January 01, 2017

Legal Considerations for a Skyrocketing Green Bond Market

Scott Breen and Catherine Campbell

The issuance of “green bonds” has exploded since the first issuance in 2007, with $42 billion issued in 2015 and an estimated $80 billion issued in 2016. Growth is expected to continue; Citigroup forecasted that the outstanding global market for green bonds could reach $1 trillion after 2020.

A green bond is a debt security that is issued to raise capital to support climate-related or environmental projects. A bond becomes “green” when an issuer self-labels the bond as such according to the issuer’s selected criteria. Typically, the proceeds will then be used for a “green” project including low carbon buildings, renewable energy, or public transit. Investors are attracted to these bonds due to the steady return and positive impact that green bonds may offer, and the issuer can benefit from a strengthened business reputation and investor diversification.

The growth in the issuance of green bonds has not led to internationally binding standards or one set of criteria by which issuers can establish the integrity of the “green” label and investors can verify the integrity of a green bond. Instead, multiple voluntary standards have been introduced. With the expected growth of the green bond market and the multiple voluntary standards currently available, more client-investors may ask attorneys for assistance in understanding the legal considerations of green bonds. Attorneys advising investors on green bonds should search the news for green bonds to stay current. In fact, the information and options in this market are changing so rapidly that it is quite possible important developments may occur between the time this article is submitted and the Winter issue of NR&E is published.

This article will (1) detail the history of green bonds and their expected future growth; (2) survey existing green bond frameworks and the various instruments using them to measure the validity of the “green” label; and (3) discuss best practices for lawyers advising client-investors on green bonds.

The green bond market started in 2007 when the European Investment Bank issued a “climate awareness bond.” During the following year, the World Bank issued green bonds at the request of Scandinavian pension funds looking for safe investments that would also tackle climate change. The green bond market grew modestly until a turning point in 2013, when the first $1 billion green bond issue sold within an hour of issuance, the first corporate green bonds were issued, and Massachusetts became the first U.S. state to sell green bonds with a $100 million issuance.

Today, corporations, municipalities, development banks, and commercial banks issue green bonds. Development banks are currently the largest issuer of green bonds, but corporate issuance is a fast-growing segment that at one point in 2016 was estimated to reach $28 billion, three times more than in 2015. For example, Apple Inc. made headlines in February 2016 when it issued a $1.5 billion green bond—the largest green bond to date issued by a U.S. corporation—dedicated to financing clean energy projects in its operations globally. In the municipal market, Seattle-based Sound Transit made the largest municipal issuance to date with $900 million raised to improve the bus and train system. This issuance was also the largest use-of-proceeds bond ever to be issued exclusively for transportation.

Many countries are involved in the green bond market, with issuances in 25 currencies as of July 2016. Forty-one percent of the green bond market is denominated in U.S. dollars, but China is becoming an increasingly large player. China issued almost half of all the green bonds worldwide in the first seven months of 2016. The G20, at its September 2016 meeting, included language in its communiqué acknowledging the need to “scale up green financing,” and it also welcomed a report from the G20 Green Finance Study Group, co-chaired by China and the UK with more than 80 participants representing every G20 country, detailing ways these major economies can mobilize more private capital for green investment. G20 Leaders’ Communiqué Hangzhou Summit (Sept. 9, 2016), available at http://www.g20.org/English/Dynamic/201609/t20160906_3396.html.

