Green bonds and the blockchain: a new way forward?
Blockchain technology could provide the platform for reliable, accessible and updated data on sustainability-linked deals
THE ADVENT of green bonds and other colours of ethical financial instrument has been perhaps the most important development in capital markets of the last decade. Digitalisation may be the most important development of the next one. It is no surprise, therefore, that the intersection of the two is generating a great deal of excitement.
The world is moving towards climate catastrophe and vast investments are needed in order to avert it. The green bond market hit $1tn cumulatively in 2020, according to the Climate Bonds Initiative but the same institution estimates that $5tn-$7tn of investment per year will be required to transition the world to a low carbon economy. At present, the green bond market is providing only around 10% of that.
Closing that gap will require a massive increase in scale. This will certainly require a huge increase in the resources working towards the goal — more staff at banks, investors and, of course, on the ground working on environmentally friendly projects and technologies. But technological improvements to make the market run more efficiently and lower the barrier to entry will also be a crucial part of the story.
Complexity of green data
The environmental, social and governance bond market has become a fiercely complicated place with a bewildering alphabet soup of taxonomies, principles and systems for certifying what is and is not green. Fundamentally though, the concept is simple: a bond is sold and the proceeds (or an equivalent amount) are spent on projects expected to bring about positive outcomes for the environment. The issuer is then responsible for reporting the impact these projects have.
The hope is that investors will pay more for these assets than for an issuer’s conventional bonds — the so-called ‘greenium’ — and thereby incentivise ethical, environmentally beneficial behaviour among borrowers.
Within this process, there are several different stages where new technologies like blockchain could meaningfully improve the instruments and add to their functionality.
The same advantages of digitalising conventional instruments also apply to green bonds, of course.
Nevertheless, it is important to acknowledge that efficiency savings in capital markets can have an important impact in stimulating more green finance activity. Many smaller issuers, particularly those in the SME sector, find it difficult to access capital markets because of the costs of setting up these programmes.
‘It’s important to lower the barrier to entry to capital markets for and small- and medium-sized enterprises,’ said Benjamin de Forton, bond origination and digital assets expert at BNP Paribas. ‘They play a key role to solve the climate challenge but if they’re not accessing the ESG bond market easily and in size, then we can’t use the market to incentivise more environmentally friendly behaviour in that sector.’
Those same techniques might also produce similar savings with green or ESG bonds. If digitalisation allows issuers to spend less time working on term sheets, that frees up resources to work on methods of efficiently gathering data they need for green bond issuance.
‘It’s labour intensive and costly for issuers to produce impact reporting for example,’ said de Forton. ‘The barrier to entry on a lot of green and social projects is partly due to the volume and quality of the data that’s required and the cost of gathering it.’
Standardising ESG reporting
One of the biggest challenges in the green bond market is the range and complexity of the methods issuers use to catalogue the impact of their green investments. The details of issuers’ green projects and the impact they’re supposed to have are typically contained in ESG framework documents, usually presented in pitch decks or PDFs.
Since each issuer produces their own framework documents, it is difficult for investors to compare assets to evaluate their greenness.
‘Because this is a fairly young market, there is no standardised way to report on impact,’ said Cecilia Repinski, chief executive officer and founder of Green Assets Wallet. ‘This makes it almost impossible for investors to compare, aggregate and evaluate their impact investments.’ Green Assets Wallet is attempting to address these challenges by giving investors a tool to standardise impact data across the issuers and securities in their portfolios and get a sense of their overall impact.
The key is to harmonise and structure the data provided in ESG frameworks and impact reports. At Origin Markets, founder Raja Palaniappan has been working towards this goal, creating a database of issuers’ funding needs and programmes. ‘10 years ago, that would have been their base prospectus,’ he said. ‘Now, many have set out ESG frameworks, which we’re adding as well.’
At first, these frameworks were, in Palaniappan’s words, ‘fairly loose’ but he says that gradually, more structure is creeping in.
‘With the arrival of the European Union taxonomy, issuers are increasingly using structured data that can be categorised in a database,’ said Palaniappan. ‘Issuers can select and tag the standards and principles that they adhere to.’ These might include the International Capital Market Association’s green bond principles or the EU’s green bond taxonomy. ‘The UN’s sustainable development goals are particularly useful because there’s a broad range, so you can map your project to the SDGs it supports.’
This allows a dealer to search through the database for issuers that meet particular specifications, like nationality, the class of issuer they represent or the area in which their proceeds will be invested.
At present, this service is available to bankers on Origin’s platform, helping dealers and salespeople source assets for investors, but Origin may make it available for investors directly.
The hope is that, by making it easier for investors to track and assess the impact of their portfolio, more will be encouraged to invest in ethical instruments.
Challenges with data
Developing shared standards for ESG reporting is a key stage in digitalisation. It won’t be easy — it has taken many years to develop even the ICMA’s green bond principles, which are basic pillars that lay out issuers’ reporting obligations. Drawing up the EU’s taxonomy of what is and is not green was an even more contentious process and many are still far from satisfied with the result.
