Green Bonds: An Introduction and Legal Considerations

Over $40 billion of so-called “green bonds” were issued in 2015, a record amount. ¹‘2015 Green Bond Market Roundup’ Climate Bonds Initiative, 2016) http://www.climatebonds.net/2016/01/2015-year-end-review-tall-trees-many-green-shoots-evolution-green-bond-market-continues-2015, accessed Jan. 31, 2016. Recent high-profile green bond issuances have included Shanghai Pudong Development Bank Co.’s record 20 billion yuan ($4.3 billion) issuance in January 2016 and an October 2015 $1.25 billion issuance by French energy company Électricité de France (EDF), as well as continued strong issuances from development banks such as the European Investment Bank (EIB), KfW and the World Bank group. Given its short history, the long-term future of the green bonds market remains unclear. Nevertheless, recent announcements of fossil fuel divestments by large pension funds and other endowments as well as the new U.S. Clean Power Plan and the Paris climate change accord are indicative of long-term drivers of the green energy and infrastructure markets. This article outlines what a “green bond” is, surveys the green bond market and highlights some legal considerations regarding green bonds.

Definition of a “Green Bond” and the Green Bond Principles

Green bonds are, in the broadest definition, any bonds the proceeds of which the issuer uses to invest in so-called “green,” or environmentally friendly, projects, assets or businesses. Green bonds are largely self-labeled; the issuer decides (in consultation with advisers and underwriters) to market their bonds as “green.” In some cases, particularly in the case of project bonds, the bonds are not marketed as green bonds but fit the definition given their stated use of proceeds. These bonds are often included in market totals and are eligible for green bond indices.

In order to provide a more specific definition of green bonds, the International Capital Market Association (ICMA), an industry group of banks, asset managers, brokers and their professional advisers, has formulated the Green Bond Principles (GBPs). The GBPs define a “green bond” as a bond that adheres to the four GBPs, which are as follows:

1. Use of Proceeds. The proceeds from the issuance should be used to finance or refinance projects that provide clear environmentally sustainable benefits, as determined by the issuer, including but not limited to: renewable energy, energy efficiency, sustainable waste management, sustainable land use, biodiversity conservation, clean transport, sustainable water management and climate change adaptation.

• 2)  Project Evaluation and Selection. The issuer should outline the process it follows and the criteria it uses to determine eligible green projects, as well as the environmental objectives of the projects.

• 3)  Management of Proceeds. Net bond proceeds should be credited to a separate account or sub-portfolio or otherwise tracked and attested to by a formal internal process. So long as the bonds are outstanding, the use of proceeds should be tracked, and pending investments in or disbursements to eligible projects, the issuer should make known to investors the types of temporary investment instruments for the balance of unallocated proceeds.

• 4)  Reporting. In addition to disclosures at issuance, the issuer should produce at least annual reports on which projects it has used the proceeds. Quantitative reporting and quantification of the impact of the investments (e.g., reductions in greenhouse gas emissions) are encouraged.

Market Overview and Rationale

Market Overview

Globally, new green bond issuances more than tripled in 2014, totaling $36.6 billion, after also more than tripling the year before, according to data from the Climate Bonds Initiative, a nonprofit that tracks the green bond market. ²‘Bonds and Climate Change – The State of the Market in 2015’ (Climate Bonds Initiative, 2015) http://www.climatebonds.net/resources/publications/bonds-climate-change-2015 accessed Aug. 9, 2015, 8, hereafter referred to as “State of the Market 2015.” This high growth rate did not continue in 2015, but the 2015 year-end total of approximately $41.8 billion exceeded the 2014 total. ³Climate Bonds Initiative, ‘Green Bonds Market 2015’ http://www.climatebonds.net/ accessed Dec. 8, 2015.

Green bonds have been offered in a diverse range of markets and with a diverse range of structures. Development bank issuances in 2015 made up approximately $15 billion, with corporate issuances providing $14 billion, municipalities $6 billion and the remainder from commercial banks and asset-backed issuances. ⁴‘2015 Green Bond Market Roundup’ (Climate Bonds Initiative, 2016) Offerings have been made in both registered markets in small denominations to retail investors and in the restricted private placement market to institutional buyers, in addition to exempt offerings by development banks and municipalities.