There is room for growth in the labeled green bond market. The more optimistic projections put the entire green bond market at $100 billion of issuance for all of 2016; by comparison, the corporate sector alone typically issues $100 billion per month in traditional bonds. Today, total green bond issuance is less than 1 percent of the total bond market, and green infrastructure assets are less than 1 percent of global institutional investor holdings. In addition, the labeled green bond market does not capture all projects financed by bonds that positively benefit the environment. The Climate Bonds Initiative (CBI), a nonprofit focused solely on mobilizing the bond market for climate change solutions, reported that only 17 percent of the $694 billion outstanding climate-aligned bond universe are labeled green bonds, while the rest are unlabeled climate-aligned bonds. Unlabeled climate-aligned bonds are bonds whose proceeds are used to finance climate solutions but are not labeled green. These climate-aligned bonds may not be labeled green because a company such as a wind turbine builder, whose operations by definition are climate-aligned, wants to avoid the extra work that may come with self-labeling, such as annual reporting or because the issuer wants to avoid creating an expectation among investors that the funds will definitely benefit the environment. Low carbon transport dominates CBI’s climate-aligned bond universe at 67 percent of the total, and the China Railway Corporation is the largest issuer with $194 billion. The climate-aligned bond market reflects the valid point that the labeled green bond market does not reflect the totality of bonds being used to finance the transition to a low-carbon economy.

Expected Future Growth

A number of reasons support the expectation that green bonds will eventually constitute more of the bond market, as described further below. First, those pursuing climate change adaptation projects may use green bonds as a way to access the bond market for financing. Second, an increasing number of green buildings and resiliency projects will be seeking capital due to commitments to address climate change. Third, more investors are incorporating environmental, social, and governance (ESG) factors into their investment decisions. And finally, the recent launch of green bond indices signals the growing demand and interest in the green bond market.

Creating access to the multi-trillion dollar bond market to increase funding for climate-friendly projects was the reason green bonds started in the first place, and that money is critically needed to address the impending effects of climate change. The International Energy Association says $1 trillion of additional investment is needed worldwide each year for the next three decades to avoid the worst effects of climate change. Public funding will not be enough to finance this “clean trillion” annually. For example, the Green Finance Committee, composed of an elite group from China’s financial community, estimates that public funds will only account for 10 to 15 percent of the green funds needed in the country over the next several years.

Countries could turn to the green bond market to help finance the projects needed to satisfy the goals in the Paris climate agreement. Over 180 countries committed to reducing their greenhouse gas emissions through individualized Intended Nationally Determined Contributions (INDCs) delivered at Paris, which represent some 96 percent of global emissions. Many developing countries will need outside funding to meet their INDC. Under the Paris Agreement, developed countries are urged to raise $100 billion annually by 2020 to support climate action in developing countries. CBI is offering to help countries develop “green investment plans” to attract private capital for meeting their INDCs.

Socially responsible investing (SRI) is a large and growing segment of the market. More than one out of every six dollars under professional management in the United States—more than $6 trillion—is managed according to SRI strategies. SRI is an investment discipline that considers environmental, social, and corporate governance criteria to generate long-term competitive financial returns and positive societal impact. From 2012 to 2014, SRI enjoyed a growth rate of more than 76 percent. SRI’s continued growth means more money going toward projects like those that green bond proceeds are dedicated to funding. More organizations may also enter the green bond market to establish their sustainability bona fides and earn credibility with SRI investors.

Today’s green bonds are oversubscribed, attracting new investors, and trading at a premium. Demand for a green bond at times exceeds five or six times the initial issuance. An example of this high demand is Sound Transit’s $900 million offering, which sold out in its first morning. That offering also attracted 20 investors that had never previously invested with Sound Transit, exceeding Sound Transit’s expectations. ABN AMRO, a Dutch bank, received €1 billion in orders for a €350 million issuance. Also, the Industrial Bank of China issued a green credit asset-backed securitization at a value of approximately $401.6 million that was 2.5 times oversubscribed. While the offering price mainly drives whether a bond is oversubscribed, these oversubscriptions are a sign of future growth. High levels of demand are expected to continue—for example, public pledges in 2015 came from Zurich Insurance, Deutsche Bank treasury, KfW, Barclays treasury, and ACTIAM to build €1 billion green bond portfolios. Demand is expected to rise in China with forecasts of $46 billion in annual sales through 2020. Some believe investors are currently paying a premium to acquire green bonds, as a Barclays’ report found an approximately 20 basis point (0.2 percent) difference between the spread of green bonds and comparable issues. This may not sound like much, but it equates to a $2 million premium on a $1 billion bond and typical bond underwriting fees are between 15 and 35 basis points. Philip Ludvigsen & Bernard T. Delaney, Green Bonds: De-Risking Deals to Maximize Returns, Environmental Law in New York (LexisNexis Oct. 2016). The oversubscriptions and promises of increased demand will likely motivate hesitant entities to issue green bonds.

