This report is one of the results of joint research project “Green bond assessment and credit rating” by Golden Credit Rating International and Trucost.
This report describes the mechanism by evaluating the internalization of environmental benefits or costs into cash flow of the issuer or a specific project. And by analyzing the impact of the cash flow, credit risk of the issuer or particular debt could be assessed.
The report also applies natural environment credit analysis framework for the development of green bond credit ratings methods. The methodology determines the credit level of green bond and its issuer by analyzing the impact of green factor on internalization of cash flow from the business or project the issuer is engaged in, and the protection degree of green bond principal and interest other than other debt from the same issuer.
The report was written by Golden Credit. During the researching and preparing process, we receive technical support from Green Finance Committee and Trucost.
Research team from Golden Credit: Yu Chunjiang, Ai Hua, Yang Yumeng, Li Rui
Research team from Trucost: Huang Chaoni, Ye Hanxin
Golden Credit Rating International Co., Ltd, (Hereinafter referred to as Golden Credit) one of the major credit rating agencies in China that holds a full range of qualifications for credit rating, is now making strenuous efforts to promote green bonds credit rating.
TRUCOST, an international professional research institute which conducts environment-related research and data standardization and assessment, has engaged in extensive cooperation with the Chinese Ministry of Environmental Protection, China Securities Regulatory Commission and other government departments on green certification and environmental cost analysis.
The natural environment is becoming an important factor in the bond pricing mechanism. A considerable portion of the green bonds’ interest rate is lower than comparable non-green bonds in the same period, reflecting to a certain extent the role that natural environment of risk plays in the bond pricing.
The reason why natural environmental factors will have an effect in the bond risk pricing depends on two aspects: 1) For green investors with preference for environmental benefits, they would incline to invest in the environmental benefits project and even willing to pay fermium for the benefits; 2) natural environmental benefits or cost will convert into cash flow of the issuer, affecting its solvency and default risk.
Natural Environment Credit Analysis
Natural environmental benefits or cost will affect the cash flow of the subject being evaluated, thus leaving an impact on the credit level. Golden Credit believes that ultimately the impact of natural environmental leaves is on the amount and natural of the cash flow generated, and whether the cash flow generated could affect significantly the solvency level of the issuer or the debt.
Based on above judgments, Golden Credit analyze the mechanism of internalization of cash inflow, including but not limited to direct methods such as government subsidies, tax incentives, government procurement, environmental quota trading, fees and other rights, and other indirect methods. And for cash outflow, the analysis includes but not limited to direct methods such as environmental taxes, fines or punitive taxation, litigation and indirect method such as blacklist.
To evaluate the net cash flow that environmental factors bring, it is necessary to consider the environmental sensitivity of the business, regional differences in law and policy, environmental risk preference and environmental credit history. For debt, this framework could also be used combined with transaction structure.
Green Bond Credit Rating
For the credit rating of green bond, Golden Credit comprehensively analyze both the issuer’s capability of cash flow generating and the impact of specific green project leaving on the issuer. Credit rating agencies will disclose separately the analysis result of environment impact.
Credit rating of green bond will help the market with more accurate pricing of environment risk: 1) credit rating agency’s analysis of cash flow will help investors to determine the green benefit or cost that brought by the green bond;2)the comprehensive assessment of credit risk raised by credit rating agency will provide a reference for investors to judge the financial security of green bond investment.
SECTION I THE DEFINITION OF NATURAL ENVIRONMENTAL BENEFIT AND COST
I. Natural environmental benefit and cost
1. Natural environmental benefit, also known as green benefit, mainly refers to that rated entities work on normal business or specific project to improve, repair, protect natural environment ( including but not limited to climate, air, water, soil, vegetation）or reduce the natural environment damage extent. Natural environment usually benefits the whole community or specific area, with positive externality.
2. Natural environment cost, also known as natural cost, mainly refers to that the business or specific project the rated entities work on can cause damage to the natural environment. The consequence of the natural environment deterioration is usually suffered by the whole society or a specific region, with negative externality.
II. Natural environmental benefit and cost internalization.
1. Natural environmental benefits internalization means that rated entities who work on environmental benefit project can gain cash flow from direct or indirect environmental benefit output. The higher the degree of natural environmental benefit internalization, the more motivation enterprise have to produce environmental benefit; The lower the degree of natural environmental benefit internalization, the less possible enterprise is to produce environmental benefits, only depend on government to provide environment benefit.