The large majority of issuances have been in the investment-grade space, although renewable energy companies have also been active issuing high-yield green bonds. Other recent issuers and structures have included “green guarantees” of renewable energy projects from the U.S. Overseas Private Investment Corp., a green German Pfandbrief from Berlin Hyp secured by long-term mortgages on green buildings, asset-backed bonds from SolarCity secured by long-term leases of rooftop solar systems, Hawaiian municipal bonds secured by revenues from a green infrastructure utility fee and a €2.5 billion issuance from GDF Suez (now Engie), notable both because of its size and because it was issued by a company with a majority of its revenues derived from natural gas and coal.

According to the Climate Bonds Initiative, green bonds have been issued in 23 different currencies, although USD and EUR issuances have dominated the market. Geographically, the majority of issuers are from the U.S. or EU, although there have been multiple issuers from China, India, Australia and South Africa. In 2015, stated use of proceeds for renewable energy projects accounted for about 46 percent of all proceeds, followed by approximately 20 percent for energy efficiency, 13 percent for transport, 9 percent for water projects and the remaining for waste and pollution, agriculture, forestry and climate adaptation projects. ⁵‘2015 Green Bond Market Roundup’ (Climate Bonds Initiative, 2016). Tenors for green bonds are typically greater than 10 years, consistent with the longer terms of their underlying infrastructure investments.

Several green bond indices are now maintained, including by S&P Dow Jones, Barclays MSCI and Bank of America Merrill Lynch, and the Oslo Stock Exchange (Oslo Børs) has launched a separate list of green bonds listed on the Oslo Børs and Nordic ABM marketplaces. S&P Dow Jones maintains an index of project bonds that includes both bonds labeled as “green” and unlabeled bonds meeting certain green eligibility criteria.

Rationale

The reasons commonly cited for issuers to issue green bonds (as opposed to a non-green bond) are:

1. Highlighting the issuer’s green projects to access capital from environmentally conscious investors. These may include retail investors, specialist investors that make only environmentally friendly investments, including green bond funds (of which there are now several), or larger mainstream asset managers such as pension funds and endowments that have allocated a portion of their assets for green investments;
2. Stimulating additional capital investments in green infrastructure from the broader market and raising awareness of environmental issues, stated goals of development bank issuers;
3. Generating positive publicity and goodwill with other company stakeholders, such as stockholders, employees and customers; and
4. Obtaining preferential tax treatment of the bonds, if available. ⁶Special tax incentive programs have periodically been enacted by the U.S. Congress. For example, two such programs, Qualified Energy Conservation Bonds and Clean Renewable Energy Bonds, provide tax credits to bond holders or cash rebates to issuers to reduce borrowing costs. Qualified Energy Conservation Bonds are available only to government issuers, and Clean Renewable Energy Bonds are to be used for capital expenditures incurred by qualified owners, including governmental bodies, public power providers, or cooperative electric companies, for one or more qualified renewable energy facilities.

Market participants suggest anecdotally that the market is generally more receptive to green versus non-green issuances but that it is not yet possible to discern a clear pricing advantage for green bonds, either at primary issuance or in secondary trading.

Structuring the Use and Tracking of Proceeds

A prospective issuer of a green bond has a number of structuring decisions regarding the use and tracking of the proceeds. If the issuer wishes to comply with any particular voluntary certification standards or be eligible for certain green bond indices, the relevant certification/admission requirements should be consulted. In general, the GBPs serve as a minimum standard for many structuring considerations, with other voluntary standards, such as the Climate Bonds Standards (developed by the Climate Bonds Initiative), requiring more stringent measures on the part of the issuer, including specific technical requirements for the funded green projects. A group of 11 major development banks have also recently published guidance on impact reporting for green bonds. ⁷‘Green Bonds: Working Towards a Harmonized Framework for Impact Reporting’ (African Development Bank, et al., December 2015), available at: http://www.afdb.org/fileadmin/uploads/afdb/Documents/Generic-Documents/Working_Towards_a_Harmonized_Framework_for_Impact_Reporting_December_2015.pdf.