Even the term sheet — one of the most ubiquitous pieces of documentation in the conventional bond market — still does not have a standard format, and ESG data is far more complex and varied.
Heike Reichelt, head of investor relations and sustainable finance and at the World Bank warned that: ‘It will be a while before we can fully benefit from technology as part of ESG analysis. The problem in much of the ESG market is: how do you aggregate impact data? You have to harmonise and standardise the metrics, so that when it gets to the impact reports, it’s easier for investors to compare and interpret the data. But the context is always critical for the correct interpretation.’
The World Bank and other international finance institutions, now as part of an impact report working group, have been working together to agree on an expanding set of harmonised metrics for reporting since 2015, when the first impact reports were published for green bonds. This work built on joint efforts on climate reporting agreed by multilateral development banks to track climate finance. Progress has been made since the early days, with Reichelt saying that: ‘It took months to agree on the first template that was published.’ Even with harmonised metrics, it’s difficult to compare assets without context, although this is becoming easier with progress in areas like greenhouse gas accounting.
The problems are not all technical. Green bond investors can have philosophical differences on the purpose of a green bond. ‘Some investors want to own assets that are making the biggest impact on trajectory of climate change, while others want to hold something that’s very green but doesn’t necessarily solve the problem,’ Reichelt said.
A green bond financing project in North Africa, for example, may have a much bigger, positive impact than one in a country in Europe because the baselines for each are so different. ‘Technology might be less developed in an emerging market,’ said Reichelt. ‘So, on a marginal basis, investment there has a huge impact versus more sophisticated technologies in developed markets. Both are important, but it’s difficult to compare on a like-for-like basis.’
Reichelt also highlighted that it is not just about collecting data. It depends on how appropriate the data is as an input to the decision-making and how it is interpreted. ‘Having the right metrics and understanding the context and how to interpret them is even more important. Those analysing green bond impact data should not simply take data gathered at face value, but try to understand what’s behind the data,’ she said.
Issues like this mean that even if issuers agree to present their reports in a uniform manner and technologists develop a means of efficiently scraping impact data from green bond reports and presenting them for investors to compare, it will still be a complicated task for investors to assess the impact of each individual instrument.
Green bond market sustains strong growth
Green, social and sustainability-themed debt issuance, $bn
Source: Climate Bonds Initiative database
So far, however, this only covers the first layer of digitalisation — structuring existing data to make it more easily usable by banks and investors.
A more distant and radical prospect is digitally native, smart securities — perhaps based on blockchain technology. These have a far greater potential to spur seismic changes in capital markets, as a whole, and ESG markets, in particular.
For conventional financial instruments, smart securities offer a means of automating various payment streams over the life of the bond. But the potential of the technology goes further. Smart securities can take in information and perform functions well beyond cashflows.
Many green bonds, particularly those issued by the public sector, are not funding a single project but a portfolio of loans to specific projects. Maud Le Moine, head of head of sovereigns, supranationals and agencies debt capital markets at Goldman Sachs, said: ‘You can represent the loans via tokens as well, which means you can efficiently match bonds and loans to ensure you get the most precise data available on the impact of a particular security.’
One can envisage securities that restrict whom they can be held by, ensuring no one can receive a security they are not eligible to hold, perhaps because of sanctions, a lack of know-your-customer information or simply that they are not qualified institutional buyers.
Issuers sometimes choose to preferentially allocate their green bonds to ESG investors, ensuring that their green assets end up in the hands of those with the mandate and headcount to analyse the impact reporting fully. It would certainly be possible to make use of a smart security function to keep this allocation in place within the secondary market, as well as in the primary market, although it is worth remembering that first, this will result in less liquidity for the instrument and second, that given green investors typically hold instruments to maturity, the secondary market is not especially active.
One of the features that makes smart securities such a flexible and useful instrument is that they are able to take in information from external sources and modify themselves automatically in response. In conventional securities, this might mean internally compounding the daily fixings of a floating rate note for the payment of a coupon or updating a status in the event of a ratings downgrade, warning bondholders automatically.
There is the possibility for specific applications within the ESG space. Corporations have started to issue sustainability-linked bonds. Rather than having a fixed or floating interest rate, these bonds have a coupon that can increase or decrease in response to pre-determined key performance indicators. The idea is that the issuer is incentivised by the prospect of a lower interest rate on its debt if it achieves environmentally beneficial or socially positive aims.
So far, this asset type has mostly been the preserve of the private sector, with corporates achieving lower coupons for achieving KPIs like sourcing a higher percentage of its power from sustainable sources or reducing the carbon footprint of its office space and manufacturing process.
Chile became the first sovereign to issue a sustainability-linked bond in early March 2022 and others could follow. A World Bank report, published in November 2021, contains a long list of potential KPIs for sovereign sustainability-linked bonds. These include the renewable energy share of total energy consumption, air pollution (mean annual exposure), renewable energy output, forest area (thousands of hectares of net change) and total greenhouse gas emissions.
It would certainly be possible for digital securities to automatically update the coupons they pay investors based on these indicators, as verified by an independent third party.
