A sustainable future demands more than greenwashing

Clive Smith

Russell Investments

Given the costs associated with moving to an environmentally sustainable future, the ability of entities to access appropriately priced capital to enact change becomes critically important.

Against this backdrop, it is inevitable that green bonds will, over the coming decades, play an integral part in funding the shift toward a more sustainable future. Yet the growing importance of green bonds has highlighted several problems which heighten the risk of greenwashing.

The issues associated with green bonds

Green bonds can be broadly defined as fixed income securities issued by entities such as governments, multinational banks and corporations to raise capital for a project which contributes to a low-carbon, sustainable economy. While this sounds great in theory, in practice there are some complications.

Firstly, green bonds are effectively self‑labelled, meaning that for a bond to be categorised as green simply requires the issuing entity to label it as such. Obviously, the self-labelling nature of the green bond market provides the potential for mis-labelling.

To try and overcome this issue, and to promote the integrity of the green bond market, the International Capital Market Association developed the Green Bond Principles (GBP) in 2014. The GBP provides voluntary guidelines for the market’s broad usage, including principles regarding the use of proceeds, the process for project evaluation, the selection, management of proceeds and reporting for green bond issuances.

More recently, the European Commission in 2021 proposed the European Green Bond Standard. While the existence of such standards alleviates some of the inherent risks around the mis-labelling of green bonds by issuers, that such standards remain voluntary means there is still a lack of enforceable rules and regulations governing green‑labelled securities.

Secondly, the approach to the labelling of the green bond itself can also present issues, as this is based on the project the bond is tied to, not the issuing entity itself. This separation of the individual projects funded from the overall issuing entity can be a double-edged sword.

On the one hand, such a disconnect means green bonds can be issued to support specific environmentally friendly projects.

On the other hand, the disconnect between bond and issuing entity can give rise to conflict between the climate‑friendly proposal and the issuing entity’s overall practices. In this situation, there is a risk that an issuing entity may aim to embellish their green credentials and/or reduce borrowing costs by selectively carving out environmentally friendly projects/activities from its overall operations.

As the importance of, and investor demand for, green bonds has grown, the complications associated with these issues has resulted in a growing risk of greenwashing.

Broadly speaking, greenwashing is the practice of channelling proceeds from green bonds toward projects or activities having negligible or negative environmental benefits.

Apart from the significant reputational risk greenwashing creates for socially conscious investors seeking to diversify their portfolios by investing in ESG-friendly practices (environmental, social and governance), it also risks undermining confidence in the green bond market.

Examples of potential greenwashing

These risks are heightened because the nature of determining what comprises ESG-friendly activities – and by extension identifying greenwashing – is nuanced and not necessarily clear cut. Below are four examples which highlight the potential difficulties in identifying whether greenwashing is occurring.

  1. The oil and gas sector’s first green bond was issued by Spanish energy and petrochemical company Repsol in May 2017. The company raised €500 million, which it claimed would help cut CO2 emissions by 1.2 million tonnes within three years. Complicating the bond’s green credentials was that the money raised was to be used to upgrade Repsol’s existing fossil fuel refineries by making them more efficient.
  2. In 2016 and 2017, the Mexico City Airport Trust issued green bonds to finance a new airport in the country’s capital. The Trust raised US$6 billion, with the debt earning green evaluations from both Moody’s and S&P. However, in 2018, the newly elected Mexican government stopped construction of the airport. Whilst green rating downgrades followed, the bonds still retained a green label despite not funding an eligible green project.
  3. Saudi Electricity Company, a state-owned monopoly in an oil-rich country exporting around 6.6 million barrels of oil per day, raised €1.3 billion from a green bond sale to invest in the installation of smart meters across its grid.
  4. China’s Three Gorges Dam issued US$840 million in green bonds with the proceeds to be used to back wind power projects in Europe. When considered in isolation, wind power projects are unequivocally climate friendly. However, Three Gorges Dam has been continuously cited for water pollution and damaging surrounding ecosystems.

Steps to avoid greenwashing

Despite the risks associated with greenwashing, there are steps investors can take to minimise the potential for investing in green bonds which are not compatible with the desired outcome of a low-carbon and sustainable economy.