Important additional factors to consider in structuring are 1) the issuer’s funding needs and flexibility required and 2) costs associated with, and feasibility of, compliance with the commitments made. Accounting issues in proceeds management should also be considered. Some of the key structuring questions are:

1. Permitted uses
   • a.  What types of projects will be funded (energy, transport, buildings, water, etc.)?
   • b.  Do investments in acquisitions of green assets or companies count? What if all of the acquired company is not “green”?
   • c.  Will proceeds be used for new investments only or will there be a “look-back” to investments made during a certain period pre-issuance?
   • d.  Will proceeds be used for refinancings or only greenfield financings?
2. Proceeds management
   • a.  Will proceeds be deposited into a separate account or comingled with other corporate funds and tracked “on paper”?
   • b.  What investments can be made with the proceeds while the issuer is waiting to make green investments (e.g., cash equivalents)?
   • c.  If green investments mature before the bond matures, do returned proceeds need to be reinvested in other green projects?
   • d.  Will a portion of any profits earned be reinvested in green projects?
   • e.  What use is allowed for proceeds earmarked for green investments that never materialize?
3. Reporting
   • a.  Will a second opinion (as discussed below) be given at issuance?
   • b.  What reporting on the use of proceeds will be made? How frequently? How detailed? Will impacts of the investments be quantitatively or just qualitatively measured?
   • c.  Will any third-party auditing or assurance be given post-issuance?

Legal Considerations

The green bonds market is still developing, and minimal regulatory or judicial guidance specific to green bonds is available in most markets. Two recent exceptions are China, where the People’s Bank of China (the Chinese central bank) issued new regulations in December 2015 under which banks and financial institutions may issue green bonds, and India, where the Securities and Exchange Board of India issued final green bond regulations in January 2016. ⁸Hamza Ali, ‘China Releases National Green Bond Standards’ (Environmental Finance, Dec. 23, 2015) available at: https://www.environmental-finance.com/content/news/china-releases-national-green-bond-standards.html; ‘SEBI Board Meeting’ Press Release No. 10/2016 (Securities and Exchange Board of India, Jan. 11, 2016) available at: http://203.199.247.102/sebiweb/home/detail/32793/yes/PR-SEBI-Board-Meeting.

What follows are some general legal considerations for participants in green bond issuances. Given the diversity of the green bond market, each issuance will naturally raise its own unique legal issues for counsel to address. Furthermore, in addition to any legal considerations, issuers and their advisers should be mindful of the risk of reputational harm for violating green commitments, especially for issuers that repeatedly tap the capital markets.

Securities Laws and Regulations

The touchstone of green bonds to-date has been issuer statements in offering materials regarding the use of bond proceeds according to specified criteria and procedures. Issuer statements on their planned use of proceeds vary in scope and specificity. In the absence of express regulation (as in China and India), general laws and regulations governing securities offerings apply to these statements.

In the U.S., the Securities Act of 1933, Securities Exchange Act of 1934 and rules promulgated thereunder provide civil liability and private rights of action against issuers and, in certain circumstances, underwriters and other market participants for untrue statements or omissions of a material fact in registration statements, prospectuses and other offering materials and communications. ⁹E.g., Sections 11 and 12 of the Securities Act of 1933 and Rule 10b-5 under the Securities Exchange Act of 1934. While municipal bonds are exempt from many requirements of the U.S. securities regulations, they are still covered by the general anti-fraud Rule 10b-5. Other jurisdictions have similar disclosure requirements, including member states of the EU. Therefore, when a bond is marketed as “green,” and when an offering document contains statements about the use of proceeds and any proposed reporting, these statements must be true and complete in all material aspects. Some issuers have also included a risk factor in offering materials regarding their green statements and the suitability of the bonds for investors seeking exposure to green assets.

