Green, social and sustainable bonds focus on too narrow a range of activities in climate mitigation and structures need to improve before they can be used to tackle climate adaptation, according to a report by Fitch.
Less than a quarter of use-of-proceeds bonds fund new projects and more than a third fund projects that are more than three years old, the report said.
"The current use-of-proceeds issuances are not perfect, and we need to address that before approaching new areas,” said Jonathon Smith, associate director of ESG research at Fitch.
Issuers of use-of-proceeds bonds focus on capital-intensive projects that are easy to measure to avoid greenwashing allegations, but structures will have to tighten if they are to tackle underserved areas such as pollution prevention, employment generation and biodiversity.
Most green, social and sustainable bonds are used to mitigate CO2 emissions as issuers focus on reducing Scope 1 and 2 emissions from their own operations and purchasing energy, rather than adaptation which addresses the physical risk of the consequences of climate change, such as extreme weather.
"The labelled bond market is providing limited financing for adaptation activities," the report said. “We believe going beyond mitigation to focus on and finance climate adaptation is paramount."
Low scores
Within the existing structure of use-of-proceeds bonds there are a couple of areas of improvement that could lead to additional impact. Impact investing is a hot topic in the market that is increasingly seen by issuers and investors as the best way to counter potential greenwashing allegations.
Financing new projects rather than existing assets is a key indicator of the quality of a use-of-proceeds bond as higher allocations to new projects have greater additionality and impact, while "lookback" periods that determine the age of projects that can be included should meet the market standard of no more than two years.
However, Fitch said too many use-of-proceeds bonds attract low scores on its assessment criteria either because the share of new projects financed is less than 25% or the issuer has not provided any information on the split between old and new projects. Only 3% of companies allocate at least 75% to new projects, and 5% of deals have zero allocations.
Lookback periods are also problematic as half of use-of-proceeds bonds include assets that are between one and three years old, while 38% have lookback periods of more than three years or do not specify the age of projects, the report said.
"We are seeing deviation from best practice or established guidelines in terms of financing projects that are outside the recommended 24 months. There's also just a lack of information as it’s really just not clear what issuers are doing," Smith said.
Mitigation and adaptation
In green bonds, renewable energy is the most common category accounting for 27% of all transactions, followed by energy efficiency (22%), clean transport (16%) and green buildings (16%). More new projects are being financed in transport and utilities.
Half of green bond proceeds focus on energy-related improvements, including power sector investments such as electricity transmission and smart grids, and technologies to reduce carbon intensity such as carbon capture, usage and storage.
The most common use of proceeds on sustainable bonds are green buildings, while the top social bond purpose is affordable housing, socioeconomic empowerment and advancement, and affordable basic infrastructure.
Relatively few use-of-proceeds bonds address biodiversity or climate adaptation, although a handful of companies target associated activities such as sustainable water and forestry management.
Some adaptation projects are implemented via labelled bonds in a number of particularly vulnerable sectors, including utilities. San Diego Gas & Electric has issued bonds that focus on infrastructure and grid resilience and improvement projects across the company's network to reduce exposure to physical climate risks like wildfires.
Pollution mitigation could become a bigger focus, which could see use-of-proceeds bonds issued to reduce CO2 or other greenhouse gas emissions, potentially including methane leaks, the second most important contributor to climate change after carbon dioxide. The US is also pushing to develop critical mineral processing capabilities and green bonds could be issued to tackle sulphur emissions from nickel processing, according to Fitch.
Use-of-proceeds deals could also potentially be used to finance carbon capture and storage, although questions remain about the scalability of the technology and whether technical developments can increase capture rates to a point where they can be considered green.
"There is definitely some interest in green bonds for carbon capture and storage," Smith said.