Every day on the walk home from school, little Barry asks his mum if he can have an ice cream. Little Barry’s mum doesn’t have a lot of money, so the answer is always no. One day, close to little Barry’s birthday, his mum hands him a $5 note for the long-asked-for ice cream. Barry races into the corner shop, the crisp $5 note wrapped tightly in his hand, and buys himself his favourite caramel swirl cone. He is very happy his mum gave him the money for the ice cream.
Big Barry is 35 years old, also lives in Australia, and also loves ice cream. Big Barry is quite wealthy — he has a portfolio of stocks and a salary from his job doing company research — he always has money flowing into and out of his bank account. Big Barry has an ice cream every day after lunch — also a caramel swirl cone. As Big Barry is working from home this week, he bought a box of ice cream cones so he could still enjoy his habitual after lunch ice cream and put them into his freezer. Today is Big Barry’s birthday and as his mother knows how much he loves ice cream, she used PayID to send him $5 to treat himself to an ice cream on his birthday. That afternoon, Barry pulls his regular ice cream from his freezer and thinks about his mum. Big Barry also really likes Scotch whisky and every night he polishes off a bottle. His mother doesn’t like this and would hate to think that she was funding this habit so when she sent him the $5, she marked it as “for ice cream only!”.
So, what does the tale of the two Barrys have to do with green bonds? It all comes down to “use of proceeds” clauses.
Green bonds often refer to a “use of proceeds” clause to justify the greenness of the bond. “Use of proceeds” indicates what the issuer of the bond intends doing with the money they have raised from issuing the bond. With green bonds, a “use of proceeds” type bond indicates that the proceeds raised by the bond will be “earmarked” for green projects. They also use a verification process on the projects funded by the bonds. Little Barry clearly used the funds from his mother to buy his ice cream, but did Big Barry use his $5 for his ice cream rather than going towards his whisky? A standard “use of funds proceeds” approach would answer this question as “Yes — the money went towards his ice cream”. Indeed, most green bond projects will spend most of their effort verifying that the cone is actually an ice cream rather than if the “use of proceeds” is really justifiable.
Many “use of funds” green bonds issued by financial institutions are issued for loans that have already been made. There is no legal, credit or funding transfer from the bond issued to the “green project”. Legally, financially, and credit risk-wise — they are identical to all the other bonds of the issuer. Money raised is not actually segregated from other cash holdings — it is “notionally segregated” — meaning that it is recorded in a ledger somewhere separately — but not actually separated.
While there are green bond projects and green bond issuance that are clearly linked to each other, many green bonds, particularly those issued by financial institutions, are issued on a portfolio basis and the use of funds is not dissimilar to the story of Big Barry. The underlying loans have already been made and the money raised by the green bond is used to “nominally refinance” the original source of funds. It is important to understand whether the green bond you are investing in has been issued by the likes of Big Barry who spend reasonable amounts of their money on whiskey and sometimes buy an ice cream.
Other key verification items that leading investors often consider in assessing the “greenness” of the bond issue include intentionality and additionality. Were the underlying “green loans” made with the intention of improving environmental outcomes or is that simply a by-product of the industry the loan was made to? Also did the green loan occur as a part of normal business as usual operations or did this represent a net improvement?
While it is important to verify that the cone is an ice cream, it is also critical to identify whether the use of funds model follows the approach of Big Barry or Little Barry. Green bond verification needs to cover the project, the use of funds, and the normal activities of the issuer to see if all three align with the bond proceeds.
Tony Adams, head of sustainable investment research, Lonsec Research
