Advanced topics in green bonds: Risks

By Phillip Ludvigsen

The unique set of risks presented by the fledgling green bond market are explored by Phillip Ludvigsen

The following is the first in a series of thought leadership summaries that address the unique risks, rewards, and risk management considerations related to issuing, selling, and buying green bonds.

Greenwashing

Perhaps the most recognised risk related to green bonds is 'greenwashing', which is defined as the superficial or insincere display of concern for the environment¹. A common form of greenwashing is when environmental claims are made without supporting evidence.

There have been many examples of well-meaning companies touting consumer products as environmentally friendly, biodegradable, and/or good-for-the-environment, only to have their reputation damaged by proving a lack of supporting evidence for their claims.

One investor's idea of a "dark green" is another's "light green", "vanilla," or even "brown"

In the area of green bonds, critics might argue that the funded projects may not produce a net environmental benefit. For example, financing a university parking garage may encourage gasoline consumption; and a large hydroelectric dam project in South America may produce more greenhouse gases than it reduces, while potentially dislocating indigenous populations.

One investor's idea of a "dark green" is another's "light green", "vanilla," or even "brown," leading to an "I know greenwashing when I see it" attitude.

Non-disclosure risks

To keep things simple and transaction costs low, some argue that so called 'pure play' green bonds should be exempt from certain aspects of the Green Bond Principles, such as detailed reporting.

It may seem obvious that a company that finances rooftop solar projects is inherently green. However, it may not be that simple.

Let's say the proceeds from the green solar bond are actually re-lent to consumers who borrow these funds to ultimately pay for their own rooftop solar installations? Let's also say that the 'pure play' company makes more profit on its consumer lending operations than on its solar installations. Perhaps the solar installations are a loss leader to bring in more consumer lending business. Is this company really a 'pure play' or is it simply a consumer lending operation like any other bank financing rooftop solar?

What if the 'pure play' company is controlled by a large coal-burning utility and the green bond proceeds are funneled to the parent to pay off its 'brown' debt? If 'pure play' green bonds are exempt from reporting and verification standards, it becomes much more difficult for investors to assess if a bond is green enough for them.

"Second opinion" risks

To help provide investors with some additional insight into the overall "greenness" of a green bond, it is common for issuers to hire a second-party consultant to provide a review or "opinion." The hired consultants (typically an academic or research organisation) review documents, interview management, and generate a report as to the overall green credentials of the proposed financing. Problems can arise when this type of second-party review and consultation is presented as an "independent" professional opinion.

It is common to see an "independent second-party opinion" published by the same organisation that helped develop the green bond framework, including the project selection criteria.

In some cases, the ... second-party opinion provider rates or scores the green bond framework it helped develop, and claims this is an "independent" opinion

In some cases, the same second-party opinion provider rates or scores the green bond framework it helped develop, and claims this is an "independent" opinion. Reviewing your own organisation's work is not exactly an arms-length relationship!

If second-party opinions were truly independent, wouldn't they be called third-party opinions?

Regulatory risks

In the area of consumer products, a lack of evidence supporting green claims (i.e. greenwashing) has led to regulatory actions.

The Coca-Cola "plant bottle" ruling under the Danish and European Marketing Practices Act demonstrates this point. The company could not produce sufficient proof that its new bottle was greener than any other soda bottle.

In the US, Section 5 of the Federal Trade Commission Act provides legislative authority to regulate deceptive acts and practices related to commercial activities. This includes misrepresentation, either directly or indirectly by implication, that an environmental benefit will be delivered. These types of regulations are directed at primarily consumer products and not financial products sold to institutional investors.

For better or worse, the interest in selling green bonds to the public as a retail financial product is increasing², potentially leading to greater regulatory risks.

Environmental non-performance risks

If a green bond issuer and/or underwriter provides misleading or insufficient information such that a reasonable investor would consider it material to their investment decision, this could open the door to potential litigation. Without widely accepted guidelines and standards, it is difficult to judge whether there has been an extreme departure from a reasonable standard of care.

The green bond market does have the Green Bond Principles (2015) as well as certification to the Climate Bonds Standard 2.0.

Both are starting to have an impact on defining good practice and, possibly, a reasonable standard of care. Assuming a court assigns liabilities, what level of damages could be assessed?

It is common for investors who finance carbon offset (i.e. "green") projects to include recourse for environmental non-performance in their purchase agreements. These penalties can be in cash and/or an equivalent environmental benefit, such as carbon credits purchased from a similar green project.

