Proposed guidance published as part of a public consultation on the Global GHG Accounting and Reporting Standard by the Partnership for Carbon Accounting Financials (PCAF) could affect how carbon footprints are recorded across bond and equity portfolios.
Representing “meaningful progress” toward a standardised approach, the guidance has implications not just for green bond holdings but for the carbon footprint of conventional bond and equity portfolios, given the need to adjust companies’ overall metrics to reflect any green bonds they issue.
Insight Investment’s senior ESG solutions specialist, Jorg Soens, talks through its recommendations for measuring the carbon footprint of green bonds, the key challenges in developing a standardised approach, and how it could help tackle the broader challenges in ESG investment.
Why is the current approach to measuring the carbon footprint of green bonds ineffective?
When you think about a lot of asset owners – for example, pension funds – that have put these decarbonisation targets in their portfolios, or they have a desire to reach net zero carbon emissions in their portfolios, they have increasingly been using green bonds over the last couple of years. Partly, that’s because they have become a bigger part of the investment opportunity set, as green bonds are now quite a big portion of the total fixed income market.
But green bonds often don’t have a carbon footprint attached that is linked to what they are financing, and, when you look at the calculation of the carbon footprint of the portfolios that these clients want to manage, and the fact that they want to decrease the carbon footprint over time, these green bonds have been using the same carbon footprint as the one of the overall issuer. So, there has been a bit of a disconnect between green bonds becoming a bigger part of the overall investment market.
How does this work in practice?
If you think about, for example, investing in a green bond of a utility company, you might specifically finance a wind farm, although that utility still has some kind of legacy fossil fuel business. In that case, although you’re financing a very low carbon footprint, your actual carbon footprint in your portfolio would still be linked to the issuer, which has a much higher carbon footprint. So, there was a disconnect between trying to finance those climate solutions and being properly rewarded for it in terms of your decarbonisation trajectory.
And then there are several ‘perverse effects’ of the current approach. For example, if you look at green bond indices at the moment, they have a higher carbon footprint than conventional bond indices because most of the green bonds are issued by these higher carbon issuers. So, although you might want to allocate to a purely green bond index, actually the carbon footprint of that index is higher than a vanilla market index. So, that’s another thing in the market that isn’t intellectually correct.
How are asset managers currently dealing with this issue?
Asset managers, over the last couple of years, have all adopted different approaches to how to cater for green bond carbon footprints. Some asset managers might have already reduced the carbon footprint to zero for some of these green projects. Other asset managers might have just reduced it by 50%. From our perspective, we’ve always been very conservative. Without this industry guidance, we have just attached the carbon footprint on the issue level.
But the problem is, at the moment, there is no comparability across asset managers, because they’ve all catered for this in a separate way, which obviously can lead to potentially greenwashing concerns by not having this industry guidance around how to treat these instruments. So, this guidance, if it comes out, will lead to a more level playing field across asset managers.
What factors did Insight Investment consider when developing its recommendations for measuring the carbon footprint of green bonds?
Initially, when we published our paper two years ago, we recognised you could adopt a variety of approaches, depending on how granular you want to be. Obviously, the most intellectually correct way would be for issuers to report the carbon emissions of their green bonds. Issuers already have such a higher reporting burden, but that would be the purest form of transparency on the carbon emissions of the online green bonds.
One of the challenges is that we had to engage with issuers to make this information available because it hasn’t been done in this way up until now. We should see an uplift over the coming years when this guidance comes out, saying that companies need to disclose the carbon emissions of their green bonds separately, but it might take a while before companies get on board.
What incentives are there for companies that publish the carbon footprints of the green bonds they issue?
If asset managers and asset owners are now able to account for the local carbon footprint of a green bond, it might actually increase the appetite to invest in these instruments, because it’s a clear way to decarbonise your portfolio. So, it might just catalyse the green bond market over the next couple of years when this guidance comes out, because we as asset managers can use it as a tool to decrease the carbon footprint of our portfolio, aligned with what the industry guidance tells us. So, I think that’s a good outcome of this guidance.
Additionally, there’s also the concept of increasing the transparency around what the carbon footprint of these green projects is. Typically, what issuers have done up until now is to talk about what the avoided emissions are by investing in a green bond, but they haven’t provided the absolute emission profile of these green projects. For some investors, the concept of avoided emissions is harder to understand in terms of comparability with different companies, because companies calculate it in different ways. So, in terms of having a bit more transparency around the ground footprint of these green bonds, it’s actually very useful to have this proposed guidance that issuers should ideally report the absolute emissions of these green bonds individually.
Obviously, failing that, when issuers do not report carbon emissions of the green bonds separately, the guidance does say that you can estimate carbon emissions based on emission factors for certain sectors or certain processes, which is a good alternative.
Mostly, PCAF’s guidance aligns closely with Insight Investment’s recommendations. However, PCAF has not suggested mapping the appropriate to each International Capital Market Association-aligned (ICMA) green project activity, which is something Insight Investment called for. Why do you feel this is necessary, and why do you think PCAF stopped short in this area?
That was something we advocated for as a heavy investor in green bonds, and it would have made it quite straightforward for us to. when we invest in green bonds, see the product activities that it finances and help us link it to the emission factors of those activities. The problem, I guess, for PCAF is that it’s not intended to capture only green bonds.
So, PCAF talks about use of proceed structures in general – of which green bonds is the most clear instrument. But they also refer to private equity companies that are pure play, or that are set up just to finance single projects that are also use of proceeds structures. I think they wanted to avoid linking it purely to green bonds, which makes sense, because you want to have a wide adaptation of use of proceed structures in general, and not only focus on green bonds.
The other feedback that we got from them when we suggested using the project mapping is that ICMA is still a voluntary standard. It’s not clear that everyone uses ICMA in their green bond assessment, although it’s widely adopted. We would like to suggest that they include referring to the ICMA standard as a potential option for asset managers of green bonds, but it’s more of a ‘nice to have’ than a must have.
What are the key challenges in achieving a standardised approach to measuring the carbon footprint across bond portfolios?
If issuers do not agree to report the absolute carbon emissions of these green bonds separately, you might see a small uptake in the reported data, and that still might lead to a potential decrease in comparability between asset managers. Maybe some asset managers will estimate emissions in a different way than others.
So, the more issuers that report on the absolute emissions of these green bonds, the better comparability across asset managers, and how that has been used. For example, MSCI already has some sort of carbon footprinting portfolio tool which looks at a different carbon footprint for green bonds, and that was purely based on six high-level project categories. So, again, the more we have transparent, standardised data issued by the companies, the more this guidance will increase the transparency and comparability across the markets.