Another signal of high demand is the recent launch of several indices exclusively covering green bonds. These indices help investors understand and benchmark green bonds’ performance. Not all indices have taken the same approach. S&P Dow Jones Indices has created two indices—the S&P Green Bond Index, which covers only bonds flagged as green by Thomson Reuters or CBI; and the S&P Green Project Bond Index, which captures bonds that produce environmental benefits but are not necessarily labeled “green.” In its green bond index, Bank of America chose only to include bonds that were clearly designated solely for activities that address climate change or other environmental sustainability purposes, rather than to include general debt obligations of corporations that are involved in green industries. The Barclays MSCI Green Bond Index goes a step further and only includes certain self-labeled green bonds following an “independent and objective evaluation assessment.” Similarly, certain stock exchanges have started offering dedicated green bond segments, including those in London, Mexico City, Oslo, Stockholm, and Shanghai. In September 2016, the Luxembourg Stock Exchange introduced the world’s first exchange that will trade only green securities. It will only allow access to issuers who can clearly show the environmental benefit of the bond.

Defining What Is “Green”

Several market participants have advocated for more credibility, transparency, and consistency in the green bond market in order to protect the integrity of the “green” label. In December 2015, investors representing $11.2 trillion of assets signed “The Paris Green Bonds Statement.” This Statement welcomes the growth of green bonds as a mechanism to finance solutions to climate change and calls for the development of clear and independent industry standards for the benefit of bond financed projects and also for transparency around the use of proceeds and their impact.

An example of a controversial green bond issue is one by Bangchak Petroleum Public Co. Ltd., a Thai oil refiner and gas station operator. Bangchak sold about $90 million of green bonds, prompting a debate about whether oil companies should be allowed to issue green bonds. Similarly, the Massachusetts State College Building Authority caused a stir by issuing a green bond to fund a 725-space parking garage near Salem State University. While the garage will have electric-car charging stations and spots for carpoolers, and will reduce the number of cars circling campus looking for spots, some argued that the project may encourage more people to drive, which is a major source of greenhouse gas emissions. Mike Cherney, “Green Bonds” for a Parking Garage?, the Wall Street Journal (Mar. 12, 2015, 12:04pm).

There are currently two leading standards for verifying the integrity of the “green” bond label—the Green Bond Principles (GBP) and the Climate Bonds Standard (CBS). GBP were launched in 2013 and have been well received by market participants. Administered by the International Capital Markets Association, a membership association with members from both the buy and the sell side, the GBP have an impressive list of supporters including the investor group Ceres, the World Bank, Bank of America, JP Morgan Chase, and Goldman Sachs. Apple Inc. also used the GBP when it made its $1.5 billion issuance.

The GBP do not establish a threshold for what constitutes a “green” bond, but rather outline four core components that should be considered when judging if a bond should be labeled green: (1) use of proceeds; (2) process for project evaluation and selection; (3) management of proceeds; and (4) reporting. That the proceeds will promote progress on environmentally sustainable activities is described as “the cornerstone of a Green Bond.” International Capital Market Association, Green Bond Principles, 2016: Voluntary Process Guidelines for Issuing Green Bonds (2016) at 2. However, this principle is vague because what promotes progress will be “assessed . . . by the issuer.” Id. It also does not say how detailed the issuer must be in describing the project but only that it must be “appropriately described.” Id. The GBP list types of eligible projects, but the list is not comprehensive as the GBP also say “definitions of green and green projects may . . . vary depending on sector and geography.” Id at 3.

