A CPI Report Donovan Escalante June Choi Neil Chin June 2020 Supported by the UK Government In collaboration with The State and Effectiveness of the Green Bond Market in ChinaCopyright 2020 Climate Policy Initiative https//climatepolicyinitiative.org All rights reserved. CPI welcomes the use of its material for noncommercial purposes, such as policy discussions or educational activities, under a Creative Commons Attribution-NonCommercial- ShareAlike 3.0 Unported License. For commercial use, please contact admincpisf.org. About CPI With deep expertise in finance and policy, CPI is an analysis and advisory organization that works to improve the most important energy and land use practices around the world. Our mission is to help governments, businesses, and financial institutions drive economic growth while addressing climate change. CPI has six offices around the world in Brazil, India, Indonesia, Kenya, the United Kingdom, and the United States. Descriptors Sector Climate finance Region China Keywords Green bonds, China, sustainable investing Related CPI Reports Contact June Choi june.choicpiclimatefinance.org Donovan Escalante donovan.escalantecpiclimatefinance.org Acknowledgements The authors of this report would like to acknowledge the financial support received from the UK PACT Programme which made this work possible and the contributions of Joyce Guo and Beibei Jiang UK Embassy China, Professor Tom Heller and Vincent Xia Stanford University, Mathias Lund Larsen and Zhiting YunIIGF, Professors Yingzhe Shi, Ying Cui and Yao Wang IIGF/CUFE, Wenhong Xie Climate Bonds Initiative and our colleagues Barbara Buchner, Vikram Widge, Bella Tonkonogy, Elysha Davila, Josh Wheeling, Dario Abramskiehn, Julia Janicki, and Alice Moi Climate Policy Initiative. 1 A CPI Report The State and Effectiveness of the Green Bond Market in China June 2020 cutive Summary 1 Estimate for 2015-2020 period; Y ao Wang 2018 2 Since only labeled green bonds have committed to upholding green standards, this figure represents the labeled green bond market only. Note “labeled” green bonds here is in reference to those that issue in alignment with China’s green bond project catalogue. ABS issuance is not included in the figure 3 Excluding ABS issuance. The Chinese green bond market has rapidly expanded demonstrating impressive ambition and demand for green financing in China. More analysis is needed, however, to understand what exactly is being funded, how these activities are contributing to climate mitigation and adaptation and whether Chinese policies are leading issuers to invest in more green projects. This is especially important in light of the fact that green bonds and other green finance instruments in China must scale substantially. For China to meet its commitment to the Paris Agreement, it must mobilize an estimated RMB 3-4 trillion roughly USD450-600 billion in green investment per year. 1This report provides a comprehensive review of the Chinese green bond market. The analysis is based on an extensive primary data collection effort to track bond issuances, their use of proceeds and their environmental and climate impacts, including new data that has never been published before. It also explores the development of the market from an economic and regulatory perspective and provides recommendations on how policymakers can support the market to continue its growth. Investment Trends Our analysis comprehensively shows the Chinese domestic labeled green bond market has grown to nearly USD 120 billion, quadrupling in size over four years and making it the second largest in the world. Through new and extensive primary data collection, we account for USD 120 billion cumulative green bond issuance in China from 2016 to 2019. 3 Of the nearly USD100 billion green bonds issued in China from 2016 to April 2019, clean transportation and clean energy received the largest share of proceeds with USD 17 billion and USD 16 billion respectively. Within the clean energy sector, hydropower accounted for the largest share at USD 7 billion. China Three Gorges Corporation was a leading issuer of green bonds for hydropower, with around USD 1.9 billion going towards the construction of several large-scale hydropower stations with capacities of at least 10 GW each. Within clean transportation, urban rail transit contributed the Figure ES1 Cumulative Issuance in China’s domestic green bond market Unit Billion USD 2 2 A CPI Report The State and Effectiveness of the Green Bond Market in China June 2020 largest share at USD 5.7 billion. According to The Green Bond Endorsed Project Catalogue 2015 Edition, green bonds can be issued for projects with marked environmental benefits, and are categorized into 6 categories Level-1 Category and 31 sub-categories Level-2 Category. Three of these sub-categories allow coal-related activities, including efficiency-related improvements for coal-fired power generation, building facilities for coal