The prevalence and popularity of “Impact Investing” and “Sustainable Investing” has led many governments to consider designating or labeling bonds to attract investors looking for investments that produce social or environmental benefits. The purpose of this best practice is to assist governments in defining the emerging designated bond market and devising a paradigm for analyzing the costs and benefits of designating or labeling bonds, such as Green Bonds, Sustainable Bonds, Social Bonds, or other alternatively designated bonds (“Designated Bonds”), for the marketing of their municipal bond offerings. 

Many municipal bond investors seek to invest their capital in projects that demonstrate positive ESG-oriented impacts and investment in these types of bonds has increased significantly in recent years. Investing in municipal bonds for these purposes does not require the investment to be specifically designated, however, the issuance of designated Green Bonds, Sustainability Bonds, and Social Bonds continues to grow in popularity in order to assist investors in finding investments for their thematic investment objectives. Governments considering issuing bonds with designated purposes may be driven by the demands of political or constituent expectations, the desire to broaden their investor base with the hope of gaining pricing benefits, investor requirements or wanting to display leadership in the ESG and sustainable investment arena. Whatever the impetus, as governments increase their focus on ESG-oriented initiatives, their desire to market Designated Bonds has increased.

Issuing Designated Bonds is relatively new and the market continues to evolve.  Currently, there is limited quantifiable evidence that a designation results in interest rate savings for governments. Accordingly, any benefit to justify the costs of issuing Designated Bonds should be evaluated critically as with any expenditure of public funds. Issuing Designated Bonds may require some level of ongoing monitoring and disclosure requirements throughout the lifespan of the funded project; therefore, it is important for governments to weigh their resources and to educate themselves on the long-term requirements, including potential negative reputational impacts that may be realized if project goals are not achieved.  

In contrast to GFOA’s suite of ESG Disclosure Best Practices which recommend that governments identify and disclose ESG credit risk factors relevant to their bonds, this best practice recommends that governments consider the potential pros and cons when issuing Designated Bonds. From a functional perspective, the issuance of Designated Bonds – as opposed to ESG credit risk disclosure by a government – is optional and a proactive signaling of the use of your bond proceeds.

Considerations for Labeling and Marketing Designated Bonds

The decision to issue Designated Bonds should begin with a thorough review of the intended benefits, associated challenges, and costs. A government should determine the motivations and justifications for issuing Designated Bonds, such as responding to market demands for sustainable development (for example, infrastructure, environmental improvement, and social benefit projects); attracting a broader investor base; and adjusting to external expectations regardless of the external stakeholder.

Governments can take varying approaches to issuing Designated Bonds based upon their expected benefits and the amount of resources the government wants to invest in issuing Designated Bonds. A government could take a basic approach of simply designating its bonds based upon the use of proceeds with no third party verifying the use of proceeds and with the government not committing to disclose project performance to bondholders in the future. A more resource intensive approach would require a third-party certification of the project and to clearly articulate project performance expectations towards meeting the sustainable investment criteria. This includes continuing reporting to bondholders on whether the project meets expectations or goals. Governments may choose to use either of these approaches or any combination of these options that best help them reach their clearly defined objectives for issuing Designated Bonds.

 The final decision to issue Designated Bonds should be consistent with the intrinsic Environmental, Social and Governance values of the government’s organization and governing body. The issuance of Designated Bonds that, based upon the organization’s past or future decisions and actions, appear to conflict with the stated purpose of the Designated Bonds could lead investors, potential investors, and rating agencies to develop a negative perception of the government.  

 Use of Proceeds, and Labeling of Designated Bonds

The issuance of Designated Bonds is a signaling that the project being financed or refinanced has certain attributes appropriate for that investment designation. Governments should select criteria for projects to be financed, and the selection criteria should be clearly explained in the offering document. Governments should establish factual and clear project goals that align with their current policies and are easily understood by the public and investors.  A government should assess its ability to define and meet those goals in order to obtain and retain the confidence of the public and investors.