With regard to project evaluation and selection, the GBP encourage issuers to be transparent in how they decide which projects are eligible to receive green bond proceeds. Once proceeds are received, they should be put in a sub-account so that they can be tracked “in an appropriate manner and attested to by a formal internal process.” Id at 4. For the last principle, GBP recommend, where feasible, quantitative performance measures, and GBP encourage initiatives to establish references for impact reporting. Id.

The CBS, a key component of the CBI, has standards by which to determine if a project is “green.” Some of these standards are included in its pre-issuance requirements and post-issuance requirements, many of which are similar to the GBP, such as keeping proceeds in a separate account, describing what projects the proceeds will be put toward, and reporting at least annually how much was disbursed and, where feasible, quantitative performance. What sets the CBS apart are sector-specific, performance-based minimum standards that are defined by science-based eligibility criteria. CBS has created a taxonomy of 47 sectors, including wind energy, new commercial buildings, and bus rapid transit systems. It has developed minimum standards for some, but not all, of these sectors. For example, hydropower standards are in development, but in the published standards for geothermal power plants, new and existing geothermal projects with less than 100 gCO2/kWh are automatically considered eligible for certification as long as the facility meets certain environmental, health, and safety standards.

The CBS’s certification scheme also sets it apart from the GBP. Once eligible projects are identified, the issuer engages a verifier that has been approved by the Climate Bonds Standards Board, such as Ernst & Young, Sustainalytics, and First Environment. The approved verifier checks that the project is eligible under the CBS and that the issuer has internal processes and controls sufficient to track the proceeds. The issuer then submits its application and a report from the approved verifier to the Climate Bond Standards Board, which decides whether to approve the project for certification. If approval is granted, the issuer can then use a mark to signal to potential investors that the project is a “green” investment, perhaps making an investment decision easier to make.

The market’s use of the CBS certification is currently limited with only 22 issuances certified as of October 24, 2016. However, more than ten percent of green bonds issued in 2016 were CBS-certified. Growth in CBS-certified bonds has been rapid: by the close of the third quarter in 2016, $7 billion in CBS-certified bonds had been issued, which is more than triple the total that had been issued at the end of 2015. The CBS is likely to grow further because it is backed by a coalition of global investor associations that manage $34 trillion worldwide. Additionally, several investment banks—many of which are the leading underwriters of green bonds and in total represent 25 percent of the green bond market in 2015—have committed to the CBI as partner organizations. The World Wildlife Fund also says CBS meets the majority of the 16 principles that WWF has identified as essential for effective and credible green bond standards.

Many issuers hire organizations as external reviewers to assess the credibility of their self-labeled green claims, and most of these reviewers utilize the GBP or CBS in their assessments. Obtaining an external review is commonplace, as 81 percent of green bonds issued in 2015 had an external review. The policies and procedures in place to ensure independence vary among the organizations that conduct external reviews. The approved verifiers under the CBS are examples of external reviewers. Moody’s and S&P Global also recently entered the external review market. Moody’s announced in March 2016 its Green Bonds Assessment, which gives a composite grade to the green bond based on five weighted factors. S&P Global then followed with its Green Bond Evaluation Tool, which gives a final green bond evaluation based on three scores: a transparency score, a governance score, and a mitigation or adaptation score.

Some issuers do not obtain an external review but instead have their own proprietary frameworks. HSBC developed its own Green Bonds Framework to determine those projects for which it would issue green bonds. The Green Bonds Framework is consistent with the GBP, and HSBC retained an external reviewer, Cicero, that awarded the Framework its highest rating. Investors also utilize proprietary frameworks. Mirova, the responsible investment subsidiary of Natixis, has a mutual fund devoted to green bonds and uses a Green Bond Analysis Grid to determine in which labeled green bonds it wants to invest.

