Editing IPCC:AR6/WGIII/Chapter-15 (section)

=== 15.6.6 Innovative Financial Products ===

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Innovative financial products with increased transparency on climate risk have attracted investor demand, and can facilitate investor identification of low-carbon investments ( ''high confidence'' ). Innovative products may not necessarily increase financial flows for climate solutions in the near term, however they can help build capacity on climate risk and opportunities within institutions and companies to pave the way for increased flows over time.

'''Investor demand is driving developments in innovative financial products (''' high confidence ''').''' Since AR5, innovative financial products such as sustainability and green-labelled financial products have proliferated ( [[#15.3|Section 15.3]] ). These financial products are not necessarily ‘new’ in terms of financial design but are packaged or labelled in an innovative way to attract responsible and impact-oriented institutional investors.

The growth and diversity of the green bond market illustrates how innovative financial products can attract both public and private investors ( ''high confidence'' ). Demand for green financial products initially stemmed from public sector pension funds. Pension funds and insurance companies in OECD countries have traditionally favoured bonds as an asset class with lower risk ( [[#OECD%20and%20Bloomberg--2015|OECD and Bloomberg 2015]] ).

Since AR5, labelled green bonds have grown significantly, exceeding USD290 billion issued in 2020 with a total of USD1.1 trillion in outstanding bonds ( [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ) ( [[#15.6.7|Section 15.6.7]] ). Corporates, financial institutions and government-backed entities (for example in real estate, retail, manufacturing, energy utilities) issued the largest volumes, with use of proceeds focused primarily on GHG mitigation in energy, buildings and transport projects ( [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ). Given their focus on GHG mitigation, green bonds are also sometimes referred to as climate bonds, but the common market terminology is ‘green’. Municipal green bond issuance has also been growing ( [[#15.6.7|Section 15.6.7]] ). Beyond green bonds, additional products such as green loans, green commercial paper, green initial public offerings (IPOs), green commodities, and sustainability-linked bonds and loans have also been introduced in the market ( [[#CBI--2019a|CBI 2019a]] ) ( [[#15.6.7|Section 15.6.7]] ).

Investor demand for green bonds is evidenced by over-subscription of deals. Recent studies indicate an over-subscription for green-labelled bonds by an average of between three and five times, as compared to non-labelled bonds ( [[#Gore--2019|Gore and Berrospi 2019]] ; [[#Nauman--2020|Nauman 2020]] ). Results of a survey of global treasurers showed a higher demand for green bonds than non-labelled bonds for 70% of the respondents ( [[#CBI--2020a|CBI 2020a]] ).

The financial crisis associated with COVID-19 has put increased pressure on debt issuers, and the extent to which the increase in indebtedness for sovereigns and corporates has been financed via climate-related-labelled debt products is not known. Further, at this time there is no identified literature assessing the degree to which international versus domestic investors are financing sovereign green debt in developing countries ( [[#15.6.7|Section 15.6.7]] ) However, since the onset of the COVID-19 crisis, continued steady growth in issuance has been observed broadly across sustainable bonds (including green, social and sustainability bonds), with more significant growth in social bonds to support the COVID-19 recovery ( [[#Maltais--2020|Maltais and Nykvist 2020]] ; [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ).

Index providers and exchanges can also play a supporting role in transparency for identification of benchmarks and innovative financial products for climate action. Low-carbon indices have proliferated in recent years, with varying approaches including reduced exposure to fossil, best-in-class performers within a sector, and fossil-free (UN PRI 2018) (see discussion on ESG index performance that follows in this section). Indices can provide transparency on low-carbon opportunities, making it simpler for funds and investors to identify green investment options. Exchanges can also play a supporting role to the uptake of green financial products through transparent listings and requirements to improve credibility of green labelling. The number of green or sustainability bond listing segments tripled from five in 2016 to 15 in 2018 ( [[#SSE--2018|SSE 2018]] ). Green security listings can also be used to enhance local capital markets ( [[#15.6.7|Section 15.6.7]] ).

'''Significant potential exists for continued growth in innovative financial products, though some challenges remain (''' high confidence ''').''' Despite recent growth and diversification, green bonds face several challenges in scaling up. Issuance of green-labelled bonds constitutes approximately 1% of the global bond market issuance ( [[#ICMA--2020b|ICMA 2020b]] ; [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ) Potential exists to increase issuance amongst corporates, for instance, and across a broader regional scope (although subject to limitations of local capital markets). Yet there remain several challenges to growing the green bond market, including ''inter alia'' concerns about greenwashing and limitations in application to developing countries ( [[#Shishlov--2018|Shishlov et al. 2018]] ; [[#Banga--2019|Banga 2019]] ).

