The Bond Villains of Green Investment

Cristina Banahan is a Sustainability Advisor. This post is based on her recent article, forthcoming in the Vermont Law Review. Related research from the Program on Corporate Governance includes Socially Responsible Firms by Alan Ferrell, Hao Liang, and Luc Renneboog (discussed on the Forum here).

Green bonds are critical to addressing climate change. The most recent Intergovernmental Panel on Climate Change report shows that unless dramatic corrective action is taken in the next decade, humanity could see mass migrations, food scarcity, and instability as early as 2040. To mitigate greenhouse gas emissions and prevent the most serious harms requires unprecedented levels of investment from the private sector and regulatory agility from government entities. Green bonds from public, private, and multilateral organizations are critical because they can serve to finance the large-scale infrastructure changes needed to transition to a zero-emissions economy. Government regulation of the green bond sector is critical to its success because regulations provide stakeholders with certainty as to the applicable legal standards and investor expectations. Furthermore, government regulation could help implement the lessons learned from past financial faux pas in the investment and issuer arenas. To apply the lessons of the past and ensure the prosperity of the green bond market in the future, governments should consider implementing a green standards committee as a simple and efficient way of meeting the financing challenges posed by climate change.

Green bonds are a type of bond issued by a private, public, or multilateral institution to finance a climate friendly or environmental goal for the issuer and create revenue for the investor. In case of default, green bonds are backed by an issuer’s balance sheet, use of proceeds, or cash flow from other assets or investments. Green bonds differ from regular bonds in that additional steps are generally taken to ensure their environmental purpose. The most common way a regular bond is deemed green is through a second-party opinion. [See, Stephen King Park, Investors As Regulators.] The second party evaluates the debt contract and certifies the security as having a legitimate sustainability purpose. Id.

While countries developed different regulatory structures for their green bond markets, international standards are available to guide in the consistency of their development. The most prominent guideline is the Green Bond Principles (“GBP”) established by the United Nations Program on the Environment to help guide issuers in setting up credible green bonds. The GBP suggested a four-part process to setting up a green bond:

  • “Define criteria for a green project”;
  • “Define processes for evaluation and selection of the green project”;
  • “Have systems to trace the green bond proceeds”;
  • and, “Report, at least annually, on the use of the proceeds.”

[See, Ernst & Young LLP, Green Bonds: A Fresh Look At Financing Green Projects.]

In addition to these steps, the GBP also recommend an independent verification of the project by a second party consultant, audit, or third-party verification. Id.

The GBP is a market response to the absence of green bond regulation. In the past, the market has sought to address the vacuum left by regulatory agencies without success.

Bond Villain #1: Green Bond Verifiers

Green bond verifiers (“GVB”) play a critical role for green investment by assuring investors of the environmental contributions of their purchases. Verifiers perform a similar role to credit agencies, by evaluating information on an investor’s behalf and developing recommendations. Within the vast universe of information, verifiers and credit agencies receive, analyze, and condense information in order to make it more accessible for investors. Both verifiers and credit agencies rely heavily on the reputation of their businesses to make them appealing to investors. Furthermore, verifiers and credit agencies both rely on an issuer pays business model; under the issuer pays model, the issuer of the financial instrument pays the credit agency or green bond verifier in exchange for a rating.

Advocates for market regulation argue that the reputational consequences that green bond verifiers and credit rating agencies face are sufficient to motivate them to create reliable recommendations for investors. The reputational concerns of credit rating agencies and green bond verifiers has proven an insufficient counterweight to the conflicts of interest represented by the issuer pays model, as proven by investigations of credit rating agencies in the aftermath of the Financial Crisis. Reputation with issuers and investors is not equally distributed with studies pointing to certifiers tipping the balance of importance towards issuers who pay for the certifications. [See, Bo Becker & Todd Milbourn, How Did Increased Competition Affect Credit Ratings?.] The testimony of employees at rating agencies to regulatory and congressional committees following the Financial Crisis suggested that profit margins took center stage over quality. In fact, the testimony further stated that the ratings methodologies in these institutions were changed in response to ratings purchasers choosing a competitor over their ratings. The Financial Crisis is evidence that certification firms competing for reputation is not a guarantee against questionable practices.

