Green bonds are fixed-income securities issued by private corporations or public bodies (such as central banks or governments) to finance environmentally beneficial (“green”) projects. They are a relatively novel creation of international finance (what is considered the first ever green bond, the European Investment Bank’s “Climate Awareness Bond”, was created in 2007), but one that is rapidly expanding.
In a recent paper, I conduct a legal and economic analysis of green bonds, focusing on two questions: 1) whether green bonds may promote environmental sustainability at private, profit-oriented firms; and 2) whether green bonds should be regulated. In light of the answer to the second question, I also assess EU policymakers’ recent efforts to establish special rules for green bonds. The analysis provides an affirmative answer to the first question, revealing that green bonds are valuable for promoting corporate environmental sustainability. The reason is threefold.
First, by enabling firms to bind themselves to develop one or more green projects, green bonds may help mitigate the credibility problem affecting firms making green pledges to the financial community. Through the issuance of a green bond, the firm may bind itself, in a legally enforceable manner, to make an environmentally beneficial investment (the development of the green project for which the bond was issued). The binding nature of the promise strengthens its credibility, mitigating quality uncertainty problems in the capital market. Reduced uncertainty, in turn, promotes the efficient allocation of “green capital” (namely, capital provided by environment-minded investors) to green projects and, ultimately, the easier financing of those projects. A related benefit of green bonds is that they allow firms to set the precise strength of their commitments. Indeed, the green bond contract allows the parties (the issuer and the bond investors) to pre-establish the exact consequences of non-performance. This feature allows firms wishing to send strong green signals to investors to achieve this goal by setting high contractual penalties for breaches of their green promises.
Second, green bonds help increase corporate environmental transparency. International standards for issuing green bonds require many detailed disclosures: issuing firms must provide a detailed description of the financed project and report periodically on how the funds are allocated. These disclosures are valuable not only for bondholders (who may more easily monitor performance on the part of the debtor company), but also for all investors (who may better assess firms’ environmental efforts). Furthermore, the value of these disclosures appears even higher because environmental, social, and governance (“ESG”) reporting is still nascent and, consequently, a set of coherent and uniform ESG disclosure requirements is currently missing.
Third, green bonds may increase the number of green projects being financed, thanks to the “greenium,” namely the lower interest rates they often come with. The ensuing lower cost of capital should allow firms to finance more green projects, thus boosting corporate environmental sustainability. Note, however, that this premium (where it exists) is usually small. Accordingly, this benefit cannot be expected to be significant.
Should Green Bonds be Regulated?
Regulatory intervention can be justified on the ground that the current regulatory framework (consisting of “private regulation”, namely the set of voluntary standards and guidelines elaborated by private standard-setting organizations, and the applicable rules and principles of contract law and securities regulation) is unable to regulate the green bond market efficiently and to address potential market failures effectively. There are two major concerns: 1) issuer opportunism in using green bonds and 2) uncertainty concerning what amounts to a green project. In theory, both may impair the proper functioning of the green bond market. However, the analysis reveals that these concerns are largely unjustified, concluding that no strong case favors regulation.
Issuer opportunism may take two forms: 1) firms may make false claims about the “greenness” of the bond’s underlying project or, which is largely the same, overstate or otherwise misrepresent its green features (“ex-ante opportunism”); and 2) firms may renege on their green pledges and use the funds for non-green purposes (“ex-post opportunism”). Existing laws and regulations already curb both types of opportunism, and several contractual solutions exist that may enhance their effectiveness.
Consider first ex-ante opportunism. Quite intuitively, this behavior involves disclosing false or inaccurate information to investors. This is not without legal consequences: it exposes the issuing firm and its management to damages towards bondholders (and often also towards shareholders) and—what is likely worse from the perspective of the issuing firm management and shareholders—it might be prosecuted by securities regulators, public attorneys, or the government as securities fraud.
Now consider ex-post opportunism. This behavior is also far from being unconstrained by the law. Unless the bond contract explicitly establishes otherwise, failure to use the proceeds to develop the proposed green project is a breach of contract, usually entailing legal liability. It also amounts to securities fraud to the extent the firm, as we assume, had no intention to invest in the green project from the outset (in fact, this behavior involves misrepresenting ex-ante the purpose of the issuance).
Furthermore, the efficacy of these basic legal remedies may be easily enhanced via contract. As an example, to deter ex-post opportunism, investors may require the issuer to subject itself to detailed reporting obligations (to make its post-contractual behavior more easily observable), or they may ask for the provision of high contractual penalties for non-performance (to make non-performance sufficiently costly to discourage it). Some of these arrangements are already common practice in the green bond market; for example, international standards for the issuance of green bonds require issuers to periodically report on how the proceeds are allocated.
Now consider the second concern that may justify regulatory intervention, namely uncertainty regarding what can be considered a green project. Intuitively, such uncertainty justifies regulatory initiatives to improve clarity (for example, the elaboration of lists or taxonomies of environmentally sustainable activities). However, it is far from certain that public regulation would be superior to private regulation in this respect.
Private regulation has the advantage of flexibility and adaptability (that is, the capacity to timely evolve and adapt to changing market conditions). These features are especially valuable in the green finance area—a burgeoning new field subject to rapid change. Public regulation has much less flexibility; changing it once enacted is usually very difficult. As such, it is exposed to a significant risk of obsolescence.
To be sure, private regulation has its weaknesses. One is the risk of fragmentation, namely the eventual proliferation of competing and reciprocally inconsistent private standards. Fragmentation would increase, rather than decrease, uncertainty and may easily give rise to regulatory arbitrage on the part of issuers, increasing greenwashing risks. Yet the green bond market displays a remarkably low level of fragmentation. It features two widely accepted standards, the International Capital Market Association’s Green Bond Principles and the Climate Bonds Initiative’s Climate Bonds Standard, that provide market participants with largely uniform guidance.
Furthermore, public regulation may reduce fragmentation problems but not eliminate them. Due to public regulation’s mostly national (or, at best, regional) nature, many different public standards, applying according to territorial criteria, may eventually coexist in the green bond market. Since policymakers’ choices concerning what amounts to “green” are not exclusively driven by technical or scientific considerations but also by political concerns, including local environmental priorities, there is a high risk of reciprocal inconsistency between these standards.
From this standpoint, private regulation appears more reliable. Usually designed as a set of universal standards suitable for issuers and investors operating anywhere in the world, it should be less influenced by national or regional environmental priorities (and political considerations more generally) and more strictly adherent to technical and scientific principles.
The paper also assesses EU policymakers’ recent efforts to establish special rules for green bonds. The EU is on the verge of adopting a regulation that, among other things, introduces a voluntary standard for the use of the “European Green Bond” (“EuGB”) designation: issuers wishing to use that designation must comply with the rules and requirements established by that regulation. Since no compelling case exists for regulating green bonds, this initiative is not strictly necessary. However, this is not to say that it is useless or harmful. The (mostly) optional nature of the new rules makes the proposed regulation a light-touch, non-invasive regulatory intervention that may benefit the green bond market by strengthening competition among standard setters, thus increasing the quality of the standards, without restricting issuers’ freedom of choice.
Sergio Gilotta is a senior researcher of business law at the University of Bologna.
This post was adapted from his “Green Bonds: A Legal and Economic Analysis” paper, available on SSRN.