Internet of things
Technology might offer a means not just of automatically updating the features of a bond, but gathering the relevant KPI data and adding it to the bond with cryptographic security.
David Creer, global distributed ledger technology and crypto lead at GFT, described the idea: ‘With an internet of things device connected to a blockchain network, you can capture data in real-time.’ Creer discussed using an IoT device to, for example, verify the power output of a renewable power generation facility. This information could then be automatically uploaded to the green bonds used to fund it.
‘It’s a means of verifying that the data is genuine, so it should improve investors’ ability to trust the greenness of their asset,’ said Creer.
One might imagine a corporation setting up solar panels or wind turbines with such devices to verify their output and certify to investors that they are producing a certain amount of renewable energy, either for their own use or as an offset that they contribute to the grid. Such a project could certainly be funded via a green bond, which, if issued as a smart security, could punish the issuer with higher interest rates if they don’t increase the share of their electricity use generated from renewable sources.
Of course, the process of setting up such devices would require verification by an independent auditor, but after that point, it would limit the possibility of greenwashing and give investors an additional assurance of the quality and reliability of the data.
‘ESG ratings are increasingly important,’ said Creer. ‘In a few years, all European stocks will have an ESG rating. Auditors will be assessing companies’ emission levels and producing renewable energy certifiably with technology like this is going to be very valuable over the next few years.’
Similar IoT devices could be used to measure air quality around a city and punish or reward the city via interest rate changes on its municipal bonds if it fails to achieve promised improvements.
A separate but related use might stem from one of the first industrial implementations of blockchain: certifying the origin of goods.
Corporations could use this technology to certify that goods purchased for green bond funded projects come from suppliers that have been independently verified as sustainable.
Digital currency integration
Digital currencies are frequently talked about as a necessary appendage for digital capital markets to facilitate atomic settlement and automation of payments. However, digital currency can also be programmed such that it can be spent only on certain things.
The Digital Currency Forum in Japan has an electricity trade subcommittee which is working on a means to complete the circle: creating digital currency tokens that can only purchase electricity that has blockchain certification to prove it was produced sustainably.
While this is focused on electricity, one could imagine it being extended to other goods and commodities that institutions purchase.
It might be possible to hypothecate the proceeds of green bonds to ensure they are spent on specific projects. However, that is not in keeping with the way green bonds typically work. Since money is fungible, a green bond is really a promise that an amount of money equivalent to the proceeds of the bond will be spent in a manner defined by the issuer’s ESG framework. Hypothecating the actual proceeds does not add much to this, since the issuer receives the same amount of money and pursues the same projects whether the money is restricted in this way or not.
However, there might be a more effective use of this function on the lending side. The proceeds of many green bonds go to fund a portfolio of loans for green projects around the world. As with many aid payments, there is a risk of corruption or the misuse of funds. Development banks combat this risk with oversight and scrutiny of the projects. Hypothecated loan proceeds might make this process cheaper by making it more difficult to spend funds on illegitimate uses.
Fractionalising and retail
Reducing the denomination size of green bonds opens them up to wider ownership — either retail (if the regulatory framework permits) or institutional accounts that want smaller positions than the traditional €100,000 denomination.
There is evidence to suggest that smaller investors, particularly at the retail level, are likely to prefer ESG investment.
Project Genesis — a Hong Kong Monetary Authority blockchain-based retail green bond project — used distributed ledger technology to fractionalise the bond. ‘It is possible to issue a green bond with smaller denominations, but DLT made it easier to change and update the fraction size during the process,’ said Creer.
Blockchain and ESG considerations
It is no secret that the bitcoin blockchain requires vast amounts of energy to ensure it remains secure. The issue is the proof-of-work consensus mechanism, which requires computer processors to search for cryptographic solutions to an encryption algorithm. The brute force computing power required is key to trust in bitcoin’s blockchain and its immutable record but it gives bitcoin an energy consumption on par with industrialised countries.
ESG investors are unlikely to look kindly on a blockchain-based capital markets instrument that relies on an inefficient consensus mechanism like proof-of-work.
One possible alternative would be proof-of-stake, which is used by the Cardano public blockchain. Proof-of-stake requires participants to ‘stake’ their holdings of tokens in order to verify new transactions.
Although proof-of-stake consumes less energy than proof-of-work, it still requires more energy than private blockchains like R3’s Corda or centralised systems.
There are no easy solutions to climate change, and no simple technological fix to make green bond investing simple and easy. These are complicated issues and market participants have difficult decisions to make.
However, properly structured data can make it easier for investors to access the information they need to make those decisions with the greatest degree of accuracy possible, while automating the process should make it cheaper for issuers to enter the market
Smart securities offer the opportunity to improve investors’ trust in the data and potentially to enable new types of green finance instrument.
All of these may help to encourage more green issuance and contribute to the effort to finance a transition to a sustainable economy.
Value of the green bond market hit a milestone in 2020
The green bond market is providing only a tenth of the annual investment needed to transition to a low carbon economy.
China became the first sovereign to issue a sustainability-linked bond.