Bond Villain #2: “Green” Bond Issuers

Certification of bonds by verifiers is supposed to insulate the green bond market from issuances of securities that call into question a project’s environmental benefit. Despite the assurances that verifiers provide to the public, the project below raised concerns as to the environmental integrity of green bond offerings.

The most famous green bond villain is Repsol, with its green bond issuance for an energy efficiency and carbon emission reduction program. Repsol was the first fossil-fuel company to issue green bonds to help finance energy efficiency and carbon emission reductions. The 2018 offering collected €500 million for energy efficiency and carbon reduction projects anticipated to reduce emissions by 1.2 metric tons. Before issuing the bond, Repsol obtained a second-party verification from Vigeo Eris that the bond was green. Vigeo Eris certified Repsol’s green bond based on the company’s commitment to reduce waste by 50 kilotons, carbon emissions by 1.9 million tons, and investments in offshore wind power. Despite receiving this certification, most major green indices declined to have the bond listed.   Critics of Repsol’s issuance assert the bond did not represent a fundamental change in Repsol’s business model, only an incremental one.

Why a Green Standards Committee?

A green standards committee (“GSC”) could offer critical assurances to sustainability-focused investors by providing clarity, oversight, and accountability of purported green investments. First, a GSC can provide a clear definition as to what constitutes a green bond. Having a clear definition of which projects constitute green bonds is an important first step in providing more clarity on the green bond market. While the GBP provide a definition of green bonds that issuers and governments have used, it is not binding on issuers. [See, Echo K. Wang, Financing Green: Reforming Green Bond Regulation in the United States.] Countries like China and India have codified similar versions of the GBP as part of an effort to standardize the kinds of projects to be approved.

Next, a GSC can require better disclosure and oversight on green investments. Increases in monitoring could improve the reliability of available information on green bonds. Although international standards and independent second party verifiers have propelled progress on green bond disclosure, current disclosure is insufficiently meaningful to provide a realistic picture about the environmental quality of the financial products being offered.

Finally, a GSC can assure investors that green bond verifiers are not engaging in self-dealing. As of the date of the Article’s publication, four of the largest green bond verifiers were contacted to comment on negative recommendations for green bond issuance—none had ever issued a negative recommendation for a green bond. (Correspondence with the top second-party verifiers on file with author.) Although various factors could influence the reasons for the absence of negative recommendations, such as issuer preparedness and early refusal by verifiers, a regulating entity, such as a GSC, could also provide assurances to the public that there are no ethical conflicts of interest between the verifiers and the issuers that purchase their services. As credit agencies did before them, green bond issuers and the firms that verify them must grapple with the same concerns raised by the issuer-pays business model. [See, Paul Rose, Certifying ‘Climate’ in Climate Bonds.]   Similarly to how credit agencies during the financial crisis were incented to put issuer interests before that of the investors that relied on the ratings in order to gain market share, second party verifiers, absent regulation, could engage in the same problematic behavior that provoked the financial crisis. A GSC that could oversee the market and provide assurances that the verifiers are not engaging in risky behavior could help prevent the challenges encountered by the securities market previously.


Whether you consider the “villains” of the green bond story to be the issuers or the second opinion verifiers, the fact remains that the market needs regulation to prevent similar past harms and support future growth. Regulating green bonds could help define the types of qualifying projects, increase transparency, and prevent the practices that triggered the financial crisis. Regulating green bonds would grow the green bond market as stakeholders are better able to make decisions as to liability and risk.

Regulating green bonds will not only be good for the market, it will be good for the environment. Green bonds are a powerful instrument to combat climate change as they open a plethora of investment opportunities to decarbonize. This investment instrument, however, has already begun being misused with some issuers diverting funds from bona fide green bond issuances to those with uncorroborated benefits. In the absence of regulation, society runs the risk that trillions of dollars in carbon-reduction investment ultimately do little to meet the 2C goal set out by the Paris Agreement. A GSC could provide the assurances that the investor community needs that by purchasing a green bond they are helping financing a sustainable future.

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