Reflecting the growing volume of green bonds, the European Union has agreed a new set of rules known as the European Green Bonds Standard (EUGBS) that can be seen as a positive step from a reporting and transparency perspective. The regulation is due to take effect late into 2024.
Bond issuers will now need to ensure that at least 85% of the economic activities that a green bond finances aligns with the EU taxonomy for sustainable activities.
Before we take a closer look, let’s recap on what green bonds are and what the funds raised are used for. Green bonds are used to finance or refinance projects that contribute to the ecological transition. They are, in our view, an essential vehicle to fund the inevitable change to a more sustainable economy.
The green bond market has been growing rapidly – in 2022, USD 63.4 billion worth of bonds aligned with the green bond classification was issued. This amounts to 5% of global bond market issuance, according to the Climate Bonds Initiative.
Green bonds are part of the sustainable-labelled bond (SLB) market. This can be broken down into three types of instruments when looking at use of proceeds:
- Green bonds finance new and existing projects that generate positive environmental impacts. Projects eligible for green bond issuance include renewable energy, clean transportation, green building and efficient wastewater management.
- Social bonds finance social projects that target positive social outcomes or address social issues. They often seek to help marginalised communities, the poor or disabled people with investments in affordable housing, food security, and improving access to healthcare.
- Sustainability bonds finance projects that involve both green and social activities.
As standards underpinning green bonds are now governed by a range of bodies on a voluntary basis, each of which prioritise different aspects of sustainability, there is a lack of clarity as to how green a green bond is and whether it is actually suitable for sustainability-related portfolios.
Since the launch of the first European green bond in 2007, definitions, standards and goals have morphed, often moving away from sustainability. The Climate Bonds Initiative, for example, says 38% of Chinese green bond issuance failed to meet its definition of a green bond in 2020, while the 2019 figure was as high as 44%.
The EU is stepping in to plug this regulatory gap, seeking to bring credibility to a complex system. We should note that despite pressure for the new standards to become mandatory in the EU, they will remain voluntary and only apply to those seeking the EUGBS label.
The emphasis on disclosure, due diligence and transparency will set the EUGBS apart: it requires close alignment with the EU taxonomy and its six overarching environmental objectives for sustainable activities:
- Climate change mitigation
- Climate change adaptation
- Sustainable water and marine use
- Circular economy
- Pollution control
Bond issuers must provide exhaustive use-of-proceeds information, demonstrating how they align with the taxonomy. Details of how the investment will help the sustainable transition are also required to prevent green investments from being offset by unsustainable investments elsewhere.
A ‘flexibility pocket’ is included, allowing 15% of the proceeds to go towards economic activities that align with the EU’s objectives, but not with the taxonomy. This leaves space for activities that may emerge in the coming years as sustainable. In other words, investors can fund innovative projects before legislation catches up, for example, bio-agriculture.
Given the rate at which the taxonomy’s sustainable activities are updated, it may come as a relief to bond issuers that ‘grandfathering’ – in which an old rule continues to apply to existing situations while a new rule is applied to new ones – will apply to certain bonds already issued. This ensures issuers can still use the EUGBS label under certain conditions, even if the taxonomy criteria change.
Under the proposed regime, pre and post-issuance verification and numerical reports on taxonomy-related issues are mandatory. They are reviewed by an independent body that is responsible for assessing whether a bond is green and for declaring any conflicts of interest. Pre and post-issuance reviews are to be published for free online to enhance transparency.
To obtain the EUGBS label, a green bond must adhere to this framework. However, there are concerns that the useability of the new standards will drive away issuers who might struggle to prove that 85% of their activities align with the EU taxonomy. On the other hand, ‘pure players’ such as electrified rail companies or renewable energy utilities can be expected to be early adopters as they can easily align their activities with the EU’s six environmental objectives.
We believe the EUGBS will bring more transparency to the green bond market and help tackle greenwashing. The EUGBS label should enhance the credibility of this segment. It is hoped that non-EU issuers will feel encouraged to adopt the framework as a benchmark for their green bonds.
The EU itself aims to establish EUGBS as a globally recognised gold standard that does away with inconsistencies in the specifications underpinning green bonds now.
For more on green bonds and broader thematic investing trends, read our 2023 Thematics Barometer.