The world marked a grim date this summer when it reached Earth Overshoot Day (EOD) on July 29th. EOD represents the point when humans have used a year’s worth of the planet’s biological resources. Passing this threshold after just seven months is a major cause for concern since it signifies that we are running up an ecological debt. In fact, consumption at this level means that we are using the resources of a planet 1.7 times the size of our own.

Last year, we reached EOD on August 22, pushed back by the impact of the pandemic. However, two years ago we also reached EOD on July 29, demonstrating that we have gone right back to consuming resources at the same rate as before the pandemic. 

Human demand started to exceed what Earth can renew in the early 1970s, and has increased every year, unless there was a disaster: oil crisis, financial distress, or the recent pandemic. Since such overuse will eventually end, the question is whether it ends by design, or disaster. Given that globally, it is disasters, rather than designed efforts that reduced demand, the concern arises that measures to mitigate climate change are not, as of yet, having as much impact as policymakers had hoped they would.

But this is not only an environmental issue, it is also an economic one considering that every economic activity and value chain requires physical inputs such as energy, materials, waste absorption capacity etc. “With continued ecological overshoot eroding our life-support system, economic prosperity is put at risk. Living off depletion cannot be a long-term strategy in any domain. Cities, companies, or countries that wait to address climate threats or overshoot risks have no advantage. Because waiting keeps them underprepared for a future that has never been more predictable: one of more climate change and less resources – one that also will inevitably be fossil fuel free,” warns Mathis Wackernagel, President of Global Footprint Network.

Given the high concentration of greenhouse gases in the atmosphere, the rapid decline of biodiversity, and many other critical trends, all indicates that we are rapidly approaching ecological tipping points governments and the financial community can no longer ignore. With COP26 just a few months away, the summit is arguably the most decisive moment for curbing, or failing to curb, massive climate change, at least since the Paris Agreement. In this critical year for climate action, governments must wholeheartedly embrace sustainable finance or risk destroying the natural capital our economies need to thrive.

Tackling climate goals with green bonds

Net-zero commitments from governments have dominated the headlines in the run up to COP26 and do provide hope that we can reverse the trend with EOD and begin pushing it back. One piece of the puzzle in reaching climate targets that is soaring in popularity is green bonds. First launched in 2007, more than $1 tn of green bonds have now been issued.

Sovereigns have embraced this new financial instrument: last year, the number of green, social, and sustainability issuers more than doubled, despite the pandemic. In total, US$41 bn of sovereign green bonds were issued in 2020, while the number of countries issuing has surpassed 20. Meanwhile, growth in the number of new issuers shows no signs of slowing down, with Bhutan, Canada, Colombia, Cote d’Ivoire, Denmark, Kenya, Peru, Singapore, Spain, Uruguay, Uzbekistan, and Vietnam all understood to be considering selling green bonds.  

Amid this breakneck pace, Italy also raised the bar this year with Europe’s largest green bond debut. The Mediterranean nation raised €8.5 bn with the offering being about 10 times oversubscribed. The high demand allowed Rome to cut a few basis points off the deal pricing, marking the latest case of a sovereign raising financing more cheaply with green than conventional bonds.

Despite this explosive growth, the opportunity for expansion of the sovereign green bond market is still enormous. And, in early July, green bonds took another step forward when the European Commission proposed a new European Green Bond Standard to drive money into projects to help the bloc reach its target of net-zero carbon emissions by 2050. As calls for standardisation of the market have begun to spring up, the European Commission hopes that its voluntary framework will form a much-needed gold standard for governments to raise money for green projects and programmes.

A flawed tool for fighting climate change

It is easy to see why sovereigns are attracted to green bonds. Issuance offers a reputational boost while also reducing funding costs, can help spark a domestic corporate green bond market, and diversifies the investor base. Sovereign green bond issuance also attracts attention to a government’s environmental performance and should encourage improved environmental regulation and performance, at least marginally.  

