Green bond black hole leaves investors exposed

By Gareth Gore

MADRID, May 24 (IFR) - Ratings agencies are ramping up their efforts to fill a post-issuance black hole at the heart of the rapidly growing Green bond market, after two incidents in the past year threatened to leave environmentally conscious asset managers in breach of their own strict investment criteria.

S&P Global and Moody's are among those that have set up new units that aim to monitor in detail how proceeds from Green bond deals are used in the years after issuance.

At present, huge amounts of work are done before and immediately after a deal to reassure investors about how their money is used, often involving verification by third parties.

But updates after that can be ad hoc. According to the Climate Bonds Initiative, a body financed mainly by the finance industry, only two-thirds of issuers provide investors with regular updates on the use of proceeds. Even among those that do, the quality of data varies wildly, with some issuers unwilling to provide specific project data due to confidentiality issues.

"It's quite a big issue in the market – it's one thing to be certified as Green when you first do the transaction, but how can investors be sure that you still meet that criterion years later?" said Michael Wilkins, a managing director in sustainable finance at S&P Global. "It's a lot of work and something that many investors just aren't able to do on their own."


Until recently, investors have been relatively relaxed about the prospect of their money not being used as had been promised. But two incidents in the past year - one linked to German energy firm Innogy and the other a new airport in Mexico City - have highlighted how funds can suddenly be diverted, potentially leaving investors in a compromised position.

Innogy was inundated with demand when it launched a €850m deal in October 2017, the first-ever benchmark Green bond from a German corporate, with more than €3.5bn flooding in from a small but growing army of environmentally conscious investors. Plans to spend proceeds on five wind farms ticked all the right boxes for many asset managers.

The euphoria was short-lived, however. Just six months later, Innogy's parent RWE announced that it would sell its stake in the company to rival energy giant E.ON. Crucially, it also struck a side agreement that would see it retain the five wind farms that had underpinned the Green bond deal. The bonds and the assets were to be split.

The divestment and asset swap threatened to seriously compromise anyone that had bought into the deal. But, despite that, for five months bondholders were left in limbo. Innogy sought to divert funds to other qualifying projects, but with no wind farms left it had to redeploy the money to its power network. That satisfied some - but certainly not all - investors.


Similarly, the US$6bn of Green bonds issued to finance a new airport in Mexico City were massively oversubscribed by a keen investor base when they came to market in 2016 and 2017. But when the country's new president cancelled the project last October, investors were once again left in limbo, not knowing what would happen to their funds.

Eventually, late last year, the issuer offered to buy back bonds - albeit only US$1.8bn, less than two-thirds of the bonds in the market, as the issuer did not have enough to buy all. The remaining bonds were transferred to a new project, prompting S&P to withdraw its Green certification, in effect leaving many investors in breach of their own rules.

So far there have been just two incidents. But the market is still young: while the first Green bond was in 2007, the market has only really taken off in the past five years. As issuance grows and tenors extend, more such instances are inevitable. Last year, there was US$170bn of Green bond issuance with several deals extending out to 30 years or more.

S&P and Moody's spotted an opportunity, and have begun offering annual updates verifying use of proceeds. While expansion is planned, so far just a few dozen bonds - out of the more than 2,000 outstanding issues - are covered. Like credit ratings, the annual check-ups are commissioned by issuers themselves, potentially skewing use towards the most compliant companies.

While investors have welcomed the move, some believe their own research is the only option.

"As an investor you always have to do your homework yourself - you have to dedicate significant resources to monitoring your investments, and it is a lot of work," said Bram Bos, lead portfolio manager for Green bonds at NN Investment Partners. "That can create a barrier to entry to the ESG market for some asset managers, but frankly so does monitoring creditworthiness. It's just part of the job."


Bos is among those who believe that the initial process of being certified as Green creates a sufficient incentive for issuers to continue complying over the life of a bond. The initial certification and impact study, usually done in the first year to reassure investors about how their money has been spent, can be costly, requiring the creation of new teams and datasets, as well as third-party opinion providers.

"Issuing a Green bond can be expensive and time consuming - the issuer has to segregate the funds and, at least initially, undertake a complex and lengthy reporting and approval process," said Trisha Taneja, manager of sustainable finance solutions at Sustainalytics, a body that certifies bonds as Green. "Not keeping their word on that commitment would be neglecting their core aims and would undermine the objective of issuing a Green bond."

The European Union has already proposed a new framework for Green bonds.

A technical expert group commissioned by the EU has suggested an "expanded and standardised" process of reporting by issuers that is "more specific than current market practice". Some think that might go some way towards addressing the current information gap. But others believe that more onerous reporting could actually undermine the entire Green market by bumping up costs and lowering issuance.

"The risk is that, if post-issuance reporting becomes legally binding, then nobody might want to issue a Green bond again," said Bos, who argues that the current model works well - even if investors have to do a lot of work themselves. "Self-policing works in the sense that issuers know that if they don't meet their targets then their reputation would be on the line. Regulation would risk shrinking the market."


Another possibility is that the market itself adapts to assuage investor concerns. Indeed, there is a growing group of environmentally conscious issuers who feel that the current Green bond market does not adequately reward them for the additional costs involved and the verifiable commitments they are making. The scepticism of some investors and information deficit of some issuers may be to blame.

As a result, over recent months, there has been increased interest in financings that have a variable rate of interest that is specifically tied to verifiable metrics linked to environmental performance. French water and waste giant Suez recently took out a loan with the interest rate dependent on its progress in areas such as the number of senior women it employs, reductions in its own emissions and how much help it provides to customers seeking to reduce their emissions.

According to Wilkins, the move towards such loans could force better reporting in traditional bonds.

"We have started to see a shift away from use-of-proceeds transactions to facilities that have variable pricing that is linked directly to their environmental or sustainability targets," he said. "That could be a very important development in helping develop regularly updated quantifiable metrics that provide investors with more visibility."

(This article will appear in the May 25 issue of International Financing Review; Reporting by Gareth Gore)

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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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