Governments will need to assign a specific label to their Designated Bonds based on its primary objectives for the projects being financed. Published principles established by finance industry groups can provide a framework for such designations. Governments can also seek guidance from their municipal advisors and legal counsel when labeling and issuing Designated Bonds. Some of the more popular examples of Designated Bond labels include:

• Green Bonds – New and existing projects with environmental benefits (examples include terrestrial and aquatic biodiversity, clean transportation, renewable energy infrastructure, green buildings, water/wastewater management projects, natural resource conservation).
• Social Bonds – New and existing projects with positive social outcomes (examples include affordable housing, food security and sustainable food systems, and access to essential services).
• Sustainability Bonds – New and existing projects with both environmental and social benefits (examples include renewable energy, climate change adaptation or mitigation, and clean transportation).

Governments should be aware that such labels create expectations that the bond proceeds will be used to meet goals related to the Designated Bond label. Consequently, governments should be careful to describe in their offering documents what procedures and standards were used to evaluate the financed projects in order to label the associated Designated Bonds.  In addition, the offering document should include a self-certification or third-party verification to show that the bond proceeds are used to finance projects that satisfy the expected outcomes related to the Designated Bond label.

Increased Disclosure and On-going Project Reporting Requirements

Governments should consider the additional disclosure and reporting requirements if they choose to issue Designated Bonds.  Governments will need to include additional disclosure in their initial offering documents regarding the use of proceeds, project selection criteria, and project goals. These reporting items may include comparing defined project performance measures to the original goals of the project.  Governments should clearly state within their offering documents if they are committing to on-going project performance monitoring and reporting. If governments commit to on-going performance measurement and reporting, those commitments will likely require the long-term commitment of resources, thereby increasing costs for the life of the bond issue.  Additionally, because of the evolving legal and regulatory framework, governments should consider legal risks, after consulting with bond or disclosure counsel.

Governments should consider whether to develop an alternative or contingency plan if circumstances change that may reduce the ability to meet the original project performance goals. If the original project performance goals are no longer attainable due to changed circumstances of the project or other factors, the government may need to modify the project goals to reflect the change in circumstances.

 Legal Considerations

The legal and regulatory landscape associated with issuing Designated Bonds is evolving. There are currently no specific requirements for issuing Designated Bonds, but both the MSRB and SEC are gathering information about market practices. Governments should be aware that regulatory requirements for Designated Bonds may be forthcoming. Also, governments should be mindful that the antifraud provisions of the securities laws do apply and could be used in SEC enforcement actions [1]. The antifraud provisions prohibit governments and underwriters from misrepresenting material facts in connection with bond offerings. Governments should consult their bond counsel or disclosure counsel about the appropriate disclosures and legal risks of issuing Designated Bonds; antifraud provisions prohibit governments and underwriters from misrepresenting material facts in connection with all bond offerings. 

 Weighing the Benefits and Costs of Issuing Designated Bonds

With a government’s decision to add the designation, the government should weigh the current and projected future costs against expected benefits. The intended benefits of issuing Designated Bonds could be both tangible as well as intangible. Examples of tangible benefits may include broadening your investor base that may eventually provide pricing advantages in the future. Intangible benefits could include advancing political goals and policies. Qualitative or intangible benefits may be as important as quantifiable benefits.

Costs of issuing Designated Bonds include up-front costs of information gathering, program definition, and feasibility studies, including any third-party assessments, as well as ongoing costs to monitor, evaluate, and report on program progress and results.

Governments can self-certify that the project satisfies the criteria for the Designated Bond label. Self-certification can require very little additional staff resources or may require some additional staff time to access data, evaluate metrics, and develop expertise with Designated Bond label criteria. Governments can also engage a third-party to measure and report projected and actual performance over time. Third-party verification will have additional costs that may be ongoing.  If a government decides to use a third-party verification, the government should review the qualifications of the entity measuring the project performance. With any type of project verification, the government should weigh the administrative burden and economic costs against expected benefits to ensure the prudent expenditure of public resources.

Since the framework for the issuance of Designated Bonds in the municipal bond market is still evolving and is an optional venture by governments, they should carefully consider whether the benefits warrant assuming the associated long-term commitments and potential risks. Additionally, it would be insightful for governments who choose to issue Designated Bonds to re-evaluate their approach on an on-going basis to ensure it continues to align with their intended goals and objectives.

Notes:

1. To see definitions for ESG Risk Disclosures or other GFOA best practices on ESG, please review GFOA's resource on ESG Disclosure at www.gfoa.org/esg
2. GFOA Best Practice on Understanding Your Continuing Disclosure Responsibilities