2. Natural environmental cost internalization means that who work on environmental benefit project should make cash outflow to undertake direct or indirect environmental cost output. The higher the degree of natural environmental cost internalization, the more inhibition to enterprise and agency to damage environment, and more promotion to reduce environmental cost; on the contrary, the enterprise may ignore natural environmental cost during production process.
SECTION II THE INCREASING IMPORTANCE OF NATURAL ENVIRONMENT RISK ON BOND PRICING
The whole world is paying more attention on natural environment sustainable development, and China also has officially put forward concept of ecological civilization and green development. Therefore, the green finance market, whose aim is to invest capital with the use of financial activities in environmental benefit project, is developing quite rapidly in both domestic and international market. Natural environmental benefit and cost is becoming an important factor in green financial market pricing. For example, there is a significant portion of green bonds whose publication cost is lower than comparable non-green bonds( comparable means similar rated entities, same issued period, same debt category, same maturity), and also a considerable portion of green bonds is far more oversubscribed than non-green bonds.
Golden Credit believes the green bond market investors can be divided into green investors group and non-green investors group, therefore, natural environmental benefit or cost affect these two groups of investors by different mechanisms:
1. To green investors, environmental benefit and cost are one of the key factors in the investment and trading decisions. They prefer to invest in the project which could produce real environmental benefit, and they are willing to sacrifice financial income for environmental benefit( ie, pay for environmental cost premium); Just to avoid investing in projects whose environmental cost is higher than benefit or destructive projects, even though these projects are acceptable in terms of financial point.
2. Non-green investors make investment decisions based on financial purpose and their main concern is the related cash flow protection level to principal and interest of rated entities or debt subject. Natural environmental benefit or cost internalization will cause cash inflow or outflow of rate entities or specific project, influencing the protection level to debt principal and interest. Therefore, non-green investors also pay attention to natural environmental benefit or cost internalization.
3. Thus, the effect of natural environmental factors on bond pricing mechanism mainly depends on debt investor group composition. If green investors are the main investors, the environmental benefit / cost has a more significant impact on green bonds publication or trading price; if non-green investors are the main investors, the sensitivity of cash flow to environmental factors is more likely to affect debt publication or trading price. In China, by far there is no relative mature green investor, so in current stage, the sensitivity of cash flow to environmental factors is more significant in green bond risk pricing compared with environmental benefit / cost. If there is a stable group of green investors with the development of green finance, then the environmental benefit/cost factor is possible to increase influence in bond pricing.
SECTION III CREDIT ANALYSIS ON NATURAL ENVIRONMENTAL FACTORS
I. The impact of natural environmental factors on credit risk
Natural environmental benefit or cost internalization will bring direct or indirect cash outflow or inflow to rated entities or specific project; this may affect the credit quality of rated entities or debt project. Specifically, if the environmental benefit produced by business or equity investment project of rated entities could be internalized cash inflow, this may have positive effect on rated entities/debt project credit quality; On the contrary, if the environmental cost produced by business or equity investment project of rated entities could be internalized cash outflow, this may have negative effect on rated entities/debt project credit quality. Golden credit rating believes natural environment factors effect on rated entity or debt credit rating is ultimately up to whether the nature and amount of cash flow produced from environmental benefit or cost internalization is sufficient to prove that the solvency of rated entities is significantly different from comparable reference object, and the solvency protection level of rated entity is significantly different from other debt project from the same rated entity.
II. The Internalization Mechanism and Cash Flow Predication of environmental benefits and environmental cost
The purpose of the credit analysis on natural environmental factors is to recognize the mechanism that internalize the environmental externality produced by the issuer’s business or projects to the issuer’s inner cash flow. Following this internalization mechanism, we can thus predict the probability and the magnitude of the influence on issuer’s cash flow.
1. Cash inflow from internalization of environmental benefits
The projects that generates positive externality are mainly provided by government directly or produce the service purchased by government indirectly, since there is a limit for reasonable financial return through market-oriented approach. As the environmental benefits are typically type of positive externality, the internalization is always related to government, including but not limited to:
i. government subsidies for environmental benefits
It is the most direct internalization way that the government pays subsidies for environmental benefits generated by the projects. The form includes both granted subsidies for consumers, such as subsidies for energy-saving appliances, and subsidies directly to the supply side.
