A report extract from IEEFA’s paper on Carbon-Neutral Bonds: Has China Set the Bar Too Low?

Funding Net Zero Emissions

China-focused investors have been attempting to gauge the government’s willingness to take the difficult but essential actions required to green China’s financial markets. President Xi’s surprising announcement of net zero emissions by 2060 in September 2020 accelerated the pace.

This has the potential to be a highly important announcement, but market analysts are questioning the speed of change after the release of China’s dismal 14th five-year plan, which showed no change in the importance of fossil fuels in the country’s electricity sector. In the financial industry, there has been recent improvement. All fossil fuel-related initiatives, including “clean coal,” were formally excluded from the definition of “eligible green project” in the 2021 Green Bond Endorsed Project Catalogue, which was issued in late April.

Governor Yi Gang of China’s central bank, the People’s Bank of China (PBOC), has stated that government funding alone will not be enough to achieve China’s net zero goals, which are expected to require an estimated CNY 140 trillion in investment (around USD 22 trillion) from 2021 to 2060, and that market participants must be encouraged to step in to fill the gap.

The success of China’s diverse policy initiatives in reducing greenhouse gas emissions will play a factor in its progress toward achieving the Paris Agreement. The PBOC has taken the lead on green finance while voicing worries about the stability of China’s financial institutions as a result of substantial systemic exposure to mismanaged carbon-intensive assets. Inevitably, the PBOC will be called upon to play a significant role in roiling the market. However, if China’s bond market is to play a significant role in greening the country’s energy and financial sectors, further crucial green bond market reforms are required, particularly for the country’s high-carbon, state-owned power firms (SOEs).

Need for Credible ‘Use of Proceeds’

It’s past time for China’s financial market authorities to examine how high-profile SOEs are using the profits from their green bonds. The PBOC’s attempts to restore market confidence will hinge on enforcing the appropriate policy settings.

The creation of more credible standards governing the use of revenues for SOE green bond issuers should be a top priority. Despite the new expansion to the Green Bond Catalogue, up to 50% of SOE green bond revenues can still be used for working capital.

Carbon neutral bonds, a type of green bond that must adhere to the PBOC’s Green Bond Endorsed Project Catalogue, were issued in 2021. The bond offering paperwork stated that 30% of the profits would be used for operating capital.

According to the bond offering materials, each SOE’s present coal-fired capacity accounts for around 75% of its overall power assets, and the coal power sector will continue to be a key component of the company.

Green bonds and sustainability-linked bonds and loans have the potential to speed the energy transition. Regrettably, the SOEs’ use of revenues may jeopardise the carbon neutral bond designation in China’s embryonic green bond market, as well as the reputation of important energy SOEs.

According to a separate research by the Climate Policy Initiative, every SOE green bond issue between 2016 and 2019 had some money dedicated to working capital, averaging about USD 95 million per issuance (or around 47% of the average proceeds).

Due to the lack of a consistent reporting structure and insufficient transparency in the Chinese green bond market, the research was unable to definitively determine the use of proceeds.

Need for Transparency

The second key problem that must be addressed quickly in order to ensure that the market is built on sound foundations is governance.

SOEs have not concentrated on investor-oriented governance and accountability rules since they are fully aware of their strategic importance to the central government and are not used to the amount of scrutiny that public firms experience.

The following concerns could not be confirmed based on IEEFA’s assessment of the February 2021 carbon neutral bond papers mentioned previously as examples:

  • What is the relationship between the SOEs’ use of profits and their short- and long-term transformation goals, such as any intentions to phase out fossil-fuel energy sources? Setting and disclosing such objectives would not only give openness to external stakeholders, but it would also provide a clear financial and reporting framework for future disclosure of any use of proceeds investment choices.
  • Who makes judgments regarding qualified green initiatives inside the SOE, and what are their credentials? Is there a Party-committee and/or board-level supervision of decisions relating to the use of profits, and has a committee made up of independent environmental experts been formed?
  • What are the SOEs’ procedures for finding and determining what qualifies as a green project?
  • What would be done with bond proceeds? What internal controls do the SOEs have in place to ensure that the green revenues do not mix with general money, or that the proceeds are used only for “qualified green projects”?

If these SOEs are expected to raise additional public debt in the future, it would be prudent for them to establish credibility by ensuring that the following topics are covered in depth in the reports:

  • Detailed information at the project level that is thorough and comparative year to year, especially in respect to the use of funds and the effect of projects, including specifics on absolute emissions saved.
  • Impact assessment technique that is transparent, unambiguous, and consistent
  • As part of the third-party certified post issuance reports, a summary of the experts’ work. The job of the specialists should include
    • Verification of allocated and unallocated proceeds –
    • Assessment of the efficacy of the procedures for project selection, use, and management of proceeds, as well as their design and execution.
    • Verification of the presence of qualifying green assets as well as the correctness of the effect or performance metrics.

Addressing the Issues

China’s onshore bond market is anticipating green issuance of about CNY 500-800 billion (USD 78-124 billion) in 20216, which, along with a slew of recent policy pronouncements, may propel the government in the direction of its green goals.

However, until leading international ESG investors have more evidence that market discipline for China’s SOE green bond issuers has improved, domestic banks, insurers, and asset managers—who have been the primary holders of domestic bonds thus far—may be forced to fill the SOE financing gap that Governor Yi is concerned about on their own.