washing and processing, as well as resource utilization related to coal mining and washing processes. This is a contentious issue with international green bond investors. Almost a third of total proceeds, USD 31 billion, were unspecified or pending allocation. Bonds issued primarily by banks make up the largest share of unspecified bonds; largely because financial institutions are intermediaries and provide capital to end-users who may not have been identified or may not have allocated the funds prior to issuance. In terms of the share of funds that went to new or existing projects, 28, or USD 19 billion, were used to finance new projects, and 10 went towards refinancing debt or to existing projects. The remaining 51, most of which are financial bonds, lacked project-level details and the breakdown between new projects and refinancing remains unknown. Issuer and investor characteristics Most green bond issuers in China have been large entities with strong credit ratings that have broad access to bond markets. In general, participation in the green bond market in China is limited in its diversity. Most issuers are large entities with strong credit ratings. Nearly all investors are domestic. The benefit of green bond issuance remains mainly reputational in nature and if there is a financial impact, it remains small considering the added costs and restrictions associated with green bonds. Figure ES2 Allocation of proceeds, from issuers to allocation sector 2016- April 2019 *Note Mid-term Notes are the most common non-corporate financial debt instrument. Only mid-term notes are analyzed here. 3 A CPI Report The State and Effectiveness of the Green Bond Market in China June 2020 Functioning of the Market China’s green bond market has multiple regulatory authorities providing oversight over different parts of the market as illustrated below. Each regulator provides its own guidelines for green bond issuance and regulates different types of bonds. The resulting segmentation poses several consequences for the market such as inconsistent standards and different expectations for reporting which can decrease efficiency and increase cost. 4 A CPI Report The State and Effectiveness of the Green Bond Market in China June 2020 Green bonds in China have almost entirely been held by domestic investors, partly because foreign participation in the domestic Chinese bond market is relatively low compared to other similar bond markets, at around 1.6 of the total value of bonds outstanding. 4Recently, programs such as Bond Connect have allowed international investors to increase foreign holdings in onshore markets. Specifically for green bonds, there are foreign investor concerns regarding eligible activities, in particular coal-related projects. 5Credit ratings for green bonds are highly skewed towards the upper end of the spectrum, just like they are in the wider Chinese bond market. Most bond types are required to obtain a minimum rating of A- in order to be listed and some firms must obtain additional guarantees depending on their balance sheet. 6Comparing the overall bond market between the US and China shows that in China most issuances are AAA- rated with a very high skew towards the top end while in the US, most are BBB and follow a normal statistical distribution. This potentially implies an inefficient allocation of capital as many investment-grade participants are effectively locked out of credit markets. 78 of green bonds in China have an AAA rating. Impact Additionality We reviewed reporting from 114 issuances that have publicly-available reporting of environmental impacts out of 233 issuances prior to September 2018. Proceeds from green bonds in China are largely going to environmentally-relevant projects that likely wouldn’t have occurred without the market, though there is a lack of publicly-available reporting. The cumulative impacts of these green bonds as reported by issuers are 52.6 million tons of CO2e reduced and 11.2 GW of installed clean energy capacity. 4 IMF, 2019 5 Bloomberg, 2019 6 Enterprise bonds, corporate bonds, medium-term notes, and commercial paper require minimum ratings of AA or A-, and in some cases AAA. IMF 2019 7 PBoC Green Bond catalogue 2015 A significant share of green bond investment has been directed to clean transport including more than 3000 km of rail/subway line constructed. In terms of additionality, we used the number of entrants to the green bond market as a proxy and found that the overall number of green-related issuances drastically increased following the central bank’s launch of the green bond endorsed project catalogue in December 2015. 