green will be squeezed out of the market as they fund costlier investments than those who barely squeeze by on these regulations. Also, if these greener investments want to signal to the market that they qualify as “more green”, they need to incur even more costs through a second opinion (which is not uncommon in the market).

On the other side, investors often cannot know the green capacity of investments unless a second opinion firm spells it out for them. How will investors be able to identify the green peaches over the green lemons? The Akerlof analogy aside, what will happen in theory is that green bonds will be gravitate to the cost-effective, environmental minimum. This market friction is costly – it comes at the expense of the earth’s future.

Greener Peaches with TBL-CBA

There is a better solution than green standards alone to remove the veil of greenwashing and surface the true value of green bonds. It’s called Triple Bottom Line Cost Benefit Analysis (TBL-CBA), and it is the practice of quantifying the financial, social and environmental impacts of investments. TBL-CBA is the solution to avoiding a market for green lemons. It provides incentive for issuers to invest in projects with more capital expenditure but more realized social and environmental benefits. It allows investors to be objective and make informed decisions by seeing which bonds will be used to finance the most environmentally and socially beneficial investments. TBL-CBA allows a green bond issuer to put a dollar value on the environmental benefits of the investment, and it allows investors to compare these environmental benefits across projects.

To affect real change, we need TBL-CBA to have a place in global investment practices so that it’s the precedent in analyzing green projects. What the market needs is wide acceptance of TBL-CBA to create comparability and objectivity. Also, issuers will have incentive to be as green as possible because the extra costs incurred to prove their environmental benefits are adopted market-wide.

The market is growing, and there is an obvious appetite for green bonds, so let’s provide the market with the analysis, and hence the incentives, to be as green as possible.


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