What a difference a year makes.
Having issued virtually no green bonds in 2015, China bounded to the top of the global league table in 2016, printing US$34 billion-worth during the year, or 36% of the global total.
Most of the action took place onshore, which accounted for 85% of total issuances and also saw a number of ancillary developments such as the publication of various issuance standards and the launch of two green bond indices . But it was offshore issuances that grabbed international investors’ attention, with Bank of China notably jumping into the market last July with, what was at the time, the largest ever green bond.
The rate of issuance has dropped off so far this year, with only around US$1.8 billion issued domestically in the first quarter of 2017 and no offshore bonds. One possible explanation is that this is a temporary hiatus resulting from the recent shift in focus towards upgrading the regulatory environment. Indeed, the strength of political will behind these regulatory changes implies that the development of the green bond market remains very much on track, and that volume is likely to kick back in once this process is complete.
Looking at the recent evolution of China’s environmental policy, there is a clear sense that the supertanker is turning. The country has pivoted from its previous role as spoiler of international climate efforts to avowed environmental champion. Its ambitious environmental targets under the 13th Five-Year Plan cover everything from the energy and carbon intensity of the economy, to renewable energy production, pollution reduction, reforestation and carbon trading. Meeting these targets will require a whopping annual investment of US$600 billion according to Zhou Xiaochuan, Governor of the People’s Bank of China (PBOC). Only 10 to 15% of this is expected to come from the government, with private capital needed to make up the rest.
This augurs well for continued growth in green bond issuances, which is, on the face of it, a clear opportunity for China to attract international capital to help finance its environmental program. But the reality is that China’s green bond markets are, at present, a largely domestic affair, and that far-reaching reforms are needed to turn the country into a meaningful supplier of green bonds to international investors.
Most fundamentally, investors need much greater visibility on what they are funding.
In the international market, the eligibility criteria for green bonds are defined and disclosed by issuers and voluntary standards, with third-party verification by private agencies providing credible and reliable visibility.
In China, by contrast, the scope of the green bond market is based on guidelines published by the PBOC and the National Development and Reform Commission (NDRC). The Shanghai and Shenzhen stock exchanges have also published their own guidelines for listed companies and private placements by small and medium-sized enterprises.
Investors have little visibility into the greenness of a bond except for the fact that it has been approved by the relevant regulator. Vital information such as the list of projects to be funded, the definition of “green”, the use of proceeds, and the reliability of reporting seem to be shared with regulators only.
On current guidelines, Chinese issuers of green bonds may use the proceeds for projects with questionable environmental benefits. These include the upgrading of coal fired power stations (so called “clean utilization of coal”), the construction of large hydropower projects, and the funding of public transport powered by fossil fuels. Issuers may also use up to 50% of proceeds to pay down existing debt, or even leave the use of proceeds undefined, as many have chosen to do – see chart.
If it wishes to attract international capital, China needs either to tighten the criteria of what it calls “green” or encourage enhanced transparency on the use of proceeds so as to enable international investors to have a clear view.
The reason for the current leniency is that, in contrast to the West where green bonds are driven by investor demand, China’s market was created to meet specific policy needs. Demand for the bonds is a result of government fiat, domestically at least. Most Chinese institutional investors do not integrate social and environmental constraints into their investment processes and there are few, if any, domestic SRI or green funds. Chinese funds buy green bonds because the government, rather than their investors, requires them to do so. The greenness of the bonds is, in this context, irrelevant, because they are largely treated by investors as normal bonds. The few offshore issuances that have taken place have been better on this front, for example those of Agricultural Bank of China, which made an effort to both demonstrate its Green Bond Principles’ compliance and the categories of projects funded.
Efforts should be made to harmonize standards of regulation and assessment, both between the various Chinese regulators and ratings agencies, and between Chinese and international standards. Without a reliable standardization of criteria, the additional workload required by investors to assess individual green bonds will offset any potential yield benefit, and make Chinese green bonds unviable to rationale investors.
An additional important point is that, in order to enable international investors to even consider investing in their green bonds, Chinese issuers should obtain and maintain international credit ratings.
Given this daunting to-do list and the astounding growth in green bond issuances that China has achieved through its domestic investor base, it is pertinent to ask whether China needs or even wants international investors to be more involved.
We believe that the answer is yes, on both counts.
The objective behind China’s green bond policy is, ultimately, to clean up the country’s environment and nudge the economy towards a more sustainable model. International green bond investors’ demands for visibility on the use of proceeds would allow the government to delegate responsibility for overseeing projects to the private sector, turning the market into a formidable ally in the fight against environmental degradation.
As an added bonus, the sticky nature of green funding – investors tend to hold green bonds to maturity – would be a welcome source of stable foreign cash that would support the country’s efforts to stem liquidity outflows and diversify credit risk away from the dominant banking sector.
China has, sure enough, taken a number of steps that could ultimately lead to greater participation by foreign investors in its green bond market.
First, domestic credit rating agencies have been encouraged by regulators to develop their views on green bonds, and a number of them, including Golden Credit Rating, China Cheng Xin International Credit Rating, United Ratings and China Bond Rating, have launched their respective approaches to assessing green bonds.
Second, efforts towards enhancing comparability of Chinese and international standards are underway. Notably, the European Investment Bank and the PBOC recently announced an initiative aimed at developing a “common language” for green finance. This is expected to result in the publication of a report later this year, including suggestions towards harmonization of standards.
Third, accessibility is improving. The gradual opening of China’s financial markets is making domestic investment more viable for international investors. The PBOC has, for example, invited a wide range of foreign entities to directly participate in the domestic interbank market, where many of the country’s green bonds are issued. But more innovative avenues for international investors are also being explored. One interesting new venture is a family of “high grade” Chinese green bond indices  listed simultaneously on the stock exchanges of Shenzhen and Luxembourg, and developed in partnership with the International Institute for Green Finance (IIGF), which assesses the bonds’ green credentials.
A great deal clearly remains to be done, and any expectations of a significant near-term rise in foreign participation in the financing of China’s green transition should be tempered by the existence of more structural barriers, such as the limited exposure to China that most international funds are permitted under their investment mandates.
But momentum is clearly building, underpinned by strong political will. This encourages us that visibility, harmonization and accessibility will continue to improve, drawing more international funds into Chinese green bonds, particularly those issued offshore by leading bluechips well known to the market.
The author Orith Azoulay, Head of SRI Research at Natixis, spoke at FinanceAsia's Green Bonds Asia-Pacific Conference in Hong Kong on April 27.
 CUFE CNI High Grade Green Bond Index, CUFE CNI High Grade Unlabeled Green Bond Index, CUFE CNI High Grade Labeled Green Bond Index