There is no globally accepted definition of green bonds, and varied definitions of eligible green activities are evolving across regional bond markets. Beyond the most commonly used green label, other related labels such as blue, sustainable, transition, sustainable development goal (SDG), social and environmental, social and governance (ESG) have some overlapping applications ( [[#Schumacher--2020|Schumacher 2020]] ). The degree to which these labels represent climate-relevant investments depends on underlying criteria and how they are applied ( [[#15.6.4|Section 15.6.4]] ).

There are several initiatives aimed at protecting the integrity of the green label. Guidance on use and management of proceeds established by the International Capital Markets Association’s Green Bond Principles (GBP) is followed on a voluntary basis, which notes eligible use of proceeds as primarily climate mitigation and adaptation projects. The GBP also recommend independent external reviews at the time of issuance, with 89% of green bond issuers in 2020 having external reviews at the time of issuance ( [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ). In addition to best practice based on voluntary principles, a further check on greenwashing, although insufficient on its own, is the fear of reputation risk on behalf of investors, issuers and intermediaries in the age of social media ( [[#Hoepner--2017|Hoepner et al. 2017]] ; [[#Deschryver--2020|Deschryver and de Mariz 2020]] ). A report on post-issuance green bond impact reporting notes that despite concerns ( [[#Shishlov--2018|Shishlov et al. 2018]] ), greenwashing incidence is rare, with 77% of green bond issuers reporting on allocation and 59% reporting on impact, but with significant variance in quality and consistency of impact reporting ( [[#CBI--2021b|]] [[#CBI--2021|CBI 2021]] b ).

Financial disclosure regulatory developments can help further align and specify definitions of green in the financial sector but are not a substitute for climate policy ( ''high confidence'' ). Developing a common basis for understanding a green label could further reduce uncertainty or concerns of greenwashing. Regulatory developments in some regions seek to further guard against greenwashing with more specific definitions. The EU sustainable finance package, including the EU Taxonomy and EU Green Bond Standard draft regulations, is the broadest reaching, but not the only, regional initiative focused on disclosure of climate risk ( [[#15.6.3|Section 15.6.3]] ). Taxonomies across regions are not always aligned on what can constitute a green project, for example with respect to transition activities ( [[#Pfaff--2021|Pfaff et al. 2021]] ) ( [[#15.6.7|Section 15.6.7]] ). While standardisation can help reduce uncertainty in markets with imperfect knowledge, the green bond market is currently developing and is expected to continue to reflect regional differences in economic governance approaches ( [[#Nedopil--2021|Nedopil et al. 2021]] ). Regulations may also have trade-offs in terms of transaction costs for green financial product issuers. Classification approaches can also face challenges, depending on how they are designed, in their ability to capture new technologies and social impacts ( [[#15.4|Section 15.4]] ).

Green bonds have been primarily targeting climate mitigation projects, with far fewer projects identified as adaptation. Green bonds mainly finance projects in the energy, buildings and transportation sectors, which constituted 85% of the use of proceeds of green bonds in 2020 ( [[#CBI--2020b|CBI 2020b]] , 2021a). Agriculture and forestry projects, including adaptation projects, have been less suited to be financed in a bond structure, which could be in part due to the more dispersed and smaller nature of the projects and in part due to project ‘bankability’ or ability to contribute steady streams of financing to pay back the terms of a bond. However, adaptation projects may not be identified as such as resiliency becomes more mainstreamed into infrastructure planning ( [[#15.3.2|Section 15.3.2]] ).

While green bonds have the potential to further support financial flows to developing countries, local capital markets can be at varying stages of development ( [[#Banga--2019|Banga 2019]] ) (Sections 15.6.2 and 15.6.7). While multilateral and bilateral development finance institutions have been active in the green bond market, global issuance in 2020 in the top 10 countries included only one developing country ( [[#CBI--2021a|]] [[#CBI--2021|CBI 2021]] a ). Targeting international investors can be enhanced via de-risking activities (15.6.4).

'''Identifying green financial products can increase uptake and may result in a lower cost of capital in certain parts of the market (''' high confidence ''').''' Investors face a systematic underpricing of climate risk in financial markets ( [[#Krogstrup--2019|Krogstrup and Oman 2019]] ; [[#Kumar--2019|Kumar et al. 2019]] ). Transparent identification of financial products can make it easier for investors to include low-carbon products in their portfolios. Investors with mandates that include or are focused on climate change are showing an interest in green-labelled financial products. Investors that identify themselves as green constitute approximately 53% of the investor base for green bonds in the first half of 2019 ( [[#CBI--2019b|CBI 2019b]] ).

