The United Nations have estimated that reaching the key goal of the Paris Agreement to limit the global temperature to 1.5°C, will require over $3-6 trillion of targeted investment every year to 2050. Similarly, investors are increasingly wanting to tailor their portfolios to be more mindful of ESG factors.
The first green bonds were established by the European Investment Bank in 2007, acting as a model for the entire green bond market. Since then, green finance has become one of the fastest growing segments of capital markets and a key player in meeting global climate goals.
What is Green Finance?
Typically, ‘green’ refers to assets that fund projects with environmental benefits, however, as a relatively new concept, there is no singular established definition of green finance. Green financing typically appears in four main varieties:
-> Green bonds: bonds issued to fund projects that are environmentally beneficial.
-> Green loans: issued by some Australian banks and non-bank lenders to finance assets meeting green eligibility criteria.
-> Green securitisations: also known as green asset-backed securities (ABS), involves the combination of various financial assets. Green securitisations can either be entirely ‘green’, or have green tranches included.
-> Ethical equity funds: managed funds that advertise a commitment to ethical, sustainable or ESG objectives.
Interpretations of ‘Green’ Vary
Standardised definitions of green projects and assets are still in development which can lead to confusion for both investors and issuers as to what falls within the scope of approved uses for funds.
For green bonds, the majority of issuers tend to apply the International Capital Market Association’s ‘Green Bond Principles’ which are based on key criteria such as the proceeds being used to fund projects with clear environmental benefits and providing disclosures on projects funded.
Valuing green finance instruments
Green finance can be attractive to issuers due to the presence of a ‘greenium’ (green premium), with results from international markets suggesting that green finance may be able to attract investors at lower levels of returns. Similarly, for green loans, borrowers tend to receive a discount on their interest repayments. This suggests that investors are no longer making their investment decisions based solely upon traditional profit-centric measures and are instead placing value upon associated ESG-positive impacts.
How to measure the value of these impacts, however, is very subjective. For example, carbon finance (carbon taxes and
emissions trading) is highly regarded as a way for countries to meet their Paris Agreement obligations, yet establishing a value for carbon is very complex as it has no intrinsic value to start from. Non-financial benefits to investors such as a ‘social licence to operate’ are also difficult to measure due to their intangible nature.
Investors have no guarantee that bonds will be used for their green purpose
Despite the best intentions of bondholders, the proceeds of green bonds may not necessarily be used to finance green projects. The green requirements are rarely included as direct covenants in the terms of the bonds, and as a result, the failure to use the proceeds for a green purpose constitutes neither a default, nor a ‘step-up’ event allowing investors to claim higher returns. This provides little recourse to investors, who may struggle to prove that a loss has been incurred.
In some cases, the failure to use the proceeds for a green purpose may even place the bondholders themselves in breach of their own investment criteria, obliging them to sell the bond in the secondary market, possibly at a loss. As the prevalence of green finance continues to increase, regulators and financial institutions will need to become increasingly cautious about monitoring and disclosing the use of green finance proceeds.
Future of green finance in Australia
Currently, most green finance instruments are issued by Australian state treasury corporations and the major Australian banks. However, the Australian Government has committed to issuing its first sovereign green bonds in mid-2024, so it will be interesting to see the exact terms they attach to the offer. The Green Bond Framework outlines their key climate change and environmental priorities, and details how green bonds will be used to finance green expenditures. It also discusses how these expenditures will be identified, selected, managed and reported upon. These new bonds will allow investors to support public projects to drive Australia’s Net Zero 2050 transition.
Green finance is still only a relatively new area of capital finance markets and one that has incredible promise in boosting levels of environment-conscious investments. A standardised definition of what constitutes ‘green finance’, as well as better protection for investors when funds are used incorrectly will be particularly important in the continued growth of the sector. However, if the market is well-managed, green finance may be exactly what the world needs to propel the global Net Zero transformation into the future.