From the standpoint of bondholders wishing to enforce any commitments made by issuers in their offering disclosure, the key limitations of U.S. securities law would be the requirement of a plaintiff to show loss and the remedies available. If an issuer “violates” a proposed use of proceeds (e.g., uses proceeds for non-green investments) but continues to pay interest at the promised rate and the market price of the bonds has not changed in relation to equivalent non-green bonds, a bondholder might struggle to show economic loss and therefore be unable to recover compensatory damages. Furthermore, punitive damages are generally unavailable in U.S. securities cases.

These potential limitations have led some to ask whether regulations and enforcement regimes specific to green bonds are needed that would penalize issuers for violating their green commitments, regardless of economic loss. Conversely, many feel self-regulation through voluntary standards developed by market participants (e.g., the GBPs) is a more flexible and efficient route.

Contractual Issues

Beyond any protection afforded by securities law or reputational harm, the green obligations of green bonds could be protected contractually through the terms of the bond indenture or other documents governing the bond. For a green project bond or bonds secured with green assets, contractual protections are likely already in place given the deal structure and standard covenants and events of default seen in these bonds. But for general corporate green bonds, either in the investment grade or high-yield space, the green bond market currently does not contain strong contractual protections for bondholders regarding the use of proceeds. Consistent with this fact, ratings agencies currently evaluate green bonds using the same approach and methodology as an issuer’s non-green bonds. ¹⁰‘Sector In-Depth – Green Bonds Start to Bloom’ (Moody’s Investors Service, May 27, 2015) www.eenews.net/assets/2015/05/28/document_cw_02.pdf. However, a number of contractual provisions for green bonds could be employed if there is a sufficient pricing advantage for an issuer to offset any increased default risk:

• Use of Proceeds Covenant. The various structuring questions on use and management of proceeds discussed above can be enshrined in a covenant regarding use and management of bond proceeds. This covenant will need to be drafted such that the issuer has sufficient flexibility to avoid immaterial defaults.

• Reporting Covenant. High-yield bonds typically contain obligations to provide bondholders with periodic financial statements. These typical reporting requirements could be supplemented with obligations to provide periodic reports on use and green impacts of the bond proceeds. As assurance standards are developed for green bonds, reporting covenants could ultimately require audited green reporting. There are confidentiality and commercial sensitivities limiting what reporting is feasible.

• Put Option. In the event the issuer desires to use proceeds for non-green purposes, there could be a covenant requiring the issuer to offer to repurchase an amount of notes equal to its proposed non-green allocation.

The effectiveness of these contractual protections would be based on the ability of bondholders to accelerate the repayment of principal if the issuer violated one of these covenants.

Although not enforceable by bondholders, underwriting/purchase agreements between issuers and initial purchasers of green bonds may contain representations and covenants regarding the use of proceeds as disclosed in the offering materials. For repeat issuers, the purchase agreement may contain representations that previous green bond proceeds were used as disclosed in their applicable offering materials.

Deal-Process Points

Beyond substantive legal considerations, there are several deal-process points lawyers and other advisers should keep in mind for green bond issuances. First, the issuer and underwriters will need to establish a reasonable basis and due diligence defense for the disclosure on the green aspects of the bond in offering materials. ¹¹See, e.g., Section 11, Securities Act of 1933. For example, deal participants will want to ensure the planned management and tracking of proceeds, project selection, impact reporting and security over “green” collateral, if any, are feasible and accurately described. The issuer will also need to set up the separate proceeds account, if applicable, and appropriate management and oversight systems.

Second, green bond issuances often involve a “second opinion” on the issuer’s green bond framework, as recommended by the GBPs (although this step has been less frequently taken for U.S. issuances to-date). Typical practice is for the company to hire a third-party institute or consulting firm, such as CICERO or Vigeo, who will give the opinion on a non-reliance basis. These third-party firms either employ their own grading rubric or apply a voluntary standard such as the GBPs or the Climate Bond Standards, and base their opinion on information provided to them by the issuer. Alternatively, instead of performing an independent evaluation, the third-party firm may directly help craft and validate the issuer’s green bond framework. In addition, external auditors may attest to the issuer’s compliance with its use of proceeds framework following issuance. As voluntary standards continue to develop, the rubrics used for second opinions and audits may become more standard, and access to green bond indices or funds could be based on meeting and maintaining a certain level of certification.