Adding to the myriad frameworks are the issuance by some countries of their own guidelines of what is required to be a green bond. China became the first country in the world to publish official rules on issuing green bonds with the release of the Green Bond Guidelines and the Green Bond Endorsed Project Catalogue in December 2015. These government-backed documents include requirements on disclosure and use of proceeds with the aim of creating a transparent and robust green bond market. Controversially, China’s guidelines include clean coal as being eligible for green bonds. India’s government has issued final guidelines on the issuance of green bonds. These guidelines make an external review optional but require that the issuer make disclosures, including the use of proceeds and the list of projects to which proceeds have been allocated.

Advising Client-Investors

While these guidelines, principles, indices, and standards have led most issuers to disclose more information about their labeled green bonds, investors may seek advice from their attorneys on which green bonds to buy and how to mitigate the risk that the proceeds will not go to a project that they consider “green.” Many types of potential investors in green bonds may have different resources and goals, but the following basic points could apply to any investor. The first point to make with a client-investor is to offer a reminder of what is currently legally required of issuers who self-label (hint: nothing). Next, the attorney should discuss with the client-investor how much emphasis he/she places on ensuring the project is beneficial to the environment and how much information the client-investor wants to receive about the project post-investment. This information helps the attorney advise the client-investor on what he/she should look for from an issuer. Lastly, the attorney should advise the client-investor about the limited legal recourse available if the bond does not match the client-investor’s expectations.

Explain what the green bond label means. A green bond label does not necessarily mean a net benefit for the environment. Even if the issuer is following one of the voluntary guidelines, most only require disclosure of how the proceeds are used and leave it up to the issuer to define what is green. One project whose green credentials have been questioned is the Jirau Dam in Brazil. The French power company Engie issued a €2.5 billion bond in 2014, some of which went toward funding the dam. This dam lights up thousands of homes with fossil-fuel-free power, but it also has flooded 140 square miles of habitat, and conservation groups say it has displaced four indigenous tribes.

The green label is not an indicator of higher credit quality. A prudent investor will consider other bond-related risks, similar to its assessment when investing in a non-green bond.

The green label also is not the only one for environmental and social bonds. Sustainability bonds typically fund projects that primarily benefit people through social impact. Starbucks made a splash in June 2016 when it issued a $496 million sustainability bond to buy coffee through its ethical sourcing verification program, fund farmer support centers, and provide loans to coffee growers. Blue bonds are used to fund projects that benefit the ocean. For example, Seychelles is working with the World Bank to issue $10 million in blue bonds to fund the development of sustainable fisheries. There is also the innovative environmental impact bond (EIB), which is where payments are made based on performance of the green project. In September 2016, the DC Water and Sewer Authority (DC Water) issued the United States’ first EIB and is using the proceeds to fund a green infrastructure project. If the project reduces runoff between 18.6 percent and 41.3 percent, as is expected, no contingent payment will be due. However, if the project outperforms expectations and more than 41.3 percent of runoff is reduced, then DC Water will pay the investors an “outcome payment” of $3.3 million. If the project underperforms and runoff is reduced less than 18.6 percent, then investors will pay DC Water a “risk share payment” of $3.3 million. This structure allows DC Water to hedge a portion of the risk associated with green infrastructure and puts the focus on outcomes.

Suggest ways to ensure positive impact. If the client-investor wants assurance that a project will have a high positive impact on the environment, certain steps can be taken. The client-investor could choose to work only with issuers who retain external reviewers to verify the environmental integrity of the project. As discussed, most issuers of self-labeled green bonds hire an external reviewer to verify the project is green, but some issuers do not obtain an external review because they are not required to do so, and it creates an added cost. The client should also be advised, if resources allow, to examine, or have someone else examine, the external review, as some are more rigorous than others. Another suggestion for risk-averse clients is to invest only in issuers that have committed to annual reports, which are often the best source of information on a project’s performance post-issuance. For example, DC Water reports annually on ESG indicators that were identified in the external review of its $350 million green bond issuance supporting the DC Clean Rivers Project. Like the external reviews, these annual reports also vary in their rigor. Risk-averse clients may want to consider investing with an issuer that has a track record of environmental performance. For example, the State of Massachusetts was the first municipality to issue a green bond and now has made several issuances that can be examined.

