Green bonds constitute less than 1% of market capitalisation of bond markets. Bond markets dwarf public equity markets, which makes the trajectory of sustainable finance within bond markets crucial to reach climate financing targets.
The European Union development of a taxonomy for sustainable finance is an effort to reach standardisation for green assets. With standardisation comes lower transaction costs and the potential for higher growth in green asset markets, which should be applauded. It is commonly understood that the EU taxonomy will have far-reaching impact on sustainable finance in general, and the green bond market in particular.
For issuers considering issuing green bonds, a wait-and-see approach may be completely rational
I fear, however, that the anticipation of a yet-to-be-decided taxonomy with fairly specific technical standards could serve as an impediment to green bond markets in the short term. 2018 was the first year where the green bond market struggled to match its volumes of the previous year. We can’t empirically verify that the anticipation of the taxonomy is the key driver behind this deceleration, nor can we reject it.
But to understand how this could affect the propensity to issue green bonds, consider real-estate green bonds where many today, as CICERO has noted, would not qualify. For example, Fannie Mae, the biggest volume issuer in the green bond market would not have its current bonds accepted under the taxonomy. Thus, for issuers considering issuing green bonds, a wait-and-see approach may be completely rational.
At the same time, the draft EU Green Bond Standard contains language that indicates the EU GBS label may be conferred if the bond meets the Green Bond Principles’ 10 use of proceeds categories, until such time as the taxonomy is ready. This ambiguity further complicates matters.Hence, the EU/HLEG would be well advised to urgently provide guidance on the potential for grandfathering of green bonds issued under current regimes. This would mean that bonds that are issued in the near-term or have been issued in the past would have a certainty that they are also qualifying under the new taxonomy. It would provide confidence to the investors who have already built up substantial allocations of green bonds and incentivise the first movers in the market, who have been entirely responsible for the innovations and momentum achieved to date, to continue to support it, as opposed to demotivating them.
This could have an accelerating effect on green bond issuance, rather than the deceleration we currently see.
Of course, there are risks that issuers are going to try and ‘front-run’ the application of the taxonomy, if they believe current standards are more lenient than what they will be under the taxonomy. The counterargument to this is two-fold: first, providers of green bond opinions that would be needed to qualify for grandfathering have an incentive to remain strict, as to keep their relevance for the market once the taxonomy is in place. Secondly, from a scientific urgency standpoint, we are not in a place where we should err on the side of too much caution when it comes to climate finance, nor risk significant hiatuses in green financing activity.
Similar grandfathering has been a big theme under the restructuring of bank capital over the past decade. Bond markets are thus very accustomed to the concept and we could look for guidance in terms of a technical set-up for such grandfathering in green bonds vs taxonomy. For example, to avoid the risk of locking ‘too-lenient’ criteria of grandfathered instruments, one could implement a maturity cap so that longer-dated bonds might only qualify for grandfathering a number of years into the time when the taxonomy is in effects, and the issuers could then choose to refinance under the taxonomy.
I look forward to a fast discussion around this, which could really kick-start the green bonds season of 2019. Our planet needs it.
Ulf Erlandsson is a Board Member at Cicero Shades of Green and former bond trader at pension fund AP4