The growing influence of a new kind of credit rating aimed at green bonds has prompted calls for greater regulation of how a borrower’s environmental credentials are judged in the rapidly expanding market, Financial Times reports.
Sales of green bonds rose 9.4 per cent year on year in the first quarter of 2018 to $29.6bn, according to data from law firm Linklaters, fuelling concern that more scrutiny is needed of the companies that judge how green the bonds are. Some industry observers argue that these third-party verifiers should be subject to regulation in the way that credit rating agencies are in the established debt markets.
Third-party verifiers include credit rating agencies and accounting firms, but independent environmental consultancies and research institutes have also become involved. Although some of these organisations’ broader activities are regulated, third-party verifiers of green bonds do not have to abide by any particular rules in the environmental finance market.
“Some investors are relying more and more on second party opinions,” said Suzanne Buchta, global head of green bonds at Bank of America Merrill Lynch. “Therefore it would make sense for there to be some regulation around who can write such opinions in the same way that there is regulation of the agencies that write credit opinions.”
In February Indonesia — the world’s second-largest exporter of coal — sold its first green bond. Running its eye over what the south-east Asian country had pledged to spend the proceeds on was Norwegian climate research institute Cicero. However, Cicero did not assess whether Indonesia would deliver any actual environmental improvements. Its assessment even noted: “There is a possibility that some [of Indonesia’s] eligible green projects include an element of deforestation.” Nevertheless, that level of assurance was enough for some investors: Indonesia raised $1.25bn.
Sean Kidney, chief executive of the Climate Bonds Initiative, a UK-based non-profit organisation, pointed to a concern for investors in such situations: “Because the [assessment] fees are paid by the issuer of the bond, you have the same potential conflict of interest [with third-party verifiers] as we had with the credit rating agencies before the financial crisis.”
But Christa Clapp, director of research at Cicero, said that the organisation’s status as a primarily academic non-profit means it “does not have financial or other conflicting interests”, and can be trusted to rate bonds fairly. The fees system does not create a conflict of interest, she believes.
On Cicero’s decision to give Indonesia a “medium green” rating — the second highest of its four-point rating scale — Ms Clapp said: “We are trying to encompass all the different stages of [environmental] progress, so we want to be inclusive of short-term decisions that are an improvement but are not necessarily the long-term changes that will be needed [in the future].” However, she noted, “there are really different interpretations” of international guidelines such as the Green Bond Principles among external reviewers “and I find some of the approaches a little disturbing”, so “there could be more scrutiny” of third-party assessors.
Although third-party assessors have grown in importance in recent years, relying on them is “a pretty weak way to manage clients’ money”, said Vishal Khanduja, green bond fund portfolio manager at Calvert Research and Management, a subsidiary of US asset manager Eaton Vance. Instead, investors should do their own environmental due diligence, he believes.
Borrowers who wish to offer investors a third-party verification of their environmental plans have several options. The first, as Cicero did for Indonesia, is to check before the bond is sold that it meets international standards such as the Green Bond Principles. Issuers can also be audited some time after the deal is concluded, to check what the money was spent on. The most stringent option is a report assessing what measurable outputs the borrowers has delivered — a reduction in carbon emissions or water use. Some industry insiders estimate that fewer than 10 per cent of the green bonds sold so far will give investors this level of information.
Indonesia has pledged to report annually on both the spending and impact of its bonds, and to have that report independently audited.
In an effort to ensure minimum quality standards for such reports, China is introducing a licensing scheme for organisations offering verdicts on how borrowers use they money they raise. The European Commission is also considering introducing accreditation. Ma Jun, a special adviser to the People’s Bank of China, told a climate finance conference in March that China now had 12 different verification companies active in its green finance market and they were used by 95 per cent of bond issuers.
The demands for accountability over environmental achievements will only grow, said Mr Khanduja: “A lot of clients are asking us now what we actually achieved. We are going to need to answer those questions for our clients quantitatively, including what we did for the environment.”
Regulation can be costly, however, cautions Ms Buchta of BofA.
“If investors would really like to see impact reporting on bonds, this should not be restricted to green bonds; it should be a request across all bonds . . . If you force intensive impact reporting only on to the green bond market then you crush that market before it has really got going,” she said.
As authorities around the world ponder the best way to impose some form of order on this rapidly growing industry, the question remains: will those in the business of assessing green credentials welcome greater regulation?
“I don’t think anyone involved in charging fees for opinions particularly welcomes greater regulation. I wouldn’t expect them to,” said Mr Kidney of the Climate Bonds Initiative. “But if the market grows because of greater regulation, then their businesses will too.”
Read more at Financial Times