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Three steps to improve the green bond market

Green bonds can be a powerful tool for attracting investment in environmental projects, but reforms are needed to promote further growth of the market, argues Colin Purdie.

4 minute read

Photovoltaic cells on the background of a sunset

Where the world’s biggest pension fund leads, others follow. So global markets paid close attention when Hiro Mizuno, chief investment officer of Japan’s US$1.4 trillion Government Pension Investment Fund (GPIF), expressed scepticism about green bonds. In an interview with the Financial Times in early July, Mizuno said without key reforms the asset class risks becoming “a passing fad”.1

On the face of it, green bonds – debt instruments designed to raise capital for specific, environmentally friendly projects – look like much more than a fad. Since the first green bonds were issued by the World Bank in the late 2000s, the market has grown exponentially. According to estimates from the Climate Bonds Initiative, a not-for-profit organisation, total issuance in 2019 is likely to hit US$250 billion, up from US$3.5 billion in 2012.2

The case for green bonds is easily made. They provide a way for companies and governments to finance projects to combat climate change. They are also a good fit for investors looking to bolster their environmental, social and governance (ESG) credentials. Nevertheless, Mizuno was right to point to fundamental problems that are preventing these bonds from breaking into the mainstream.

Pricing and liquidity

One problem is that green bonds tend to be relatively small – issuance size is around five times smaller than the nearest ‘vanilla’ equivalent, on average3 – and AAA-rated issuers predominate, limiting the potential for diversification and restricting choice for investors. As a result, green bonds are less liquid than conventional securities with the same credit rating.

From an issuer’s perspective, costs surrounding labour-intensive reporting requirements and third-party verification mean green bonds can be slightly more expensive to bring to market. External attention is often focused on high-profile deals that are heavily oversubscribed, allowing issuers to cut borrowing costs: US telecoms giant Verizon’s US$1 billion green bond deal in February is a good example. But research from ratings agency Standard & Poor’s has found little evidence of an overall ‘green premium’.4 In any case, it would be difficult for investors to justify paying more for green bonds compared with traditional or ‘brown’ bonds from the same issuer.

Mizuno made clear that GPIF would like to build up its holdings of green bonds to support environmental projects but, as it stands, they are “lose-lose product[s]” that need to be redesigned to make them more appealing to issuers and investors alike.5

How green was my bond

There are also long-standing problems relating to how green bonds are labelled and defined. Despite efforts to standardise the market by the Climate Bonds Initiative, the International Capital Market Association – which authored the ‘Green Bond Principles’ – and the European Commission, there is still no definitional framework everyone can agree on.

In 2018, the Climate Bonds Initiative recorded US$23.7 billion of bonds issued with green labels that failed to meet its own screening criteria. These included ‘green’ bonds issued by companies running coal-fired power stations in China.6

Existing standards, such as the Green Bond Principles, tend to focus on the use of proceeds, not the issuer’s wider operations. This means oil and gas companies can legitimately issue green bonds even if they are net contributors to carbon emissions, leading to charges of ‘greenwashing’. Similarly, Poland has led the way in issuing green sovereign bonds despite its continued reliance on coal to run its economy. And while asset managers should support companies and governments in their transition to sustainability, labelling these bonds as green threatens to create confusion among end investors.

Then there is the possibility of a ‘green default’ – the risk an issuer reneges on its pledges. Although no major green-bond issuer has yet done this, some issues have drawn opprobrium from environmental groups. In 2014, French energy company GDF Suez (now ENGIE) issued a €2.5 billion green bond to finance renewable energy projects, using some of the proceeds to build a hydropower dam in Brazil. Environmental groups pointed out that, while the dam provided clean energy to local communities, it also caused floods that damaged the local ecosystem. Yields on the GDF bond rose amid the controversy.7

Room for improvement

So how can these issues be addressed? We would like to see reforms in three areas.

First, policymakers should incentivise institutional investment in green bonds through a form of tax relief. Some commentators argue governments should focus on making green bonds more affordable for issuers, putting the onus on investors to buy them even if they become less attractive as investments. We disagree: far from scaling up the market, this would render green bonds a niche asset fit only for specialist ESG funds.

It would be better to encourage large institutional investors to allocate more of their trillions of dollars in capital to green bonds through favourable tax structures. Precedents exist in the US, where interest on municipal bonds is exempt from federal tax; the US also offers tax incentives through the Clean Renewable Energy Bonds and Qualified Energy Conservation Bonds programmes. Structured properly, similar schemes could spur the development of the green bond market on a wider scale. On the issuance side, policymakers could consider initiatives to subsidise the additional costs associated with external verification of green bonds.

Second, policymakers and markets should expedite plans to create a universal green bond framework, ending some of the confusion around what counts as a green bond. With this in mind, we support the European Commission’s recent proposals for an EU-wide Green Bond Standard, a label that would require mandatory third-party verification and adherence to rules around the use of proceeds. The standard builds on the existing Green Bond Principles and harmonises with the “EU taxonomy of sustainable economic activities” being developed by the Commission.

Though alignment would be voluntary to start with, the EU’s backing should mean compliance with the standard becomes a de facto requirement for issuers, spurring global harmonisation. China has already signalled it will use the EU Green Bond Standard to attract European financing and Beijing is in the process of removing so-called ‘clean coal’ from its approved list of projects eligible for green bonds – a welcome step.8

Third, green bond contracts should come with better safeguards. Most contracts do not include provisions in the event an issuer breaches its promises, while uncertainty surrounds the correct procedure for investors seeking redress. To mitigate this risk, contracts should include standardised language that clarifies the procedure if the proceeds of a green bond are found to have been misused. The language should ensure investors’ and issuers’ interests are aligned. Dispute-resolution mechanisms will also be important.

ESG matters

These three steps would help spur the growth of green bonds, get climate-related projects off the ground and contribute to green finance becoming mainstream. But they will not be sufficient to raise all of the capital necessary to defeat climate change. The International Energy Agency estimates that US$1 trillion will be needed per annum globally to fund the transition to a zero-carbon economy.

If they are to make a real difference, we need to make sure green bonds are not being treated as a smokescreen for issuers and investors that want to signal their commitment to environmental causes without truly incorporating ESG across their organisations.

Just like shareholders, bond investors should engage with all issuing companies and governments to ensure best practice in ESG, not simply in the isolated schemes financed by green bonds. It is only by making green bonds part of this broader movement towards recognition of ESG across all aspects of global finance that we can ensure they are more than a passing fad.

This article originally appeared in Financial News.


  1. World’s top pension fund warns against risk of green-bond ‘fad’, Financial Times, July 2019
  2. Green bonds: the state of the market 2018, Climate Bonds Initiative, December 2018
  3. CBI data from H2 2018
  4. Why corporate green bonds have been slow to catch on in the US,’ S&P, February 2019
  5. Green bonds are a “lose-lose” product says Japan’s GPIF exec,’ S&P, November 2018
  6. Green bonds: the state of the market 2018, Climate Bonds Initiative, December 2018
  7. Beyond transparency: unlocking the full potential of green bonds’, Institute for Climate Economics, June 2016
  8. Green bond standards are converging, says CBI,’ Environmental Finance, February 2019


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