Validating the market for green financing
Simon Holden, Head of Investment Advisory Services at Lloyd's Register, writes that the green financing market needs to rethink how it verifies sustainability.
Green bonds are one of a spectrum of green financing options that have grown over the past decade following interest and pressure from investors and institutions. These green financing options also include private loans, private equity investing, and public stock markets.
Although still small compared to wider bond issuance, the market for green bonds has grown exponentially since its early days approximately a decade ago.
According to Moody’s, USD 155bn of green-labelled debt was sold in 2017, and the final figure for 2018 is expected to be between USD 175bn and USD 200bn. Research by the Climate Bond Initiative indicates that 2019 has seen just under $20bn of issuance so far.
The urgency given to investing and financing that is responsible, sustainable and green has never been greater. But these very terms are causing challenges because of their subjectivity.
Current solutions are reinforcing this problem because they are unable to tackle the fundamental issue: agreeing what it means to be responsible, sustainable and green.
The upshot has been that, hand-in-hand with the exponential growth in green financial products, cries of greenwash have also been growing. Numerous attempts are being made to tackle the problem, but many of them are falling into the same trap.
What is that trap, why does it exist and how can a different approach be beneficial?
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The difficulties of verification: cost, communication and definition
The challenge of verifying the use of the funds as green has not been lost on issuers, investors, trade bodies and ratings agencies. A concomitant industry of verifiers has grown alongside the expansion in green financing to address the potential for greenwash.
In turn, the challenges of assurance have moulded the verification industry into the shape it is today. These challenges relate to the costs of verification, communications, and definitions of greenness.
To minimize costs, verification largely involves desk-based research comprising secondary data, some of which is acquired from the borrowers themselves.
Another way to make verification practical has been to develop principles, such as those created by the ICMA and Climate Bond Initiative, which describe what ‘good’ looks like in terms of green investing.
Not surprisingly, the ‘high-levelness’ of a principles-based approach (and the element of self-reporting using borrower derived data in desk-top research) have led to disquiet about the true nature of green finance.
The challenge of communicating in simple form what is potentially a complex issue has not helped this disquiet either. Grades or stars awarded by ratings agencies and others help categorise and simplify communication, but the many hidden assumptions behind ratings have led some market participants to describe the resulting verification process as ‘black box’.
Capping all these difficulties is the fundamental challenge of defining green. Whatever approach is taken, any definition is subjective: on the one hand many will find investment in wind farms and electric vehicles to be perfectly acceptable candidates for sustainability and greenness; on the other, there are plenty of people who would find such investments ineligible.
In Germany, for example, the growth of intermittent forms of renewable generation has contributed to an increase in CO2 emissions over the last five years when lignite is burnt to produce balancing or baseload power. Others also question the cost (both human and physical) of extracting resources to supply vehicle batteries.
Shine a light and let comparisons speak for themselves
Given the challenges described above, are participants in the market (who are seeking clarity over the quality of green finance) approaching the problem from the wrong direction?
Most participants can agree on one outcome: the need for behavioural change in the way that we consume resources and interact with the natural environment.
Given this likely coalescence of opinion, a different approach might be to take a leaf from psychology and behavioural economics. You can’t manage what you don’t measure, according to the popular adage, and shining a light on the data is a good place to start.
Plenty has been written about ‘nudge theory’ and its application to different areas of public policy. So instead of potentially contentious judgements on green eligibility, a simpler (but admittedly less sexy) approach would be to measure comprehensively key impacts and compare them to other similar assets and activities.
Over time, sufficient data would enable investors to understand whether a given parameter for a particular asset or activity is in the top or bottom decile of its peers, and judge for themselves whether the investment was good or not.
Moving away from what are inherently subjective (and sometimes opaque) judgments is at the core of the alternative approach. That said, any alternative approach will pose other difficulties such as problems of completeness, the ability to compare and granularity.
To present a true picture of impact, measurement must be ‘total’ or ‘complete’, which means covering the periods of asset formation, operations, and decommissioning. The operating period of an asset is well-served by reporting, mainly for reasons of regulatory compliance. Therefore, data acquisition should not be onerous.
One area which is not so well-covered is asset formation. For example, it may be assumed that a floating offshore wind farm produces less emissions in formation than a fixed piled one because far less concrete is poured (and cement production entails a large volume of greenhouse gases emissions).
However, the vessel movements needed for floating offshore wind farm installation are potentially greater and may offset the ‘gain’ in avoiding piling. Gaining a complete picture of embedded emissions at the asset formation stage will be essential to any total audit of greenness.
The exercise of comparison will require normalizations: some of these may be simple, such as comparing footprints of the two different kinds of offshore wind farms on a per installed kW basis. Other normalisations could be more challenging and less apparent.
Granularity, or depth of measurement, and where to draw the line will also present difficulties with the suggested alternative approach.
To illustrate this difficulty, how far back in the supply chain is it feasible or reasonable to go to assess the amount of embedded carbon in asset formation? Determining where this line is drawn will be a subjective act and so run counter to the opening premise of the alternative approach - which is to remove subjectivity.
Multiple approaches: having just the one current approach is insufficient
Any approach to assessing greenness to avoid greenwash will involve difficulty and compromise. The huge variety of activity under the banner of green (i.e. not just asset investment but operational measures regarding energy efficiency) is likely to mean that multiple approaches are needed.
This means that the verification and rating work currently being done in the market is likely to remain a valid way to help investors navigate the complexities of green financing and what it really entails. But this work needs supplementing, and in some cases supplanting, by more objective approaches if green financing is to retain its credibility.
Two factors make the alternative approach to ratings and current certification practices a practical proposal. The first is the existence of publicly available and verifiable conversion factors for estimating embedded emissions (such as those published by the UK Government GHG Conversion Factors for Company Reporting or the CEF Basic Carbon Calculator).
The second is that the exercise of summing pre-trading and operating period data will already be familiar to the financial world with its method of ‘net present value’ calculations. Also, much of what needs to be verified must already be reported for compliance reasons (for example in Environmental Impact Assessments and continuous monitoring systems).
If the green financing market is to remain credible, it is time to re-think how the market verifies greenness and sustainability. Too much assessment today is opaque and reliant on secondary or unverified data. Registering and shining a light on the key metrics that affect the sustainability of our planet may be simpler, less subjective and a more effective means of driving behavioural change in investing than the current reliance on rating.
