Green fixed income issuance isn’t enough to win over investors focused on Net Zero

Investors are becoming increasingly selective about how ‘green’ instruments contribute to wider decarbonization beyond just qualifying as ‘green’. With greenwashing on the rise, investors are looking at whether an investment is consistent with and supported by credible policies of the issuers and markets to reach Net Zero commitments. Issuers, financial institutions and investors in emerging markets & developing economies will be significantly impacted but also could gain from a ‘virtuous circle’ of coherent policy support.

• Investors are starting to look beyond the ‘micro’ green credibility of labeled fixed income instruments to see how well aligned they are with broader decarbonization targets
• Emerging markets and developing economies are particularly challenging in this respect because policies are newer and may be less ‘coherent’, while the gap in financing for decarbonization is wider than in developed markets
• Financial institutions, investors and companies should evaluate the likelihood that financial sector policies will become more coherent in promoting decarbonization as they produce intermediate targets for their Net Zero commitments

As climate finance volumes grow, there will be less of a rush into investments just because they’re ‘green’ and greater investor review of the broader context in which ‘green’ bonds, sukuk and other instruments operate. For some issuers, that will feel like investors have reached a saturation point, but it will more likely come about because of a combination of reducing the gap between supply and demand with regulatory pressure to deter greenwashing.

One of the biggest issues for investors and financial institutions financing decarbonization, and policymakers finding a balance between encouraging financial flows and ensuring market credibility, is setting guidelines to determine whether investments are compatible with the necessary pace of decarbonization. This will be especially true for investors subject to stronger anti-greenwashing regulations investing across emerging & developing markets, where disclosure mandates are more limited and the funding gap is the widest.

In some cases, investors have begun communicating publicly the ways in which the process of evaluating impact claims in their green investments have already begun to happen. Investors are looking at the ‘green’ characteristics of the assets underpinning a green bond to ensure they meet their internal criteria as well as where they fit within the issuer’s broader decarbonization plans, and whether those plans are coherent.

Most of the investor shift to consider ‘green’ attributes as well as how a particular bond or sukuk will be compatible with the issuer’s decarbonization objectives and the likely policy environment the issuer will face has been from developed markets. These efforts have been enabled by greater access to a wider range of labeled green issuance and more developed taxonomies to evaluate what constitutes ‘green’ (although fewer taxonomies that define the other end of the spectrum of ‘high-carbon’ sectors).

The compatibility of specific issuance with investor, company and national decarbonization targets, and the policy coherence, was the subject of a recent World Bank policy research working paper. The research examined not only how ‘green financial sector initiatives’ could be addressed for compatibility across short-, medium- and longer-term decarbonization objectives, but also evaluated how the policy ‘coherence’ might be different in the context of emerging markets and developing economies.

This research provided a ‘theory of change’ to evaluate how different financial sector policies could impact credit markets, financial markets and the real economy in both economic & financial impacts as well as contribution towards decarbonization. In emerging markets and developing economies there can often be a more challenging balancing act because of greater anticipated and immediate impacts from climate change, more limited or more challenging access to finance, especially for companies that have difficulty accessing bank financing, and a substantial gap between what is needed and what is available that is harder to fill because of a less-developed financial sector compared to developed markets.

For example, policies to promote decarbonization such as a ‘green supporting factor’ that a central bank might adopt will have a direct impact on the cost of credit for low-emission companies, and will also impact the relative prices of high- and low-emissions companies as a result of changing the relative cost of capital for each.

The changes to cost of financing will impact the creditworthiness of both green and dirty companies, which will impact supply of credit to both. These credit market impacts will have spillover impact on macroeconomic outcomes based on availability and cost of finance. At the same time, policy momentum in favor of implementing a green supporting factor has been slowed by concerns about spillover back to credit markets if the capital relief for green financing isn’t related to the risk profile of those loans.

This is a narrow example of one policy. It shows a working model for how to trace the impact of the policies needed for decarbonization on the financial sector and also any spillover impacts in the real economy and second-order impacts on financial institutions and markets. Each policy will be impacted by the other mix of policies and the level of financial sector development, which impacts interlinkages of risks as well as overall financial sector resilience. The ‘coherence’ of policies for the financial sector with Net Zero or other decarbonization targets for each country will increasingly affect not only policy decisions, but also the ability of investors to evaluate the credibility of the decarbonization outcome of the bonds and sukuk that come to market.

Currently, the defined Net Zero pathways even at the national level are relatively loosely defined, with long-term objectives but few intermediate targets or outlines of the specific policies and incentives that will lead to the desired outcomes. There are substantial gaps in the policy map towards decarbonization in both developed and emerging and developing economies today. However, as outlined earlier, the degree of financial market development will influence the credibility of decarbonization policies and Net Zero objectives set by companies, financial institutions and countries.

Many investor/s, financial institutions and companies will have to take this landscape as a given in the short-term, and work within the constraints of policy coherence or lack of coherence. That may slow their consideration of climate risks and the issuance and market development of green financial instruments.

Governments seeking to boost green or climate-aligned finance, and having set policies and Net Zero targets, will play an important role in either increasing investor confidence or their uncertainty about the prospects for climate risk mitigation. Just like efforts for financial sector development, there is the possibility for clear and coherent policy to drive financial flows which in turn support more ambitious policies that further boost credibility. The reverse is also possible.

Whatever the outcome, financial institutions, investors and companies will have to look at both the micro level of specific instruments’ credibility but also the likelihood that policy will support macro-decarbonization efforts so that the ‘green’ label is likely to translate into progress towards Net Zero commitments.

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