Interest in selling green bonds to the public as a retail financial product is increasing⁴, potentially leading to greater regulatory risks

Currently, green bond offerings rarely quantify the financial value of the anticipated environmental benefit. Nonetheless, it can be argued there is an implied benefit (environmental externality) that can be valued as part of the security indenture.

In the early 1980s, property insurance policies were "labeled" as "comprehensive" and thus, it was argued, set a buyer's expectation of robust coverage benefits. Because these contracts failed to clearly define "comprehensive" or follow emerging industry standards that excluded pollution, environmental coverage benefits were awarded.

Even after 'pollution' was excluded from many property insurance policies, it was found (mainly in jury trials) that insurers were still responsible for environmental coverage because the word 'pollution' was not well defined and was thus ambiguous.

Perhaps the buyers of 'labeled green bonds' also have a reasonable expectation that an environmental benefit will be delivered – via "implied covenant of good faith and fair dealing" – especially if the indenture is silent or ambiguous on the subject.

Is it fair to sell a green bond at a potential premium if there is no verifiable evidence that a green benefit has been delivered?

In June 2015, the East Bay Municipal Utility District issued a $74 million tranche (Series B) legally labeled as 'green bonds'⁴. The official statement and remarketing memorandum described criteria for selecting eligible green projects. The statement also provided an overview of the anticipated financial tracking of proceeds and reporting. To the issuer's credit, the green bond follows the structure of the Green Bond Principles and is based on management-approved guidance for issuing green bonds. However, later in the offering document it states:

"The terms "green bonds" and "green project" are neither defined in nor related to provisions in the Indenture. The use of such terms herein is for identification purposes only and is not intended to provide or imply that an owner of the Series 2015B Bonds is entitled to any additional security other than as provided in the Indenture. The purpose of labeling the Series 201B Bonds as "green bonds" is, as noted, to allow owners of the Series 2015B Bonds to invest directly in bonds that will finance environmentally beneficial projects. The District assumes no obligation to ensure that these projects comply with the principles of green projects as such principles may hereafter evolve."

Here lies the risk of environmental non-performance. Although this green bond addresses the four pillars of the Green Bond Principles, the terms 'green bond' and 'green project' are "neither defined in nor related to provisions in the Indenture".

There is also no obligation to implement the Green Bond Principles. Such exclusions may not be acceptable to some 'responsible investors', who expect clear definitions and some level of obligation, albeit voluntarily assumed, to implement generally accepted good practice such as the Green Bond Principles.

Green fraud risks

Although related to greenwashing, green fraud entails deliberate misrepresentation for unfair financial advantage. One of the largest green fraud cases currently involves Volkswagen AG cheating on US air pollution tests for their "clean" diesel cars⁵.

Not only is the company looking at up to $18 billion in potential fines, several of its executives could face criminal charges. The potential consumer lawsuits could involve billions more in punitive damages. Although not labeled "green", in May 2015 Volkswagen issued its largest US dollar-denominated bond sale to date ($3.5 billion).

Imagine if Volkswagen issued a Green Bond to finance its line of 'clean' diesel vehicles – similar to Toyota's green bonds for 'green' hybrid vehicles?

It is unclear if the recent green fraud litigation will impact Volkwagen's ability to repay its bond investors. It is clear, however, that environmental fraud can pose material risks to any investor.

It is unclear if the recent green fraud litigation will impact Volkwagen's ability to repay its bond investors. It is clear, however, that environmental fraud can pose material risks to any investor.

In the area of municipal bond fraud, the US Securities and Exchange Committee (SEC) is increasing its enforcement against municipalities. A factor driving this enforcement is the intentional deceit referenced by SEC Rule "10b-5"⁶.

Because fines are typically passed on to the taxpayer, the SEC is looking to take criminal action against municipal authorities in addition to bond underwriters and attorneys⁷. The lesson for municipal officials is to provide investors with accurate and up-to-date financial and, in the case of green bonds, non-financial information.

Upside risk

Fixed income investors tend to focus exclusively on downside risks or the uncertainty of negative impacts on their returns. Upside risk can be defined as the uncertainty surrounding positive gains to the investor⁸.

For green bond market participants, upside risk is linked to unexpected potential for additional financial and non-financial gains. For example, there is uncertainty regarding the potential for what seems to be a growing price premium and liquidity in secondary markets (eg. 20 basis points or more⁹).

The next installment of Advanced topics in green bonds will address the qualitative and quantitative rewards (upside) of investing in a green bond.

Phillip Ludvigsen is a senior associate at New Jersey-based First Environment and is a certified responsible investment professional by the Responsible Investment Association.