Explainer: Decoding COP27: the many shades of green bonds

Banks, governments and businesses say financial markets can play a crucial role in driving the shift to a lower-carbon world.

At the COP27 climate conference in Egypt, companies and country delegates are discussing ways of enhancing the market for green bonds, or bonds that are linked to projects deemed environmentally beneficial.

Green bonds have their critics, but as the market has grown, it has spawned a broader industry of sustainability bonds that seek to make borrowers change behaviour.

Companies borrowed record sums via sustainable bonds last year: issuance totalled $859 billion, compared with $534.3 billion in 2020.

However, during this year's financial turmoil, the global take-up has fallen.

In the first half, green, social and sustainability bond issuance fell by 23% to $428 billion versus the first six months of 2021, Refinitiv data showed, as the Ukraine war hit sentiment.

Also known as "use of proceeds bonds," green bonds involve a company or government raising money for projects considered environmentally beneficial. For example, an energy giant could raise money to build a renewable power project.

Governments are big players, particularly in Europe. After a flurry of deals in September, this year's green bond issuance in the euro zone has already surpassed that of the comparable period of 2021.

Borrowers like the market because it can raise funds at more attractive rates, though the term "greenium" refers to the fact that green bonds offer a slightly lower yield than conventional debt.

Critics say these bonds do little to address a company's wider environmental impact and can allow some of the biggest players - energy, mining and other natural resource companies - to claim green credentials without fundamentally changing their business models.

Proponents of the market say these are the very companies that need incentives to spend on green projects and that the market is still maturing.

Companies active in the market generally subscribe to the green bond principles outlined by the International Capital Market Association (ICMA).

Sustainability-linked bonds, or SLBs, comprise a newer and smaller market than green bonds.

Companies and governments can use money raised from SLBs for anything, including general corporate purposes. But SLBs are tied to the company's sustainability targets that it promises to meet.

If they don't, the company must pay a higher interest rate.

Issuers including Enel, Tesco, and Enbridge, for example, have promised to meet certain environmental, social and governance (ESG) goals, like cutting company-wide emissions or boosting board diversity by a certain date.

Critics say the penalties are paltry, often amounting to 0.125% a year for a bond's final few years, while the targets lack ambition and are too easy to meet.

They also say SLBs allow banks to sell the bonds, and companies to raise cash, without introducing changes to benefit the environment.

The Bank for International Settlements in September called on governments to impose tougher penalities on themselves when they fail to hit targets, calling it a credibility issue for the SLB market.

Companies say their targets are verified by third-party groups and they adhere to voluntary principles set by ICMA.

Highly polluting companies need trillions of dollars to reduce their carbon emissions - far more than they can get from SLBs alone.

In 2019, transition bonds were mooted as a possible solution for companies in high-emitting sectors such as energy and transportation that are excluded from the green market.

Issuers including the European Bank for Reconstruction and Development and Italian energy company Snam have raised funding to decarbonise, but overall issuance has stagnated. Last year, nine issuers raised a total of $4.4 billion by selling 12 of these bonds, the Climate Bonds Initiative said.

Advocates nevertheless are pushing for wider acceptance of a labelled transition product to respond to the pressing need to finance decarbonisation efforts in this sphere.

Financial products that help brown companies go green are a trickier concept to sell to the market.

Without clear standards or guidelines for transition bonds, investors and bankers are wary of greenwashing accusations.

One challenge is assessing what a credible transition plan should look like for companies.

The European Commission is working on an extended taxonomy that would incorporate transition criteria, while the Glasgow Financial Alliance for Net Zero (GFANZ) is expected to publish guidance this month on real economy transition plans.

On Tuesday, Britain made good on a promise made at last year's COP26 to update its guidance on how companies should report transition plans.

Beyond bonds focused on environmental outcomes, lie pools of money for related goals around social equity or fair living standards.

A "sustainable development goal bond" that raises money for a project to improve public health, for example, could be used if air pollution from burning fossil fuels were a health threat.

Alternatively, a social bond might fund an affordable housing project that also rehouses people displaced by a climate-fueled wildfire or flood.

The small market for social bonds has been growing fast as some of the largest sustainability bonds issued have focused on social challenges - such as JP Morgan's $1 billion social bond to support U.S. housing.

Big multilateral lenders such as the International Finance Corporation as of June had sold 73 social bonds worth $4.9 billion in total.

Social impact bonds, or impact bonds, differ from social bonds in linking financial returns to the desired outcome.

Social impact is harder to measure than science-based environmental outcomes that often can be captured by a single indicator - greenhouse gas emissions.

The European Commission is expected only in 2024 to release a European social taxonomy to classify investment tools supporting EU goals, such as fair wages and improved living standards.

Impact bonds also tend to be less liquid, making them less attractive for investment funds. Scaling up impact finance while ensuring positive outcomes is a big concern for the market.