Caution that there is limited legal recourse. To date, no actions have been filed against an issuer for a project not having a sufficiently green outcome. The difficulty in bringing a suit stems from the lack of a legal definition for “green bonds” and the difficulty for a plaintiff to show actual damages. In one instance that did not involve litigation, the IRS audited green bonds for compliance with federal tax law. The IRS was involved because the developer of a large mall had sold $228 million in tax-exempt green bonds that were part of a program authorized by Congress to finance large construction projects with cutting-edge alternative energy technologies. The company ended up not installing in its mall development the major technologies that it had promised in its application. It said that the downturn in the economy made such an installation impracticable. It also argued the program only required that the bond offering describe the alternative energy features, not that it actually implement them. The IRS ultimately concluded that the bonds could still be tax-exempt. This is a unique situation with congressionally authorized bonds, but it demonstrates the difficulty of determining if an action rightly has the “green” label.

A client-investor could maintain a cause of action or ensure recovery by having the issuer include certain provisions in the offering documents. The inclusion of an ESG covenant or a reporting covenant in the offering documents could support a cause of action. These covenants would bind the issuer to certain outcomes, such as installing certain energy efficiency features or reporting annually on certain metrics. The stated enforcement for the covenant could be injunctive relief or repayment of the investment plus interest. A “put option” also could be included, which would state that if the issuer decides to use a certain amount of the proceeds for non-green purposes, then the issuer must offer to repurchase an amount of notes equal to its proposed non-green allocation. See Krystian Czerniecki & Sam Saunders, Green Bonds: An Introduction and Legal Considerations, Bloomberg BNA Securities & Law Report, Feb. 8, 2016. Another option is to include a “green event of default.” This would mean putting in the offering documents that in the event of some action or circumstance, such as a builder no longer pursuing LEED certification, the investor could demand full repayment sooner than it was originally due. None of these covenants or provisions is currently standard in green bonds. In fact, issuers may not be inclined to include any of these provisions to ensure the client-investor’s participation in the offering because the demand for green bonds is so high. If an issuer did include any of them, it would likely want a price premium.

Without these covenants, U.S. securities law provides for civil liability and private rights of action for untrue statements or omissions of a material fact in offering materials and communications. Thus, if the issuer takes some action with the proceeds that makes the offering documents false and not complete in all material aspects, the bondholder may have a right of action. However, the bondholder would have to show loss and that remedies are available. If the bondholder is receiving the promised interest rate and the market price is similar to that of non-green bonds, it may be difficult to show economic loss. Without economic loss, the bondholder could try to get punitive damages, but such damages generally are unavailable in U.S. securities cases. To date, no green bond case has been brought pursuant to U.S. securities law.

The prospect of a generally accepted standard for what makes a bond green is unclear, but there is general consensus that the green bond market is set to grow significantly in the coming years. The GBP, CBS, and other green bond frameworks will be revised over time to provide the necessary information for investors to consider when making decisions about investing in green bonds. In the meantime, lawyers should caution clients on what it means for a bond to be labeled as green and advise them on how to ensure that their investments lead to the kind of green projects that they expect.

Scott Breen and Catherine Campbell

Mr. Breen is an attorney-advisor with the National Oceanic and Atmospheric Administration (NOAA), and Ms. Campbell is an associate at DLA Piper, both in Washington, D.C. They may be reached at scott.breen@noaa.gov and catherine.campbell@dlapiper.com, respectively. The views expressed here are solely those of the authors and do not reflect those of the U.S. government, NOAA, or DLA Piper LLP (U.S.).