The amount and sustainability are the two major factors considered into the evaluation model of Golden Credit Rating to predict the cash flow produced by government subsidies.
ii. tax incentives on environmental projects
To support the environmental-friendly and sustainable development, governments may provide preferential tax rate and other tax incentives to environmental projects or to subjects engaged in environmental projects, which in turn results in the saving on the tax or tax return.
Golden Credit Rating assess the levels and credit quality of government that offers the tax incentives, the type of the tax incentives, the probability that subjects obtain the preferential policies as well as the duration of tax incentives to forecast the extent of cash inflows influenced by tax saving.
iii. purchases on services with environmental benefits by government or the third party
With the environmental benefits being considered as a type of public service, governments can purchase the service of environmental protection or environment repair service in accordance with the environmental benefits generated and thus can provide the cash inflow for the service provider. This is a common way of internalization mainly applied in the projects which generates some but not sufficient cash flows to cover the whole cost, and also the PPP projects of cooperation between the government and social capital.
Except for government, some international development organizations and green investment institutions may also be the buyers of environment-beneficial service to support the sustainable development.
To measure the cash flow generated by purchasing services, Golden Credit Rating takes credit quality of the buyers of environment-beneficial service, the relevance of deal price and service quality and the timeliness of payment into account.
iv. environment quota
Governments or international organizations usually base on domestic laws and regulations or specific international agreement such as Paris Climate Agreement to design quotas for environment purpose. These quotas can internalize environmental benefits through trading. The environment quota commonly seen in the market is emission reduction quota, such as Carbon Emission Permit quotas, renewable energy quotas.
Golden credit predicts that the cash flow generated from the quota trading mainly focus on the available quotas for trading of the rated entity and the trading price, therefore golden credit will follow the dynamic change of the trading prices for the quotas.
v. the revenue collecting rights designed based on environmental benefits
Certain project with environmental benefits can specify the beneficiary and therefore charge can be placed on the beneficiary. Projects such as treatment of sewerage, refuse disposal, clean energy and clean transportation can generate cash inflow through the setting of revenue collection from the beneficiary.
Golden Credit judges the cash flow from revenue collection rights from the legitimately effective period of the rights, the stability of revenue and the possibility of adjustment on prices.
vi. indirect internalization regime of environmental benefits
In addition to the above internalization regimes, there are some indirect internalization regimes:
a. the facilities or concessions provided by government body for green finance (green pass for issuance, release of restrictions on employment of capital or provide government investment), which will bring down the costs and provide extra financing cash flow.
b. extra policy support to the operator of the green project can be beneficial to the comparative advantage gained of the rated entity in the market competition, which will generate some cash flow. This is a very common practice in urban infrastructure constructor or certain key investment projects of local governments.
In Golden Credit’s point of view, the analysis of government support is mainly conducted through the credit quality of the government level, the specification of support, the sustainability of the indirect cash flow and the effective period of the government support.
2. Internal cash outflow of environmental costs
The mechanisms that the internal of environmental cost resulting from rated entities (or specific project) into the cash outflow of the rated entities (or specific project) include but not limited to:
i. the environmental tax government collected
Government sets the tax and charge for environmental sector, including resource tax, congestion tax, and emission fees etc., which are more conventional measures for the internalization of environmental cost.
Analysis of cash outflow resulting from environmental tax for the Golden Credit mainly based on the current tax rate government set to measure the amount of environment tax of the rated entities (or specific project).
ii. the fine of illegal act or tax penalty government set
For the illegal act of environmental sector, government probably imposes fines of tax penalty, so that the illegal entity has cash outflow to achieve the internalization. With China’s increasingly emphasis on ecological civilization and the Green development idea, the law enforcement in the environmental sector is expected to be more rigorous and standardized, which may increase the degree of internalization of environmental costs.
Analysis of cash outflow resulting from environmental fines or tax penalty for the Golden Credit mainly evaluate the probability of violating environmental rules of the rated entity, the change of how rigorous government’s enforce power is and the amount of punishment.
iii. compliance with cost of environmental policies
Government can set the mandatory environmental standards, such as the vehicle emission standards. If the rated entity is not meet the mandatory standard, it is faced the risk of unable to make production continually. Therefore, it has to reform the current equipment or doing extra investment to comply with the environmental standards.
