"Dubious or murky” green benchmarks are leaving “the door wide open to greenwashing”, said UN secretary-general António Guterres at this year’s World Economic Forum.
As the transition progresses and the demand for dedicated capital strengthens, the waters of green financing are as murky as ever.
Green bonds have grown in prevalence in recent years, leading to the emergence of oversight structures that attempt to prevent funds from being used to brand 'brown' activities as 'green'.
The Climate Bonds Initiative (CBI) and the International Capital Markets Association (ICMA) are among the industry bodies grasping for control of the market.
But while guidelines and suggested vetting systems for bonds are widespread, the effectiveness of each remains in question.
Regulators rely on a definition of 'green', but there is no central definition between bodies.In February 2023, the EU threw its hat in the regulatory ring, reaching a provisional agreement on an EU green bond (EUGB designation).
The proposed rules aim to tackle inconsistency and a lack of transparency within the debt class, offering new structures for the supervision of green bond issuance.
While the EUGB promises to be the new gold standard for the regulation of green finance, early signs suggest it may trip on the same stumbling blocks as the regulations that came before it.
Definitions and methods for oversight still need to be pinned down to reach consensus and credibility and ultimately fend off claims of greenwashing in the market.
Familiar pitfalls
If the EUGB is confirmed by the EU Council and Parliament, it will utilise external reviewers, similar to the CBI’s climate bond standard.
The external parties assess information provided by the bond’s issuer and deliver a rating for each bond, in a process that aims to make the green bond label more credible. Not all bonds pass the vetting process.
By way of example, the CBI rejected 25 per cent of the green bond applications it received in 2022.
As green bonds become more widespread, the use of third-party validators is rising, however the efficacy of these reviews is debated.
The high volume of reviewers in the market has raised concerns about the consistency of ratings and many have been criticised for a lack of transparency.
There is an argument to be made that the market should be left to reach its own definitions.Actions such as HM Treasury’s consultation into environmental, social and governance ratings providers (published in March) speak to this concern.
The system the consultation proposes is far from being in play in the green bonds market at present, highlighting how there is some way to go before external reviewers act as the effective filtering mechanism they are hailed as.
Blurred lines
To review and approve a green bond, regulators rely on a definition of 'green', but there is no central definition between bodies and the categories used by each have been known to change over time.
Indeed, ICMA recently amended its parameters to include asset-backed securities and covered bonds as “secured green bonds” and the EUGB allows 15 per cent of funds to be used for activities that are currently outside of its definition of green, recognising that the classification will evolve.
This raises the age-old debate over the extent to which regulation protects investors or straightjackets innovation.
In lieu of standardised parameters that may be limiting, ill-fitting or too vague to be helpful, there is an argument to be made that the market should be left to reach its own definitions.
More deal activity will naturally bring with it agreement on terms. And, unlike those imposed from above, these will be adapted to market conditions.
What is needed is not necessarily more regulation, but more maturation – and this will come with time as green bonds inevitably continue to grow.
Misplaced benefits?
Undoubtedly, some green projects have benefited from existing regulations and, if implemented, the EU’s more comprehensive standards will go some way towards raising the bar for the green label.
The designation does build on previous regulators’ approaches to categorising and supervising green bonds, such as by requiring issuers to contextualise the investment in their broader transition plans.
But with greater regulation will come higher issuance costs, creating a difficult balancing act between more stringent standards and the bonds’ viability.
While the 'greenium' suggests investors are willing to pay more for green bonds, piling on additional administration fees risks pushing the debt class into the red zone and channelling those seeking green project financing back to standard capital sources.
The EUGB may be well-meant, but rather than benefitting green initiatives it could ultimately best serve investors seeking to ratify their own greenwashing-free status.
One step forward
At present, a majority of green bonds fail to meet the standard’s requirement that at least 85 per cent of returns should go towards green projects, holding promise that the designation could drive a genuine phase out of polluting activities in the long run.
But like the green financing regulations before them, the EU’s standards are both optional and far from airtight, falling short of eliminating the threat of greenwashing from the green bond market.
The EU may succeed in defining new best practice in sustainable financing regulation, but standardised structures will struggle to pin down the evolving green economy.
Even if the EUGB skirts the pitfalls of its predecessors, allowing definitions to spring from market activity could well be the best safeguard against greenwashing.
The wisdom of crowds could again be proven.
Victoria Judd is counsel at Pillsbury Winthrop Shaw Pittman