7More than 160 new issuers have entered the market since 2016, and these new entrants have increased the total amount of bond financing for green projects in China, highlighting its additionality. Proceeds from these bond issuances have gone to environmentally relevant projects within the sectors allowed under domestic regulations and some have reported substantial environmental impacts. Recommendations The Chinese green bond market is in a clear upward trajectory expected to continue in the years ahead. However, there are opportunities for policymakers and investors to increase the rate of growth, broaden both the issuer and investor base, and increase the effectiveness of the market. Some of these opportunities include Continue growing the market through clear guidelines and incentives The market segmentation created by different authorities and regulatory frameworks impacts the efficiency of the market, creates unnecessary burdens on issuers, and decreases transparency. Authorities can work to address market segmentation by seeking approaches to consolidate requirements and clarify guidelines. Authorities can also strengthen regulations on use-of proceeds in a manner consistent with China’s priorities. Current regulations are mostly high-level principles and lack specific guidance or mandatory requirements. Specific procedures must be provided to enhance clarity in the market. They may be backed by appropriate enforcement mechanisms, such as fines for issuers failing to meet reporting requirements. 5 A CPI Report The State and Effectiveness of the Green Bond Market in China June 2020 Finally, the development of the market can continue to be supported through sensible financial incentives. Provincial-level incentives have been effective increasing issuance, but care must be taken these are fiscally responsible. Diversify the issuer and investor base Easing credit rules may help increase the participation of entities that have less access to credit but are still creditworthy as current regulations favor large issuances with AA or AAA ratings. Non-financial private companies are also underrepresented in the market and could play a larger role. To meet the needs of smaller projects and borrowers, authorities and issuers can work to develop the green asset-backed securities ABS market. The transaction costs of bond issuances favor large issuances that do not meet the needs of many types of projects. Using ABS, smaller projects can be aggregated and transaction costs reduced. Another strong opportunity is to increase linkages between green loans and green bonds as green loans can meet the needs of small projects. Outstanding green loans reached RMB 9.23 trillion USD1.37 trillion by March 2019, accounting for 9.9 of the total outstanding loans. 8There is a strong opportunity for financial intermediaries to raise more capital for green loans by issuing green bonds. Specific measures could include raising awareness amongst banks, developing purpose-built institutions like green banks, and developing tailored regulations and incentives to enable greater participation by banks. Increasing alignment with international standards can draw more international investors. Clean coal is not allowed under international standards and allocations to working capital should be limited to less than 5. Strengthen the monitoring, reporting and verification system A robust MRV system will help enforce transparency and boost credibility in the green bond market. Our analysis faced limitations due to the lack of project-level data on green bonds that was either difficult to find or incomplete. For bonds issued by financial institutions, which account for the majority of the market by market value, we find that project-level details on the final allocation of proceeds are not always disclosed, remaining at the category-level in most cases. Other project-level details, such as whether proceeds were 8 PBoC, quoted in China Daily 2019 used for a new or existing project, were not always available. The limited disclosure on the latter point, however, is not unique to the Chinese market. Specific measures that regulators can take include establishing a centralized depository of green bond financial and environmental data. A major challenge to understanding the green bond market in China is the difficulty in gathering the data for reporting. A centralized depository could be set up by an independent entity that would hold all relevant data and make it accessible to third parties in a free and transparent manner. Another measure is to introduce a standardized framework for environmental impact reporting that provides common ologies and metrics for issuers to track and report on the impact of their green bonds. This will allow market to better understand and communicate the benefits of green bonds and draw environmentally-conscious investors. 6 A CPI Report The State and Effectiveness of the Green Bond Market in China June 2020 Table of Contents CUTIVE SUMMARY 1 1. INTRODUCTION 7 2. INVESTMENT TRENDS 8 2.1 Financial flows 8 2.2 Project-level use of proceeds 10 2.3 Types of Bonds and Issuers 11 3. THE STATE AND FUNCTIONING OF THE MARKET 13 3.1 Regulatory framework 13 3.2 Issuer and investor characteristics 16 4. IMPACTS AND ADDITIONALIT