Analysis of environmental policies complying with cost for the Golden Credit mainly evaluate the gap between the rated entity and environmental mandatory standard, and the cash outflow to eliminate the gap.
iv. environmental litigation
The environmental cost from specific project of the rated entity may not into cash outflow of the rated entity from the internalization of government administration, but it may violate the legal rights of adjacent Party, which induce the rated entity raise the environmental civil lawsuit. If the rated entity was ruled to be tort from court, the amount of compensation will be internally into cash outflow of the rated entity (or specific project).
Analysis of cash outflow resulting from environmental litigation for the Golden Credit normally is concern about whether the matters have environmental litigation, which mainly evaluate the probability of environmental litigation and lose by the rated entity, and the probable amount of compensation.
v. indirect mechanism of internalization of environmental cost
In addition to direct internalization mechanism of environmental cost, indirect mechanism to make the environmental cost internally at this stage is more effective, such as the joint punishment for blacklist in the environmental sector, the disciplinary measures include but not limited to:
a. Prohibiting IPO and issuance of bonds, limiting access to the bank loan or other financing action, thus limiting financing cash inflow
b. Prohibiting from participating in the bidding of government sector or engaging in specific project, thus affecting their business operation
For indirect internalization mechanism, Golden Credit mainly analyze the probability of the rated entity who was jointed into the blacklist of joint punishment in the environmental sector, and the government’s strength on implementing joint punishment.
SECTION IV THE NATURAL ENVIRONMENT CREDIT ANALYSIS OF THE RATED ENTITY
I. The procedures of natural environment credit analysis
The business and specific project for Different rated entities that produce environmental benefits(or environmental cost) probably exist quite difference, part of rated entities who are doing business and specific project more prone to produce environmental benefits, For instance the investment project of the rated entity of the Green bonds must be green; part of rated entities doing business of the specific project more prone to produce environmental cost, such as the high pollution and high energy-related industry; part of rated entities doing business and specific project may not directly produce environmental benefits pf environmental cost, and not sensitive for environmental factor.
Therefore, the Golden Credit firstly assess whether the industry is environmentally sensitive, and on the basis of evaluate the rated entity are environmental benefit or environmental cost, or both.
1. For environmental benefits entities, it is needed to identify the main mechanism of internalization of environmental benefits, and under this mechanism to evaluate the amount of internal cash inflow and its constancy, and on the basis of analyzing the proportion of cash inflow of internal environmental benefits to the future cash to determine its dependence to cash flow of environment benefits.
2. For environmental cost entities, it is needed to identify the main mechanism of its internalization of environmental cost, and under this mechanism to evaluate the internal cash outflow and its constancy, and on the basis of proportion of cash outflow of internal environmental cost to future cash flow to determine its sensitivity to cash outflow of environmental cost.
3. For entity who are both with environmental benefits and cost, it is needed to identify the mechanism of internalization of environmental benefits and that of environmental cost respectively, and separately to evaluate each cash flow, and on the basis of analyzing the proportion of the net cash flow of environment factor to future cash flow to determine its sensitivity to environment factor.
4. The internal cash flow measurement of Environmental benefits or cost based on different assumptions and can get difference outcomes, thus it is needed to implement stress test for different measurement assumptions, in order to further clarify the impact of entities’ credit quality for environment factor.
II. The elements of entities’ Natural environment credit analysis
In order to estimate the sensitivity of capable of entities to obtain cash flow to cash flow of internal environmental benefits or costs, the Golden Credit normally doing the following analysis for the entity’s natural environment factor:
1. The relationship between the industry and environment of the rated entities
Different industries have different environmental sensitivity. Therefore, to determine the environment benefits or cost of the rated entities’ must analyze their business or industry:
i. whether it is easy to damage the environment;
ii. whether exist the technology and project that can reduce the environmental damage;
iii. Whether it is environmental restoration and protection?
If it defined as one of those three, it is the environmental sensitive industry; on the contrary, the rated entities’ business have no direct impact on environment, but probable indirectly affect environment by limiting the service of environmental damage product.
For whether the business of the rated entities are beneficial for environment, it is can determine by whether its business or project are supported by the official green directory such as “the green bonds supportive project directory”, “the green bonds issuance guideline”, etc.
