The fast-growing green bond market is not yet playing a role in lowering companies' carbon emissions, and investors could benefit from a rating system for firms issuing green bonds based on their carbon emissions, according to a new report.

Current labels for green bonds, which are based on voluntary guidelines such as the Green Bonds Principles from the International Capital Markets Association and the Climate Bond Standards from the Climate Bonds Initiative, do not uniformly take into account lower carbon emissions, according to the report, which forms part of the Bank for International Settlements' Quarterly Review. The latest BIS publication also said a company ratings system could provide a clearer picture for investors than is the case today, while encouraging companies to proactively reduce emissions.

The ratings could complement existing guidelines and provide additional incentives for companies with large carbon emissions to act on climate change, the BIS said.

Green bonds — which are debt instruments that finance environmentally friendly projects such as wind farms or solar power — have grown steadily in recent years, from virtually none in 2012 to issuance of $254.9 billion in 2019, based on figures from the Climate Bonds Initiative, a nonprofit promoting green investment.

Transparent green labels

The project-based approach of the European Union's proposed Green Bond Standard, as well as other frameworks such as the Green Bond Principles, encourage companies to issue green bonds and raise awareness among investors. But not all investors have the ability to assess the environmental benefits of a green bond, potentially misinterpreting such an issuance to mean that a company is reducing its carbon emissions.

"Because green labels apply to stand-alone projects rather than to the firm's overall activities, projects promising carbon reductions could be offset by carbon increases of the same firm elsewhere," the report said.

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The report's authors — Torsten Ehlers, Benoit Mojon and Frank Packer — found "no strong evidence" in their research that a green bond issuer reduced carbon emissions over time.

A green rating system would aim to help companies meet the goals of the Paris Agreement on climate change of limiting global temperature rises to less than 2 degrees C and would make it easier to compare companies and could result in lower funding costs, the authors added.

Carbon footprints

In addition, a rating system it would help investors when deciding which investments to make. Investor mandates could be applied to ratings buckets, making it easier to define green investments.

Investors could also use the ratings system to rate stocks issued by a company, as well as bonds, and the ratings could be applied to specific products to help consumers make environmentally friendly purchases.

Carbon emissions are increasingly easier to monitor because a growing number of companies are disclosing their carbon footprints, the report said, noting that in some countries, including the U.K., carbon emission disclosure is mandatory for most large companies. One way of measuring "greenness" would be to look at the ratio of carbon emissions to revenue, rather than just measuring emissions.

"Looking directly at emissions data provides a simple, transparent and cost-efficient way to verify whether corporates are on track to achieve any stated carbon emission goals," the report said.

Its authors added, however, that further analysis of how a rating system would work in practice is needed.