Green Bonds Series: Part 4 – When ‘green’ bonds go brown

In this article, part 4 of our series on green bonds, we take a look at the consequences for green bonds which fail to deliver on their promised ‘green’ investment.

Since the first issue of a green bond in 2007, the terms and conditions of green bonds have been silent or expressly excluded the right of investors in the event of a green-default. This was to encourage the growth of the green bond market. However, it did nothing to support the ‘green’ credibility of green bonds. This may be about to change. 

Investors are now starting to ask for contractual protections linked to ‘greenness’, and issuers, following the lead of the green loan market, are more comfortable accepting this as a precondition to accessing green finance. 

What is a ‘green default’?

In this context, default relates to the green features or principles of the investment. For example:

• the issuance proceeds from a green bond are not applied to the green projects as promised; or
• the intended project to which the issuance proceeds are to be applied changes in a way that means it no longer meets the green criteria on which the bond was marketed, issued and certified. 

Reporting of ‘green defaults’

The Climate Bonds Initiative, the leading industry body for green finance standards, addresses the possibility of non-conformance under its Climate Bonds Standard (Standard). With green bonds certified under the Standard, issuers must disclose ‘green defaults’ to the Climate Bonds Initiative Board within ‘one month of becoming aware of the non-conformance’. The Board may suggest ‘corrective actions’ for conformance to be restored and if conformance is not restored within a reasonable time the Board shall consider revoking the certification of the green bond.

If a certified green bond loses its status as ‘Climate Bond Certified’ the issuer must:

• refrain from use of the Climate Bond Certification Mark;
• remove the bond from the Climate Bond listing; and 
• inform bond holders, exchanges and other market participants of the loss of certification. 

The Standard addresses the failure to conform to the Standard, however, the process by which the Board deals with non-conformance is discretionary and uncertain, and the sanction is confined to a loss of certification. 

In addition to certified green bonds, many green bonds are self-labelled as ‘green’ and as a result the reporting of ‘green defaults’ in this space is arbitrary (and limited). 

What is my recourse if a green bond is no longer green?

The impact of a green bond losing its ‘green’ status is determined by the terms and conditions of the bond and any related investment mandate binding on investors. 

The historical market position is the inclusion, in the pricing supplement for an issuance programme, of an express statement that a loss of certification does not constitute an event of default and bondholders cannot exercise redemption rights or take any other action.

This lack of recourse creates a risk for investors whose investment mandates requires the investment to meet certain ‘green’ targets. The consequences will depend on the terms of the investment mandate but may include the fund being dissolved, the body losing funding approval or a need to sell the bonds in the secondary market (potentially at a loss). 

Avoiding ‘green defaults’

Investors wanting to maintain their investment mandate must:

• critically assess the degree of rigour applied to the certification and review process; and
• ensure the bond includes contractual remedies triggered by a loss of green certification. 

Otherwise investors are reliant on the issuer’s personal interest (if any) in maintaining their ‘green’ reputation. Governments, businesses, and investors are all conscious to ensure they are contributing to a sustainable environment and a ‘green default’ would prove damaging to an entity’s standing in the community. 

Are investor rights evolving for ‘green defaults’?

Due to strong investor demand, greater clarity over ‘green’ certification and the increasing pressure on corporates to improve the sustainability of their operations, the platform is set for future green bond issues to include enforceable contractual arrangements that provide investors with protections from ‘green defaults’. These arrangements may include:

• an assurance process during the tenor of the green bond with regular reporting required to be made available to investors;
• requirements for application of proceeds to the intended green purposes; 
• the ring-fencing of proceeds into a separate account, so that any unallocated issuance proceeds from a green tranche are not applied to other non-green purposes; and
• linking green failures to put events to enable bondholders to accelerate or redeem their bonds, or linking green failures to a margin ratchet requiring the issuer to pay an increased coupon if there is green non-compliance.

With these arrangements, we expect margin ratchets will be the most popular. This is due to the clarity margin ratchets provide green bond investors and issuers with respect to enforcement. The certainty is a by-product of the green loans market, where margin ratchets are a commonly utilised tool, as the successful enforcement of margin ratchet clauses (in the green loan market) has shown that they are an effective tool for ensuring the ‘greenness’ of green financial instruments. 

The green bond market may further evolve to include a full ‘green default’ regime and rights of recourse. However, at this stage, the market is not ready. 

Where to now? 

The inclusion of contractual protections for investors for ‘green defaults’ is part of the green bond markets’ growing maturity and the recognition and acceptance of green bonds as mainstream financial instruments.