2. Regional factors of environmental policy and law enforcement
The internal mechanism of environmental benefit and environmental cost is more dependent on the government, so the environmental policy and law enforcement are key factors to affect the internal mechanism. Environmental policy and law enforcement consist of national and local levels, different regional environmental policies may be set according to national levels; in terms of the local level, local government’s understanding of environmental policy may not be the same, which leads to the existence of different environmental law enforcement. Therefore, in the sensitivity analysis of the performance for the rated entities to reflect the financial capacity of the environmental benefits / cost of internal cash flow, the regional environmental policy preferences and enforcement should be taken into consideration.
Golden Credit believes that the environmental policy implementation and enforcement is relatively higher in developed areas, also true for local government in the special natural ecological region; for those relatively less developed region, they may be more inclined to economic growth rather than the protection of environment. For rated entities, the probability of internalization of environmental benefits or environmental costs is relatively high in developed areas or special natural ecological areas; for other areas, the probability is relatively low.
3. Rated entity’s preference on environmental benefit and environmental risk
If the rated entity is more preferred on environmental benefits, it is relatively more likely to engage in environmentally friendly projects’ investment and operation, and the management mechanism of environmental risk capital investment for avoiding the destruction of the environment, the use of non-environmental-friendly suppliers to provide products or services, also avoiding their own products or services sold to the non-environmental-friendly customers. Otherwise, it is possible for the entity to engage in projects directly or indirectly damaging the environment.
The rated entity’s preference on environmental benefits or environmental risk will be affected by environmental policy and law enforcement. In this regard, Golden Credit will evaluate the entity based on:
i. environmental risk strategy: whether there are official documents on environmental risk strategy clearly stating environmental risk factors in the business and investment strategy; whether the entity deviates from the strategy;
ii. the ability of environmental risk management: whether there is a environmental risk management mechanism, including management team, risk management technology, etc.;
iii. the scope of environmental risk management: whether the entity’s environmental risk management covers suppliers and customers.
4. The entity’s credit record in environmental protection field
The credit record of the entity in environmental protection field is the concrete embodiment of its environmental risk strategy. Increasing attention is attached to the credit record in the field of environmental protection, the entity’s dishonest behavior in the field of environmental protection may lead to punishment from government departments and financial institutions, which could have a significant negative impact to its cash flow; on the contrary, if the entity is encouraged by government departments or financial institutions for achievements in the field of environmental protection, it is likely to bring competitive advantage to the rated entity, even possible to contribute to positive cash flows immediately.
Therefore, main concerns for Golden Credit to take into consideration in evaluating the entity’s credit record in the field of environmental protection including the follows:
i. whether the entity is included in the environmental protection blacklist or joint disciplinary dishonesty blacklist: the date of blacklisting, whether it has been punished or the possibility of going to be jointly punished in the future; the likelihood of eliminating dishonest behavior and hence to be removed from the blacklist.
ii. the credit record in using green funds: whether there is a greenwash behavior; whether the green funds are strictly allocated to the green project; whether there is full disclosure of information.
iii. the green benefits of the business or specific projects undertaken by the entity: the extent to which it is recognized by the government or international organizations.
SECTION V THE NATURAL ENVIRONMENT CREDIT ANALYSIS FOR BONDS
I. The natural environment credit analysis for project-revenue bonds
1. The characteristics of project-revenue bonds
Although the cash flow from investment projects is the main source of revenue for project-revenue bonds, yet if the cash flow is not sufficient to repay the principal and interest, law in China does not exempt the entity’s responsibility repay from other sources, therefore the rated entity should repay with all its assets for the principal and interest.
Therefore, Golden Credit believes that the fundamental credit rating for project-revenue bonds should be the rating of the entity its own, to get the specific bond rating, further evaluation should be conducted according to the guaranteed level of the project-revenue bond, whether it is significantly higher than the same rating general unsecured debt from the same rated entity.
2. The environmental credit analysis for project-revenue bonds
The cash flow from investment projects is the main source of revenue for project-revenue bonds, therefore in estimating the project’s cash flow, the expected environmental benefits or environmental cost should be taken into consideration, and also considers the level of internalization of environmental benefit or cost in the project’s cash flow. Further judgment should be based on this analysis, that is, whether the project’s internal net cash flow related to the cost or environmental benefits lead the rated bond to a significantly higher guaranteed level than the entity's other bonds.
