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No Gold Rush for Europe’s Green Bonds

The tough requirements set by the new European standard offer greater certainty to investors but will give issuers pause for thought.

After years of debate, the European Union Green Bond Standard (EUGBS) finally made its formal debut at the end of last year. The market has already welcomed its first issue – a €500 million, ten-year security from Italian utility A2A – but few expect this to open the floodgates. Instead, many believe it will take time for the label to gain widespread acceptance.

One reason is that the EUGBS is not compulsory and there are other guidelines to choose from, such as the International Capital Markets Association’s (ICMA) Green Bond Principles (GBP) and the Climate Bond Initiative’s (CBI) guidelines. Equally as important, the regulation raises the bar higher with a longer and more prescriptive checklist. The aim is to create a ‘gold standard’ that ensures environmentally sustainable allocation of the funds along with greater transparency of the process and robust external assessment of an issuer’s claims.

More specifically, issuers have to allot at least 85% of proceeds to projects that are aligned with the EU’s green taxonomy, a separate and overarching rulebook designed to identify which economic activities can be considered environmentally sustainable. The remaining 15% is in a so-called flexibility bucket for areas such as agriculture that are not yet covered by the taxonomy.

However, all of the projects must comply with the taxonomy’s ‘do no significant harm’ (DNSH) criteria, as well as be certified by a designated EU green bond reviewer. On the regional level, these bodies are registered with and supervised by the European Securities and Markets Authority (ESMA), but national regulators also have responsibility for supervising overall compliance with the standard.

In some quarters, industry experts are optimistic that – despite the obstacles – EUGBs could become a material part of the market. For example, recent research from the Institute of Energy Economics and Financial Analysis (IEFFA) found that in 2023 alone, EU companies invested €249 billion (US$259 billion) in EU taxonomy-aligned activities. Although it did not crunch any concrete numbers, the think tank anticipates that EUGB issuances “worth hundreds of billions of euro” could come onto the market in time from issuers such as supranational entities, government agencies, sovereigns, financial institutions and corporates, forming a prominent segment of the green bond market.

“As investments aligned with the taxonomy continue growing, the new label will become a prominent subset of the green bond market,” according to IEEFA Sustainable Finance Analyst Kevin Leung. He noted that prominent existing green bond issuers should be able to easily embrace the new label, which in turn would help advance their environmental strategies and transition plans. “By showing increased attractiveness for investors and establishing overall market momentum, benchmark bonds could motivate wider participation from other issuers that may initially face proportionately higher hurdles to meet the standard’s requirements,” he added.

Another milestone

Not everyone is convinced. Kenneth Lamont, Senior Researcher at data and analytics firm Morningstar, acknowledges EUGBS is another milestone on the road towards the formalisation of sustainable investing in Europe. But he does “not expect it to make a large impact on the levels of issuance in the near term” albeit allowing that compliance with the standards could well become “table stakes” for issuers in future, even if it remains a voluntary standard.

He says, “As things currently stand, an issuer would go to the effort and cost jumping through the hoops to become EUGBS compliant to demonstrate being best of breed, but they wouldn’t currently expect that this would translate to higher demand and/or more favourable pricing just yet.”

Lloyd McAllister, Head of Sustainable Investment at French asset manager Carmignac, believes that the pipeline for EUGBS this year could be around a dozen deals, which is way below the total value of ICMA GBP deals, predicted to be worth at least US$800 billion. The latter, which just marked its tenth anniversary, is a set of voluntary frameworks that seek to promote the role of global debt capital markets in financing progress towards environmental and social sustainability.

“While the intention of the EUGBS is to improve standards and reduce the risk of greenwashing is admirable, the reality is its limited scope,” he adds. “Its prescriptive nature and rigidity, could inadvertently create friction, thus stifling the development of the sustainable debt market.  Given the significant investment needed to finance the broad environmental transitions ongoing in the economy, we are keen that additional red-tape doesn’t hinder this capital allocation.”

In addition, McAllister thinks that cost for issuers is too high particularly in terms of reporting and resources. This is especially the case in an environment where the ‘greenium’ for Euro investment grade debt, which is a significant portion of the green bond market has all but disappeared.

