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The EU’s green bond plan charts a path forward for climate finance

September 23, 2021, 2:00 PM UTC

Temperatures are rising, floods are increasing in frequency, and in Brussels, the European Union is in the midst of a yearslong, high-stakes experiment in terminology: When asset managers, bond issuers, and investors use the word “green” to describe a bond, can they all agree on what it means?

The effort to define “green” stretches across an ever-expanding financial landscape of products that purport to help address climate change. While the EU passed legislation this spring setting the groundwork for what’s required of asset managers running green funds, a sustainable finance proposal announced in July is now expected to extend legislation to fixed income. 

But the EU’s effort, intended to set a global gold standard, also hints at just how difficult it is to regulate the small but quickly growing green bond market. The proposal is currently awaiting official adoption by the European Parliament and European Council, and is not expected to be passed officially for “one year or two,” according to a press briefing with budget commissioner Johannes Hahn earlier this month. Even then, whether an institution or government actually chooses to use the framework will be entirely voluntary—and there’s no hard proof that either European institutions, or those outside Europe, will do so. 

In the meantime, the EU says it will continue issuing green debt—but not under its own rules. Instead, for the €250 billion in green debt the European Commission plans to raise by the end of this year as part of its package of COVID-19 relief spending, it will rely on another set of green bond standards—one created by an NGO.

Underpinning the EU’s legislation is its “taxonomy,” adopted in March 2021, which set out the fundamental definitions of what is considered a sustainable activity. That legislation is at the heart of a wide range of proposals intended to map out and regulate what a new era of “green” finance will look like. 

The new standard for green bonds will be the most ambitious regulations to date in terms of the level of detail and disclosure requirements, says Andreas Hoepner, a professor at University College Dublin’s business school, who is also an independent member of the European Commission’s Platform on Sustainable Finance. 

But Europe’s focus on sustainable finance legislation did not come out of nowhere: European investors pioneered concepts of green and ESG investing decades before the concept gained mainstream headway in the U.S.

“All of this started as early as the 1970s for some of these Nordic pension investment funds,” says Mara Dobrescu, director of fixed-income strategies at Morningstar Manager Research in Paris.

In December 2019, the European Commission said the entire bloc would target net-zero emissions by 2050, in line with the goals of the 2015 Paris Agreement. In 2020, the bloc put the “European Green Deal” at the center of its €1 trillion recovery package from the pandemic. That package included a huge bond package, 30% of which will be green bonds. China, too, has raced ahead—the country is now the source of 36% of the world’s climate-aligned bonds, according to the Climate Bonds Initiative, a nonprofit focused on green bonds and the creator of the voluntary, but widely used, Climate Bonds Standard. 

Meanwhile, although the Biden administration has put climate policy at the forefront of its pandemic recovery plan, targeting net zero by 2050—and though the popularity of green finance is rapidly accelerating—the U.S. is running years behind after the Trump administration pulled the country out of the Paris Agreement and loosened environmental regulations. 

The EU’s plan, when it comes to the overall regulations, is to transition the entire financial system to actively help the bloc achieve net zero by 2050. When it comes to green bonds, the goal is to make sure that a bond that is labeled as green actually has a tangible environmental benefit—and to wipe out dodgy claims of environmental bona fides in the process.

The green bond explosion

While the first green bond was issued in 2007, by the European Investment Bank, the concept has really only gained pace in recent years, as government policy has increasingly moved behind transitioning economies toward net zero by 2050. 

In the EU, green bond issues have grown fivefold in the past five years, according to the European Commission; large issues have come from such household names as Volkswagen and Engie, as well as the government of France. 

Globally, from 2016 to 2020, yearly green debt issuance more than tripled, according to the Climate Bonds Initiative. As of September 2021, $1.38 trillion in green bonds has been cumulatively issued worldwide. 

Green bond funds, which pool multiple bonds into one financial product, have also grown in size and number. In the past three years, assets in such funds have grown threefold to $350 billion, according to data from Morningstar, which was shared with Fortune. The number of funds on offer has also jumped to 900 as of 2020. 

But despite that momentum, green bonds constitute just a tiny fraction of the global fixed-income market. In the EU, where the largest green bond market resides, such bonds make up only 2.6% of all the fixed income issued, according to the European Commission. Globally, green bonds represent only about 1%, according to Morningstar. 

Even within the world of ESG investing, bonds have often been overlooked. Compared with “vanilla” investing portfolios, ESG-focused portfolios tend to be skewed toward equities. Bonds make up only 18% of such portfolios on average, according to Morningstar data, whereas in a mainstream portfolio, fixed income tends to make up about 27%. 

That means that green bonds tend to exhibit strong biases—skewing heavily European, euro-denominated, and corporate, because unlike in the regular fixed-income market, there is no “green” version of the dominant U.S. Treasury bond. 