There is some evidence of a premium, or an acceptance of lower yields by the investor, for green bonds ( ''medium confidence'' ). A survey of recent literature finds some consensus of the existence of a green premium in 56% of the studies on the primary markets (with a wide variance of premium amount), and 70% of the studies on the secondary market (with an average premium of –1 to –9 basis points), particularly for government issued, investment grade and green bonds that follow defined governance and reporting practices ( [[#MacAskill--2021|MacAskill et al. 2021]] ). In the US municipal bond market, as credit quality for green-labelled bonds has increased in the past few years, some studies show a positive premium for green bonds is arising ( [[#Baker--2018|Baker et al. 2018]] ; [[#Karpf--2018|Karpf and Mandel 2018]] ), or appearing only in the secondary market ( [[#Partridge--2020|Partridge and Medda 2020]] ), while others find no evidence of a premium ( [[#Hyun--2019|Hyun et al. 2019]] ; [[#Larcker--2020|Larcker and Watts 2020]] ). Several studies also show a recent emergence of a premium and oversubscription for some green-labelled bonds denominated in EUR ( [[#CBI--2019b|CBI 2019b]] ), in some cases for both USD or EUR green bonds ( [[#Ehlers--2017|Ehlers and Packer 2017]] ), with a wide variation in the range of the observed difference in basis points focusing on the secondary market ( [[#Gianfrate--2019|Gianfrate and Peri 2019]] ; [[#Nanayakkara--2019|Nanayakkara and Colombage 2019]] ; [[#Zerbib--2019|Zerbib 2019]] ), with financial institution and corporate green bonds exhibiting a marginal premium compared with their non-green comparisons ( [[#Hachenberg--2018|Hachenberg and Schiereck 2018]] ; [[#Kempa--2021|Kempa et al. 2021]] ).

Spillover effects of green bonds may also impact equity markets and other financing conditions. Stock prices have been shown to positively respond to green bond issuance ( [[#Tang--2020|Tang and Zhang 2020]] ). One study linked enhanced credit quality induced by issuing green-labelled bonds to a lower cost of capital for corporate issuers ( [[#Agliardi--2019|Agliardi and Agliardi 2019]] ). Issuers’ reputation and use of third-party verification can also improve financing conditions for green bonds ( [[#Bachelet--2019|Bachelet et al. 2019]] ). Green bonds are strongly dependent on fixed income market movements and are impacted by significant price spillover from the corporate and treasury bond markets ( [[#Reboredo--2018|Reboredo 2018]] ). A simulation of future green sovereign bond issuances shows that this can promote green finance via firm’s expectations and the credit market ( [[#Monasterolo--2018|Monasterolo and Raberto 2018]] ).

'''Financial flows via these instruments have limited measurable environmental impact to date, however they can support capacity building on climate risk and opportunities within institutions to realise future impacts (''' high confidence ''').''' There is a lack of evidence to date that green and sustainable financial products have significant impacts in terms of climate change mitigation and adaptation Box 15.7). Further, new products must be coupled with tightened climate policy and a reduction in investments associated with GHG-emitting activities to make a difference on the climate ( [[#15.3.3|Section 15.3.3]] .2).

It is challenging to link specific emission reductions with specific instruments that mainly target climate activities such as green bonds. Data challenges point to an inability to link emission reductions, including Scope 3 GHG emissions, at the organisation or firm level with green bond use-of-proceeds issuance ( [[#Ehlers--2020|Ehlers et al. 2020]] ; [[#Tuhkanen--2020|Tuhkanen and Vulturius 2020]] ). However one study found evidence of a signalling effect of issuing green bonds resulting in emission reductions at the corporate level following issuance ( [[#Flammer--2020|Flammer 2020]] ), and another study characterised the lifecycle emissions of renewable energy financed by green bonds, indicating potentially substantive avoided emissions but with variance up to a factor of 12 across bonds depending on underlying assumptions ( [[#Gibon--2020|Gibon et al. 2020]] ). There is also a lack of impact reporting requirements and consistency in the green bond market. Impact reporting is not typically required for green bond listings on specific exchanges, nor are there any requirements for independent reviews of impact reporting, however this could change in future if investors apply pressure.

Green-labelled products may not necessarily result in increased financial flows to climate projects, although there can be benefits from capacity building with issuing institutions. Green bonds can be used to finance new climate projects or refinance existing climate projects, and thus do not necessarily result in finance for new climate projects constituting additional GHG reductions (a framing used in the Clean Development Mechanism). The labelling process itself may not necessarily lead to additional financing ( [[#Dupre--2018|Dupre et al. 2018]] ; [[#Nicol--2018b|Nicol et al. 2018b]] ). However, the labelling process has merit in contributing to building capacity within issuing institutions on climate change ( [[#Schneeweiss--2019|Schneeweiss 2019]] ), which could support identification of new green projects in the pipeline.

Climate risk disclosure initiatives, some of which are voluntary in nature, may have a limited direct climate impact. Transparency on climate risk may not change investor decisions nor result in divestment, especially in the emerging economies, as support and clear direction from regulatory and policy mechanisms are required to drive institutional investors at large ( [[#Ameli--2021b|Ameli et al. 2021b]] ). On the other hand, there is evidence of reduced fossil fuel investments following mandatory climate risk disclosure requirements, indicating a broader signalling effect of transparency ( [[#Mésonnier--2021|Mésonnier and Nguyen 2021]] ).

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