Analysis: Ratings agencies are launching dedicated green bond assessments

S&P, Moody’s and others are taking a “fundamental step”

S&P will next year become the third credit rating agency to launch a dedicated green bond assessment, in a trend that marks a profound extension of the industry’s traditional remit.

“We’ve been providing credit ratings on green bonds for a number of years, in just the same way as we do on conventional bonds,” explains Michael Wilkins, Head of Environmental & Climate Risk Research at S&P Global Ratings, whose sister firm S&P Dow Jones Indices recently acquired environmental data firm Trucost. “But now we are going beyond credit risk and into a very different area of analysis – it’s quite a fundamental step for a credit ratings agency.”

Moody’s was the first to throw its hat into the ring, when it launched its Green Bond Evaluation service earlier this year.

“What became clear to us is that there was a growing appetite for more rigour and transparency around ESG risks generally, and green bonds in particular,” says Henry Shilling, Senior Vice President at Moody’s. As a result, Moody’s green bond evaluation focuses on an issuer’s governance credentials, use of proceeds and the mechanisms put in place to manage a green bond.

“We provide a forward-looking opinion of the effectiveness of the issuer’s approach to managing, administrating, allocating proceeds to, and reporting on environmental projects financed with the proceeds of a green bond,” explains Shilling. “The evaluation basically attempts to offer our view about an issuer’s capacity to deliver on what they say they’re going to deliver.”

On the green side, Moody’s looks at a bond’s alignment with the Green Bond Principles, and its adherence, “as appropriate”, to more prescriptive third-party environmental taxonomies, such as those from the Climate Bond Initiative, the IFC and industry- or region-specific frameworks like real estate’s LEED standards, or national green bond guidelines out of China and India.

“We feel a lot of work has been done in this area already, so why try and reinvent the wheel by coming up with our own environmental criteria when other good work has already been done?” says Shilling.

The value of the Moody’s evaluations, lies, he adds, in the fact that many feel there’s value to be derived from the brand and its experience in setting standards. “The credibility of a Moody’s rating, and the information content, seems to be appreciated by the market place.”

The Moody’s scale runs from GB1 (excellent) to GB5 (poor). Similarly, the S&P scale will run from E1 to E5, but its scores will focus much more heavily on the environmental value of green bonds.

“S&P Global Ratings’ evaluation tries to take the work of the second opinion providers and take it several steps further,” says Wilkins. “We look at the governance and transparency of the bond – at how well, for example, you follow the Green Bond Principles – but we also look at the projects funded by the proceeds of the bond and how green they are in relation to peers.”

The environmental credentials of the projects are assessed two ways. Firstly, against a ‘local baseline’, which puts the environmental impacts of the bond in geographical context. So, for example, ‘clean coal’ projects may have a net environmental benefit in countries like China, where they are likely to push dirtier, business-as-usual technologies off the grid; but, in a country such as Sweden this wouldn’t be the case. Therefore, a green bond in Sweden that supported ‘clean coal’ would score very badly on the ‘local baseline’ assessment, while the same projects in China may score better, given the national context. There will be a cap on how highly a green bond for controversial technologies like this can score under the S&P approach, regardless of the short-term net emissions benefit, because they stand to lock-in less green infrastructure in the long term.On top of the ‘local baseline’ assessment, S&P overlays a ‘hierarchy’ assessment. This element looks at the projects financed by bonds in a wider context, establishing a scale based on long-term environmental benefits. In this part of the assessment, a ‘clean coal’ project would score badly, regardless of its location, while a wind project in Sweden – which may only have a marginal benefit in the context of Sweden’s energy grid – would score well because it’s a very ‘green’ technology.

The ‘hierarchy’ is given more weight in the overall S&P evaluation score than the ‘local baseline’, but the two assessments can be disaggregated for investors seeking to finance region-specific climate transitions, or those only interested in finding dark green opportunities globally.

S&P is not the first credit ratings agency to develop an in-house assessment of the environmental potential of green bonds. This summer, Nomura Research Institute, a consulting and finance IT firm owned by Nomura Group, issued a green bond with a ‘GA1’ rating from an agency called Rating and Investment Information (R&I). R&I is a mainstream credit rating provider in Japan owned by Nikkei Group. In September, having observed the development of the green bond market over recent years, it says it decided to launch a green bond ratings service to help boost Japan’s fledgling market. Its assessment runs from GA1 to GA5.

Mirroring the ‘four pillars’ of the Green Bond Principles, the service assesses a transaction’s use of proceeds, the process of project selection, the management of proceeds and the issuer’s reporting commitments.

R&I has identified nine eligible categories under which environmentally beneficial projects can fall, and assesses the selection of those projects based on whether they fall in line with environmental policies or “other generally accepted viewpoints” and whether they adhere to a standard or have a certification.

“But in addition to the four pillars of the Green Bond Principles, we have developed a fifth component to our assessment: the issuer’s environmental contributions,” explains Takashi Morioka, Chief Analyst and Head of the Specialised Finance Group at R&I, who focuses on green bonds and credit risk analysis for the renewable energy sector.

This is where R&I diverges from S&P, which looks strictly at the projects being financed by the green bond, not the profile of the issuer (it has launched an ESG Assessment product to do that separately).

“If one issuer has a history of engaging in environmental activities and another has never been involved in the space before, then we believe the former is likely to be able to perform better on a green level,” Morioka says. “In short, we believe green issuers issue greener bonds.”

To date, R&I has only performed one green bond evaluation – for Nomura Research Institute – but Morioka says there have been “many enquiries” from banks, companies and government agencies interested in the new service, particularly as the Japanese government is pushing the asset class with an upcoming set of national standards.

Moody’s has a few more notches on its green-bond belt, with nine assessments so far. Issuers include property financing firm Renovate and Mohawk Valley Water Authority in the US, Mexico airport in Latin America and Rabobank subsidiary Obvion and Gothenburg in Sweden.

All the transactions assessed by both agencies have so far been awarded the top green bond score (GB1/GA1).

“Issuers gravitate towards that grade, and are willing to adapt their practices to achieve it,” says Shilling. “We’ve made the scorecard quite transparent, we think, and it’s abundantly clear to issuers how they can achieve a high grade – although it’s entirely up to them.”

He adds that, over time, he would expect to end up with a green bond assessment landscape similar to the credit ratings space – with a variety of grades to suit the needs of different investors. “In credit ratings it works because investors value the opinion. What we would like to believe is that in time, the same will apply to green bonds: investors will not be prepared to invest in green bonds without these external reviews to factor into their analysis. And once that begins to ripple through the system, you’re more likely to start getting distribution along the scale.”S&P Global Ratings closed the consultation on its service at the end of last month, with a view to launching it in the first quarter of 2017.

“The aim is to make it easier for investors to compare green bonds and their pricing based on their greenness, in the same way they can with their creditworthiness. And ultimately, the market may reward the greener bonds with better pricing in the same way, too,” says Wilkins. “That is one way to encourage companies to start taking environmental activities seriously, and may lead to better scaling up of climate finance and improve the sustainability of countries and the global economy.”