Alban de Faÿ, Head of Fixed Income SRI Processes at global asset manager Amundi and Vice-Chair of the ICMA GBPs, also believes that the cost of the bond will be the main determinant. “If the price rises due to extra transparency, they will not want to pay for it,” he adds. “Demand will also depend on the type of issuer and whether the green bond is consistent with its overall long-term strategy.”

EUGBS-labelled bonds will not fit certain sustainable debt financing needs. John Ploeg, Co-head of ESG Research, Fixed Income for PGIM, also makes the point that issuers can use other capital such as vanilla bonds or equity to fund a project. “Most of the time, they’ve already funded the same or similar projects that way in the past.”  he adds.

Tatjana Greil-Castro, Co-head of Public Markets at asset manager Muzinich, notes there are only so many green investments that companies can do in a year. The larger companies will have more projects, but smaller firms turn to conventional bonds because they do not have sufficient projects to print a green bond where all the proceeds need to go to demonstrably sustainable investments.

Regulators can help unlock the flows, according to Hans Biemans, Head of Sustainable Markets at Dutch bank ING, and member of the EU Platform on Sustainable Finance, and advisory body to the European Commission. He believes that compliance with DNSH and minimum social safeguards needs to become easier or, alternatively the 15% ‘flexibility pocket’ becomes much larger. Moreover, “there is just a lack of data to prove full taxonomy alignment”, he adds. “In those cases, an auditor cannot provide negative assurance. They need to do testing with high levels of details based on review protocols. However, it is often not possible to provide evidence that you did not do any harm.”

Biemans cites a brand-new building with an A label for energy efficiency as example of the complexity involved in meeting high standards of proof. It is a complicated process that requires looking beneath the energy performance certificate to measure the sustainability of the building. This includes having an infrared camera and blower door test, as well as a calculation of the potential CO2 in the building materials.

At the starting gate

In terms of the types of issuers, Bierman expects that large companies such as utilities with relatively simple green assets will be at the EUGBS starting gate. Projects range from renewable energy to electricity grids and flood protection.

However, investors are advised to do their own detailed due diligence and not just rely on the standard to substantiate a company’s green credentials. As Daniel Karnaus, Portfolio Manager at Swiss asset manager Vontobel, puts it, the measure of a green bond does not come from the ICMA GBP or EUGBS, but from the sustainable business model of the bond issuer. “It is therefore essential that a green bond, in addition to having an accredited label, also comes from an issuer who has a sustainable business model,” he adds. “Consequently, the selection of the issuer must be given as much weight in analysis as the selection of the issue.”

Saida Eggerstedt, Head of Sustainable Credit at UK-based fund manager Schroders, concurs, adding that “investors need to do their homework as they would with any other bond”. She notes that despite the EU frameworks and increasing data availability, it is important to have specialists and second party-opinions to evaluate whether the bonds are a good sustainable investment.

For Nicolas Jacquier, Portfolio Manager in Ninety One’s EM fixed income team, this means looking at issuers’ ESG policies and assessing whether they are making progress on their transition plans. This means using their own proprietary as well third-party research well plus having the right key performance indicators to measure the outcomes.

Although the EUGBS is forecast to have a slow start, overall global sustainable bond issuance is expected to remain steady at around US$1 trillion this year, marking the fifth consecutive year at this level, according to a report from Moody Ratings. Green bonds will continue their dominance at US$620 billion with sustainable bonds – which combine green and social – and pure social bonds trailing behind at US$175 billion and US$150 billion respectively.

Unsurprisingly, issuance from US companies is expected to be lower given incoming President Donald Trump’s policy on climate change and withdrawal from the Paris Agreement. However, Moody’s notes that “a continued focus on climate mitigation financing, as well as growing interest in climate adaptation and nature, will spur green and sustainability bond issuance”.

The research found that climate mitigation projects will remain the focus, but investment drivers will evolve, leading to more issuance related to data centres, nuclear energy and emerging green technologies. The market is also expected to diversify toward climate adaptation and nature finance.

 

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