China has become the world’s largest green bond market, with green bonds issued in the first half of 2016 reaching 75 billion yuan (US$11 billion), 33% of the world total. This figure is approximately two percent of the total assets of China’s commercial banks, and demand for green bonds is expected to rise to 20 times that much.

Green bonds provide access to an ever-growing and important market to corporate issuers and international investors. Bloomberg Business estimates that China’s green bond market may be worth US$230 billion in the next five years – an opportunity too big for the international business community to ignore.

China’s green agenda

Environmental protection is of high importance for China, both politically and for business. China is the world’s largest source of carbon emissions, and the air quality of many of its major cities fails to meet international health standards. Last November at the Paris Conference, China promised that its CO2 emissions would peak around 2030 and be cut per unit of GDP by 60-65% of the 2005 level.

Green bonds will be an important mechanism in China’s commitment to reduce carbon while balancing the books and stimulating international investment. Ma Jun, chief economist of the Research Bureau at the People’s Bank of China (PBoC), estimates that China will need to invest at least US$320 billion per year in green initiatives and projects over the next five years to meet its sustainability goals. Traditional financing options have historically been able to cover only 15% of this requirement. It is of little surprise therefore that China has prioritised green finance high for its G20 presidency and its recommendations on green finance is on the agenda at the G20 meeting in Hangzhou this September.

Critically, green finance is part of a much broader green agenda that China is putting into place. The new Environmental Protection Law and, in particular Articles 21 and 22, are a good illustration of the role economic instruments are now playing in Chinese environmental regulation. These Articles provide that the state will encourage and support environmental protection and support enterprises achieving pollution reduction beyond compliance standards by using “fiscal investment, taxation, pricing and government procurement policies.”

Defining green bonds

According to Ma Jun, in order for green bonds to play a bigger role in climate change solutions and economic upgrading, standards for green bonds must be clarified.

In China, green bond guidelines have been published by the PBoC and the National Development and Reform Commission (NDRC). Linked to the PBoC guidelines, the Green Finance Committee of China Society of Finance and Banking released the Green Bond Endorsed Project Catalogue in December 2015. The catalogue is an important supplement to the guidelines, setting out the boundaries of what is and is not considered “green.”  Regulations are also underway from the National Association of Financial Market Institutional Investors (NAFMII). It is expected that the standards and definitions overall will be applicable to 90% of bond issuers.

However, some of the projects which are permitted under the green bonds guidance in China may not meet the commonly-accepted standards for what is a green bond in other geographies, such as “clean coal” projects. China’s Industrial Bank used 26% of the proceeds from its inaugural green bond to finance “clean coal” projects – projects that seek to improve the emissions efficiency of coal-fired power plants. Such projects are included as possible use of proceeds, under the pollution prevention category, in the Green Bond Endorsed Project Catalogue.  However, outside of China, the funding of fossil fuel power generation would struggle to meet the international green bond guidelines and standards such as the Green Bond Principles and the Climate Bonds Standard. According to Sean Kidney, CEO of the Climate Bonds Initiative, “We do note that this bond fully meets regulatory requirements in China and we applaud that. While they have done a fantastic job pushing the green agenda in China, it’s likely that this bond won’t be included in our overall numbers.”

Green striping: the future?

It is perhaps problematic that a Chinese company could comply with the procedural norms of the international green bond market (such as those laid out in the Green Bond Principles) and could use the vast majority of the proceeds to fund projects meeting any international environmental sustainability standard, but be shut out from investment by international green bond investors because a portion of the proceeds were eligible to be invested in, for example, clean coal. One potential solution could be for issuers to commit to use a specified portion of the proceeds of a bond for purposes that comport with international green bond standards (the “green stripe”). With this approach, rather than all green or all non-green, the bond would be “green striped.”  An analogy could be drawn between green striped bonds, and the methodology of ranking green bonds as light, medium or dark green.  For example, CICERO, a provider of second party opinions, uses different shades of green to reflect the climate and environmental ambitions of green bonds. CICERO labels bonds “light green” if the projects and solutions are environmentally friendly, but not by themselves a part of the long-term vision, whereas “dark green” bonds fund projects and solutions that realise the long-term vision of a low-carbon and climate-resilient future already today.

The primary advantage of using green striping in this manner would be that it would enhance the ability of international investors to participate in Chinese bonds by providing a way to invest without modifying their overall green investment criteria. Investors could account for their investment based on the percentage of the proceeds that are committed to meet international standards.

Environmental issues remain a key priority in China, and as the government works to implement its green agenda, we can expect more focus on green bonds. To sustain green bond issuances, standards must be clarified and current inconsistencies addressed.  Green striping could be one way to overcome a situation where it is unclear whether including certain project types within a projected use of proceeds prevents the entire bond from being “green”.

This post was prepared with the assistance of Alice Gunn in the London office of Latham & Watkins.