That has given European banks a strong foothold in arranging them. Seven out of 10 of the top green bond arrangers in 2019 were European banks, according to Bloomberg data, even though they are outmatched in the general, global fixed-income market by U.S. banks. That year, the top green debt arranger was still J.P. Morgan, but the second and third place were held by BNP Paribas and Crédit Agricole, both based in France. 

Because green bonds are so new, there also isn’t much data to definitively compare their performance against regular bonds. But the quick pace of growth shows that hasn’t held them back. As Fortune has reported in the past, most green bond issues tend to be oversubscribed. 

One step further

There’s a larger problem, however: When it comes to standardizing what a green bond should look like, there are few official guardrails. The EU’s efforts to standardize the system are part of a broader push to formalize the ESG market; in the U.K., the government has a task force to tackle greenwashing, the practice of marketing a product as green when it’s not. And in the U.S., the SEC is expected to issue expanded disclosure requirements by the end of the year.

This lack of transparency and comparability on what “green” really looks like is a problem across the entire ESG-investing world, and is not limited to green bonds. Many experts say the rise in demand for ESG has given rise to a kind of “green creep”—an expansion of what investors or issuers will call “green,” including the conversion of already existing funds with little change other than a rebrand.

To address the vacuum in standards, NGOs have largely stepped into the gap. In the world of green bonds, two standards are already widely used: the Green Bond Principles laid out by the International Capital Market Association—which the EU itself plans to use for its green bond issues this year—and the Climate Bonds Standard, from the Climate Bonds Initiative. Both standards are widely respected, multiple experts said. The EU Green Bond Standard, since it is also voluntary, mainly differs by having standards that are even stricter. 

“If you look at the requirements for the reviewers, it just goes a step further,” says Shanawaz Bhimji, a senior fixed-income strategist at ABN AMRO in Amsterdam.

Much of that is due to the standard’s reliance on the EU taxonomy, which underpins the whole universe of regulations on sustainable finance the bloc is trying to introduce, including the Sustainable Finance Disclosure Regulation (SFDR) passed in March. (This requires anyone marketing a financial product as green to produce a battery of disclosures justifying how and why it qualifies.)

In simple terms, the taxonomy is an evolving encyclopedia for what the EU considers to be a green activity, from what qualifies as green steel, to what qualifies as a biodiversity project or a rail infrastructure project. To meet the standard, a bond issuer has to justify how it stacks up against the taxonomy.

The issuer is then required to disclose to its investors before, during, and after the bond reaches maturity how the proceeds were intended to be used for a green project, and to prove that they were deployed as promised.

Those disclosures are then checked by an outside financial reviewer, who is in turn supervised by the European Securities and Markets Authority. Any entity, not just a European company or government, can issue a European green bond.

Under the SFDR, an asset manager, for example, must justify how its green fund investments are green; this justification is then supported by the disclosure and certification process of, for example, a European green bond. 

If the standards seem demanding, Hoepner points out that they are limited to funds with self-declared sustainability objectives.

“No one is forced to run a sustainable fund,” he notes.

A (voluntary) gold standard

While the EU’s latest green regulations set a new standard in their scope and level of detail, there’s a catch: Its green bond standards are entirely voluntary. Even once passed by law, there won’t be any legal ramifications under this specific regulation for calling a bond “green” when it plainly is not.

Nonetheless, the EU is clearly hoping that in the Wild West world of ESG investing, the European green bond system eventually becomes the gold standard that investors demand issuers meet. Because it is not exclusive to European issuers, the standard’s long-term success may ultimately be measured not just in whether it’s adopted by local issuers, but whether international issuers start using it, too. It’s still too early to know whether the standard will have that kind of uptake—and whether investors are truly worried enough about greenwashing to get behind a framework that requires even more verification than current standards already do. 

That said, there are some ideological debates that even a popular green bond framework won’t solve—including whether companies who have been responsible for high emissions in the past should be able to take advantage of green financing to fund their transitions to low-carbon businesses.

The conundrum is, “Okay, it ticks all the boxes, but at the end of the day, I’m still putting my money into a business where the majority is still generated by fossil fuels,” says Bhimji.

But under the green bond standard, any company—no matter its record—can in theory issue a green bond, as long as it meets the requirements and goes toward where the company has said it will go. 

Whether to buy that bond or not is a question individual investors will have to answer for themselves.

Even so, the implications of truly transitioning debt toward sustainability could have significant knock-on effects, funding vast investments in new systems of energy, transport, infrastructure, and building required to truly transition the global economy away from carbon. 

And while investors can simply sell equity that doesn’t serve their climate goals to another investor, debt presents a critical opportunity to make financing conditional on climate progress, says Fabiola Schneider, a Ph.D. student at University College Dublin who studies climate finance with Hoepner. 

“There’s a big moment when you can really have some influence,” she says. “And that’s when you have to refinance.”

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This story is part of The Path to Zero, a series of special reports on how business can lead the fight against climate change. This quarter’s stories explore new markets emerging in the sustainability space.