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On 6 July 2021, the European Commission published its proposal for establishing an EU green bond standard (EUGBS). The proposed Regulation is one of the actions listed in the European Commission’s 2018 Action Plan for Financing Sustainable Growth, and part of the EU’s Renewed Sustainable Finance strategy, both aimed at redirecting and boosting capital flows towards a more sustainable economy. This necessary move is intended to enable the EU to achieve its climate objectives for 2030 and beyond. The European Commission has estimated that, in the period 2021-2030, investments in the energy system (excluding transport) to the tune of €336bn per year (2015 prices) will be necessary to meet the EU’s current 2030 energy and climate targets.
Can the proposed standard help drive sustainable finance?
As of 2020, green bonds represented just 4% of total corporate bonds issued, a share that will have to increase if the climate targets are to be met. In the first half of 2019, Europe accounted for 48% of the global green bond market. Bonds have great potential as instruments for financing the green transition, as institutional investors, who make investment decisions on behalf of individual members or shareholders, typically hold more bonds than equities. More generally, greater issuance of green bonds can prompt those wishing to go beyond maximizing strictly financial returns to include environmental sustainability in their financial decision-making.
Investors wishing to invest in environmentally sustainable projects face a fundamental information asymmetry: they cannot easily find reliable and comparable information on how genuinely environmentally sustainable a project is. This also constitutes a reputation problem for bond issuers, as they need to demonstrate their credibility to persuade investors to buy their bonds and reassure them that they are not just ‘greenwashing’. Already in existence to guide investors, the aim of green bond standards is to remedy these information asymmetries by setting requirements regarding the exclusive use of bond proceeds for green projects, on how the greenness of bond-financed projects is assessed, on how bond proceeds are managed; and on reporting on their use.
The EU green bond standard regulation proposes a uniform standard across the EU to tackle these questions. For a bond to be certified as an EU Green Bond, its proceeds would have to fund environmentally sustainable activities as defined by the EU Taxonomy. Compliance with the EU Taxonomy regulation is to be checked by external reviewers registered with and supervised by the European Securities Markets Agency (ESMA). The application of the standard across the EU will facilitate the creation of the Capital Markets Union and in principle extend funding opportunities for issuers of EU green bonds. The transparent use of bond proceeds will be safeguarded through detailed reporting requirements. The proposed standard is voluntary: bond issuers wishing to finance environmentally sustainable projects can choose whether to seek certification for a particular bond issue or not. The standard covers public and private, EU and non-EU bond issuers.
Is the proposed standard likely to achieve its stated objectives?
Various concerns have been raised. First, as the definition of what constitutes a green project is fully aligned with the EU Taxonomy, debates concerning what is included in environmentally sustainable activities in that taxonomy extend to the green bond standard. More specifically, there is an ongoing debate concerning so-called transition activities, i.e. activities for which there are no technologically and economically feasible low-carbon alternatives but which the EU Taxonomy classifies as ‘substantially contributing to climate mitigation’ under certain conditions, most notably, if they support the transition to a climate-neutral economy consistent with a pathway to limiting global warming to 1.5◦C above pre-industrial levels. The recent delegated act specifying the technical criteria used to qualify economic activities as substantially contributing to climate change mitigation did not take a stance on whether activities in the gas and nuclear sectors should be included in the EU Taxonomy.
Furthermore, the technical screening criteria used to qualify an activity as sustainable are to be reviewed every three years, taking account of the latest scientific and technological developments. If, given updated technical screening criteria, activities financed by EU-labelled green bond proceeds no longer qualify as transition activities, then, under the proposed EUGBS regulation, the bond issuer has five years to reassign the proceeds to activities compatible with the EU Taxonomy. This creates the risk that environmentally minded investors may find themselves having financed activities incompatible with their objectives, even though they invested in a green-labelled product.
Second, the voluntary nature of the EUGBS may give too much leeway to corporations and governments to ignore it when issuing bonds. To the extent that other green bond standards in the market are arguably laxer, the potential exists for non-EUGBS ‘greenwashing’. This might also delay the expansion of the market for EU-labelled green bonds, limiting financing opportunities despite increasing demand.
Other EU policies might be able to contribute to promoting EU green bonds. For example, there has been an ongoing debate on whether the ECB should gear its asset purchases to support investment in activities compatible with the EU’s climate targets. If this were to take place, preference for EU green bonds could stimulate demand and increase their attractiveness.
Overall, the EUGBS is a necessary step for redirecting capital flows towards activities helping the EU to meet its climate targets. Given the relatively high EU presence in global green bond markets, an EUGBS could also become the leading global standard, thus shaping global developments in sustainable finance. Developments in the EU Taxonomy will be crucial for building its credibility among sustainability-minded investors as a tool genuinely promoting climate goals, while stronger incentives for bond issuers to seek certification will also help it fulfil its objectives.
Photo credit: Indysystem