Green keeps growing: a strong segment and bond-market asset class

Corporate finance: recent developments in green financing

By Karsten Wöckener and Tamas Tözser

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Green bond market

Green bonds, which are used to fund environmental- and climate-protection projects, currently constitute a strong, growing segment and asset class within bond markets and could help to achieve the goals of the new Paris Agreement (COP21). And although green bonds predominated in the European and US markets in the past, interest in these products is now growing rapidly in emerging markets. In this regard, India and China are especially important due to the size of their economies. Green financing is not limited to a single sector, but rather covers a very broad scope of economic activities, ranging from agriculture and waste disposal to the real estate and construction industry. A historical comparison of issue volumes shows increased demand from investors for sustainable investment opportunities. According to the Climate Bonds Initiative, the total issue volume of green bonds in 2013 totaled $11.0 billion (48 issues). This amount tripled to $36.6 billion in 2014 (163 issues) and quadrupled to $41.8 billion in 2015

(260 issues). The volume reached at the beginning of this fall was approximately $48.3 billion (141 issues). The composition of the issuer community has also experienced significant changes: While multinational development banks were predominant in 2013, private companies, public-sector market participants, securitization companies and private banks are now key green issuers in the market.

Characteristics of green use of proceeds bonds

The green use of proceeds bonds is generally defined as a standard fixed-income debt obligation to finance or refinance, in part or full, projects with specific environmental benefits. Such bonds involve the same default risk exposure and rate of interest as conventional bonds, but proceeds are credited to subaccounts, moved to subportfolios or otherwise tracked by issuers for environmentally sustainable purposes. Repayment is not linked to the use of the net proceeds or the performance of the eligible green projects. Today’s markets are developing very broad, diverse structures for green financing mainly due to the further development of existing standards. Plain vanilla bonds have mostly been issued, and asset-backed securities have been created for infrastructure projects that have a green purpose. To create a standard for this fairly new asset class, the industry organization International Capital Market Association established a taskforce that developed the Green Bond Principles (GBPs) in 2014. Compliance with the GBPs, which set global standards for green bond issues, is voluntary. To benefit from the “green label,” however, issuers must meet the GBPs’ four core components. These include the use of proceeds, process for project evaluation and selection, management of proceeds and reporting.

New milestone

The GBPs’ annual update drew from numerous comments made by GBP members, market participants and observers during the consultation process that ended in early September 2015 as well as on the results of discussions in the internal working groups established by the GBP Executive Committee. In essence, the GBPs’ recent update aims to promote best practices for sharing information and conducting external reviews (previously known as “second opinions”) in order to support robust green bond markets and to facilitate more capital allocation for green fundraising. The key criterion of the GBPs is its Use of Proceeds. This point describes how the bond proceeds for the green project are utilized. Although background information on the Use of Proceeds is normally provided in a securities prospectus, such information may be made available in various forms:

(a) The use of a second opinion, such as a reference on the credibility of green bonds in the Use of Proceeds section of the offering document.

(b) An extra section after the Use of Proceeds section in the prospectus that describes the eligibility criteria with respect to the issue of the bonds as green bonds.

(c) A separate green bond guideline sheet that generally defines the following terms: the eligible projects, the account, the selection of eligible projects and transparency.

Reporting by issuers plays another key role. Reporting provides investors a description and updated information on use of proceeds. To prevent misuse and to increase transparency, the updated GBPs include a recommendation to issuers to use an “information template” for impact reporting to summarize information on green projects and conformity with the core components. This information template can be useful as a due diligence standard with regard to the issuer as well.

A pillar of the green bond market has been the second opinion, which increases transparency in green issues. It is worth mentioning here that this pillar expanded with the annual update and there are three additional ways to conduct a review (verification, certification and rating) in order to ensure different levels and types of an audit. Publishing the results of the external review, or at least a summary of it, is also recommended. Regardless of the approach taken, the names of the reviewers and their expertise may not be kept secret.

Specific products

Since their creation, GBPs have brought different types of green bonds to the market, including investment-grade and high-yield corporate green bonds, bespoke first promissory loan notes and green covered bonds as well as green structured notes.

In terms of project finance, infrastructure projects have traditionally been financed through financial institutions. With implementation of Basel III however, the regulatory capital framework entails more sophisticated lending requirements. This has led to the need for new innovative forms of financing to be considered for infrastructure projects.

One solution could be the Green Use of Proceeds Project Bond to open up debt-funding sources for single or multiple green projects for which investors have direct exposure to project risk with or without potential recourse to the issuer. Generally, green project bonds with a completion risk include certain sectors where risk is tolerated, for example, wind farms, solar farms or buildings. Completion risk for a green project is shared by all bondholders in that an incomplete project is not be able to generate the cash flow necessary to repay the debt. In terms of the external review mentioned above, a green project can be sufficiently monitored and effectively evaluated and followed on the basis of disclosure by providing documentation and periodic reporting.

Driven, inter alia, by the European Union capital market action steps, it is foreseeable that the use of bonds for infrastructure projects will play a substantial role in promoting economic growth in Europe. This likelihood is demonstrated by the example of the offshore Windpark Meerwind in Germany. A total of $1.5 billion in initial green project financing (including an initial green project bond) was placed to finance the construction of two offshore drill ships, with the parent company agreeing to provide cash support benefiting the project companies in the event of cost overruns before completion of the project.

One of the most important trends in connection with green bonds is the increasing number of issues in emerging markets such as the rupee-denominated masala bonds or the various renminbi-denominated bonds.

The rising issue volumes of social bonds – that is, bonds whose proceeds exclusively finance or refinance social projects – prove that issuers use the basic idea of the GBPs as a basis for other types of bonds. This new trend resulted in another initiative for social and sustainable bonds to be launched last summer by three investment banks. Based on this initiative, key characteristics shared by these two types of bonds have been established, including specific guidance for issuers comprising, inter alia, the definition of social bond and social project.

Listing and regulatory developments

Green bonds have the same regulatory status of equivalent “nongreen” bonds and can normally be issued through standard prospectuses. Some jurisdictions do, however, require adoption on mandatory standards and the GBPs as the minimum starting point to which additional mandatory requirements are added. The rapid development of green ­issuers encouraged prominent global stock exchanges to create specific green bond market segments. The London Stock Exchange as well as the Luxembourg Stock Exchange have established and operate a designated green bond listing and trading segments.

To be listed as a green issuer in Luxembourg, issuers must, as fundamental requirement, commit to showing that 100% of the proceeds from the bond will be used for green purposes. Additional criteria relate to managing proceeds, ex ante transparency and ex post reporting. Emerging market issuers are also expressing greater interest in developing green bond frameworks in various jurisdictions. Some jurisdictions have started to integrate elements of the voluntary GBPs guidelines into domestic green bond regulations and mandatory market criteria. It is, however, important to be aware of regional differences in the developing green bond market. These differences include, for example, the investment grade of the company or lower cost of the green transaction. In terms of China, the country has created green bond guidelines in line with national capital market rules. These codified criteria cover the distinction between regular bonds and green bonds, the necessary documentation and certification as well as green project catalogs.

Sustainable green bond sector

Over the last few years, it has become apparent that application of GBPs deters the misuse of bonds as “green washing.” At the same time, the GBPs have not led to administrative obstacles for issuers to enter green capital markets. This year’s update of the GBPs has resulted in a more precise restatement of these principles, particularly in terms of transparency and accountability, and increases their broad acceptance across the global market. All things considered, we may look back on 2016 as the year when the credibility of green bonds was not only maintained, but also further developed.

karsten.woeckener@whitecase.com

tamas.toezser@whitecase.com