The risks behind the 'green bond' boom

Key impulses here were the Climate Agreement of Paris, the Green Finance Study Group of the G20 and the Hamburg Climate and Energy Action Plan of the G19.

Including financial markets in a climate strategy is a logical step with insufficient public funds to finance the necessary investments in green technologies.

At the same time, the financial sector is showing interest in financing green technologies.

Green Bonds are regarded as a key green financial product.

Since the first issuances by the European Development Bank and the World Bank a decade ago, the issuance volume of green bonds has grown enormously.

While a global volume of $3bn was issued in 2012, the issuance volume increased to $157bn in 2017.

The heightened demand for green bonds can be attributed either to greater awareness of sustainability and to the downsides of climate change, but also to the fact that green bonds are more transparent than traditional bonds.

Investors in a traditional bond have limited information on how proceeds are invested, while green bond issuers are allowed to use the funds raised only for green investments. They also document this for the investors.

Definitions needed

However, for such a market to thrive, investors need a definition of green investments and a definition of what a green bond is. In addition, disclosure standards are required so that investors can easily access and compare information about these bonds.

The EU's main effort to strengthen the green bond market is to legislate for a common taxonomy on green bonds and to increase the demand for green bonds through a green supporting factor in bank equity capital regulation, i.e. lower capital requirements for green bonds.

While the taxonomy is relevant to all investors, it was specifically intended to encourage banks to lend money for green investments.

However, this effort must be viewed critically.

Since a bank's equity capital is a limiting factor for lending, the design of capital requirements for banks directly impact demand for specific types of assets of banks.

Since a bank's equity is a buffer against unexpected losses, bank regulation should ensure that banks hold sufficient equity capital relative to their risk.

However, a green supporting factor means that banks will have less equity capital against the unexpected losses of a green bond.

The only rationale for lower capital requirements for green bonds is a lower probability of default compared to traditional bonds.

As long as this is not the case, the green supporting factor would only result in banks being undercapitalised against losses on green bonds.

Political project

As the green bond market is a political project, there is a risk of favouring green bonds in financial market regulation in order to achieve policy goals.

From our calculations, we derive a risk of political intervention to stimulate the demand for green bonds.

The annual green bond emissions would then have to increase by a factor of 45 to finance the potentially required annual green investments of up to $7trn.

To meet the additional investment necessary to achieve the Paris climate target, the annual green bond emissions would have to increase by a factor of 4.5.

In the past, the US made the mistake of using the Community Reinvesting Act to increase housing investment through policy instruments aimed at banks expanding lending to households.

The EU should not make the same mistake and overuse the financial system in order to achieve environmental goals.

The emergence of a green bond bubble and the bursting of that bubble would be detrimental to the financial sector and hinder the achievement of climate targets as investors refrain from investing in which they have previously lost money.

In order to promote green investments, the EU should therefore prefer to rely on existing environmental policy instruments.

Instead of pushing for a rapid growth of the green bond market, the EU should strive for its organic growth.

This should be driven by the market.

To this end, the proposed harmonisation of taxonomy within the EU is a necessary step, as different national taxonomies would hamper the emergence of cross-border green bond markets.

The EU should ensure consistency in the regulatory framework for green bonds with other rules for financial institutions and ensure consistency in the future.