1. Does the bond align with acceptable green bond frameworks?

Whilst there is a lack of enforceable regulations as a first step, investors in green bonds should ensure alignment with at least one of the widely accepted green bond frameworks. In particular, investors should look for:

  • Clear disclosure of use of proceeds
  • Proceeds being used to fund green activities/projects which provide clear and quantifiable environmental benefits.
A bond being certified as green by an external, expert entity is the greatest certainty an investor can have as to the appropriateness of a green label on a bond.

That said, a bond being correctly labelled green doesn’t necessarily ensure the optimal outcome for an investor seeking to support the transition to a sustainable future.

2. Is the project being funded sufficiently green?

Ensuring an activity is sufficiently green can assist in reducing the risk of greenwashing by eliminating those projects making a more marginal contribution to a low carbon, sustainable economy. An example of such a framework is the one applied by the Oslo-based Center for International Climate Research (CICERO), which uses three shades of green:

  • Dark green is allocated to projects and solutions that correspond to the long-term vision of a low-carbon and climate-resilient future, e.g. wind energy.
  • Medium green is allocated to projects and solutions that represent steps toward the long-term vision but are not quite there yet, e.g. plug-in hybrid buses.
  • Light green is allocated to projects and solutions that are environmentally friendly but do not by themselves represent or contribute to the long-term vision, e.g. more efficient fossil fuel infrastructure.

In addition, CICERO allocates the colour brown to projects that are in opposition to this long-term vision of a low-carbon and climate-resilient future, e.g. new infrastructure for coal.

Application of such a framework as part of a ‘negative list’ can also assist in reducing the risk of investing in a project which is not sufficiently green.

3. Is the issuing entity acting appropriately?

Of increasing significance to investors wishing to avoid greenwashing is ensuring that the project being funded is consistent with the issuing entity’s overall behaviour. This requires that investors take a more holistic view of an issuing entities behaviour.

Put another way, allocating capital to a project with excellent green credentials may not be appropriate if the issuer displays contrary practices throughout the rest of its organisation.

Even where a bond has formal green accreditation, this should be considered not in isolation but rather in conjunction with the overall ESG creditability of the issuer to prevent the cherry picking of green activities.

Green financing needs to be viewed as simply one part of an overall, long-term strategy toward sustainability by the issuing entity. Application of such a holistic approach to assessing the issuing entity is a key consideration toward minimising the risk of greenwashing by ensuing that the issuing entity has ESG commitments and targets that aim to make the overall business ‘greener’ and more sustainable.

It is this increased focus on the overall activities of the issuing entity which has led to a growing market for sustainability-linked bonds and loans.

Unlike green bonds, these products do not specify how an issuer should spend the money. Rather, they reward the issuer when they improve on pre-determined metrics, such as reducing emissions, or punish them with higher interest payments if they miss those targets.

An example of this type of bond in Australia is the recent issuance by Wesfarmers of a sustainability-linked bond. As part of the transaction, Wesfarmers has committed to obtaining all the energy requirements for its Bunnings, Kmart Group and Officeworks retail businesses from renewable sources by the end of 2025.

The company has also committed to limiting the average emissions intensity of its ammonium nitrate production plant to 0.25 tonne of carbon dioxide equivalent per tonne. Failure to achieve these targets will see the coupon on the sustainability bonds rise by a maximum 25 basis points at the trigger date.

As environmental awareness amongst bond investors grows, so too does the desire of issuing entities to embellish their green credentials and be seen as part of the movement toward a sustainable future.

Unfortunately, green bonds can enable such embellishment by virtue of the lack of a regulatory framework as well as their links to specific environmentally friendly activities. This can disguise the overall impact of an issuing entity’s activities and, in turn undermine the benefits derived from green bonds.

While analysis of a green bond is an important part of the selection process, to avoid the risk of greenwashing this should not be undertaken by investors in isolation. Equally important is ensuring that the issuance of green bonds occurs within the framework of an overall move by the issuing entity toward a more sustainable operating model.

By undertaking a more holistic approach, investors will be able to exert maximum pressure on issuing entities to adapt and make a more material net contribution to a sustainable future.

Clive Smith
Senior Portfolio Manager
Russell Investments

Clive Smith is the Senior Portfolio Manager on Russell Investments’ Australian fixed income team. Responsibilities span management of Russell Investments’ Australasian fixed income funds as well as conducting capital market and manager research...


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