However, a deeper look at the impact of green bonds reveals several shortcomings. For starters, green bonds carry zero information value about the environmental footprint of the issuer, or whether the issuer’s footprint is declining. Additionally, since the bonds do not have different shades of green and are categorized as merely green or not green, all bonds that are classified as green are viewed as equal and without standardization and classification, what is ‘green enough’ to qualify for the label is a source of contention. This has also led to calls for more nuanced ‘greenness’ ratings with greater granularity of green bond classification.

Another pitfall for green bonds is that since it is a new and rapidly growing market, there is an intense fight for market share among those service providers that provide the “green” stamp of approval. As a result, ratings shopping is even more acute than in the traditional credit rating industry. This means that the risk of greenwashing is heightened by the incentives of the providers of second party opinions to grant the ‘green’ label. Furthermore, there is also the risk that issuance of a green bond may give issuers a feeling of having taken climate action, which could inversely (perversely?) demotivate the issuer from making a real impact on improving its environmental footprint.

A lack of regulation has also spurred warnings from environmentalists that sovereign issuers' environmental claims can amount to greenwashing. A growing body of data echoes this. Among corporate issuers, for example, a study by the Bank for International Settlements found that there is no strong evidence that green bond issuance is associated with any reduction in carbon intensity.

Controversial incidents have also tainted the reputation of green bonds, such as the issuing of green bonds by the operator of the Three Gorges Dam in China, which has been criticised by environmentalists for polluting water and damaging the surrounding ecosystems and to GDF Suez using them to finance the Jirau Dam in Brazil, where satellite images show the dam has caused flooding of the rainforest. International policymakers will need to strengthen regulation, standardisation and transparency of green bonds to guard against environmentally harmful incidents. 

For sovereigns, green bonds serve a more diminished role, making their importance as a PR tool greater. For governments, regulation and taxation are the optimum methods to improve environmental performance and neither requires sovereign funding, whether through green or other bonds. Thus, a more robust and transparent taxonomy will add more meaningful environmental value than green bonds, which are more likely to serve as a distraction than to actually make significant environmental progress.

The cynicism surrounding sovereigns is perhaps best epitomized by Poland, which issued the first sovereign green bond in 2016. However, the country is considered a laggard in environmental policy for resisting the EU 2050 carbon neutrality target, when it effectively blackmailed its partners for added financial transfers. Meanwhile Hungary issued to much fanfare a €-denominated green bond last year and added HUF-green bonds this year. However, the country had previously joined Poland in resisting the EU’s carbon neutrality goal and the nation has one of the lowest renewables share in overall energy production. Clearly, sovereign’s issuance of green bonds does not provide an instant stamp of approval that a government is taking progressive action on climate change.

In order for green bonds to move the needle in the fight against climate change and ecological destruction, sovereigns must ensure that the instruments are constructed to lead to additionality. That has usually not been the case and our Chief Economist Moritz Kraemer discussed this shortcoming in Germany’s twin bond issuance last year. In short, the country’s green bond receipts were allocated to green projects that were already executed in the past, making it unlikely that this approach will lead to any structural shifts in the budget to spur commitments to action on emissions reduction. 

Germany also used a structure of ‘twin bonds’, with the green bond an instalment of an existing conventional bond with identical coupons and maturities. With a 1:1 exchange rate between the conventional and green twins, price equalisation prevents a true green bond yield curve from emerging, instead mimicking the conventional one. Ultimately, it means the green and conventional bonds are identical twins limiting the green bond from maximising impact.

The sovereign green bond market offers enormous potential to combat climate change but, in its current form, it is not an instrument that will help us to reach our climate goals or push back EOD. First and foremost, a harmonisation of international and domestic guidelines and standards for sovereign green bonds is required, detailing principles for the use of proceeds, processes for project evaluation, the selection, and reporting for green bond issuances in order for the international community to develop a robust sovereign green bond market that creates additionality and transforms budget spending for green projects.

Earth Overshoot Day serves as a clear wakeup call that we cannot continue to consume the planet’s resources at our current pace and must find tangible solutions to the climate crisis that protect natural capital. While full of enormous potential, green bonds are young and still must grow up. It is now up to governments and the financial community to ensure that green bonds maximise their impact.