In terms of the evaluating elements, there is no difference between the environment credit analysis of the project and the entity, and there is only one thing that is to accumulate the internalized cash flow to the cash flow statement of the investment projects.
II. The natural environment credit analysis for PPP debt financing instruments
1. The characteristics of PPP debt financing
PPP debt financing projects are included in project-revenue financing, compared with the pure project financing, the credit quality of PPP debt financing has the following characteristics: first, the main business and the financing entity of PPP project is usually a joint body composed of government and social capital, government investors and social capital investors have only limited liability to the antithetical couplet body by law, therefore it is the true project-revenue financing; second, a considerable part of the cash inflow of PPP is from government’s purchase of services or fiscal subsidies, but the government only has the obligation to repay for the PPP entity, there is no obligation for payment on the joint body or fallback responsibility, but still, the government level and credit quality has vital influence on the PPP joint body and PPP project's cash flow; third, if the PPP project is an important government one, in order to ensure the continued operation of PPP project and service quality, it is possible to obtain government or social capital investors’ support (such as financial support, assistance projects and debt transfer, etc.),when there are management difficulties or repayment difficulties for the PPP project.
2. The natural environmental credit analysis for PPP debt instruments
Golden Credit’s analysis of environmental credit for PPP debt instruments, including but not limited to the following aspects:
i. social capital investors’ credit quality and their environmental credit : social capital investors are actual operators of PPP projects, therefore their credit quality and environmental credit will have a significant impact on environmental benefits or environmental costs of PPP project.
ii. government investor’s credit quality: the government investor is the key to internalization of environmental benefits in PPP projects, therefore its credit quality is directly related to the stability of the cash flow in project’s operating activities.
iii. types of environmental benefits or environmental costs of PPP project: in addition to government’s purchase of services, whether there is other environmental benefits or environmental cost internalization mechanism for the PPP project , if exists, it is necessary to estimate the cash flow amount internalized and its certainty.
iv. the importance of the PPP project in its affiliated area: the main assessment is the possibility of the government's assistance in case there are operating difficulties or debt servicing difficulties.
III. Natural environment credit analysis of structured finance instruments
1. Characteristics of structured finance instruments
The most significant characteristics of structured finance instrument is the realization of bankruptcy separation of the cash flow of the originator from the cash flow of the financing project through the setting of SPV ( which is normally through trust in China). This arrangement can avoid the influence on cash flow of the financing project from the bankruptcy risk of the originator. Theoretically, the credit quality of the structured finance instruments has no relation with the creditworthiness of the originator. However, in practice the credit quality of the structured finance instruments is influenced by the originator in certain degree in China. The main reasons can be summarized as follows: first, the originator normally may continue to participate in the asset management and operation after the underlying asset has been transfer to the trust or SPV, as a result the cash flow of the underlying asset still have certain reliance on the originator. Second, from the design of the cash flow mechanism, it is possible that the cash flow of the underlying asset is first collected by the originator and then transferred to the bank account of the trust or SPV, therefore the cash flow of the structured finance instruments can to certain extend determined by the creditworthiness of the originator or the designated trustee (i.e. the possibility of cash flow being retained by the originator). Third, under the circumstance of inadequate cash flow from the underlying asset, the obligation to supply incremental cash from the originator may be adopted, thus the cash flow of the originator itself constitutes the substitute cash flow available to the structured finance instruments.
2. Natural environment credit analysis of the structured finance instruments
Golden credit’s natural environment credit analysis of the structured finance instruments includes but not limited to:
i. the evaluation of influence from environmental factors of the underlying asset cash flow: the types of underlying asset, the sensitivity to environmental factors, the possibility that environment benefit turn to cash flow of the underlying asset, and the proportion of cash flow accrued to environment in the total cash flow of the underlying asset.
ii. the environmental credit of the originator: as the underlying asset mostly continues to be operated and managed by the originator, the environmental credit of the underlying asset is commonly determined by that of the originator, and possibly effect the cash flow of the underlying asset. Additionally in the setting of obligation for supplement of incremental cash, the effect from the environment on the cash flow of the originator may spill over to the cash flow of the structured finance instruments.
iii. the creditworthiness of the originator: the possibility of cash flow being retained by the originator, and the willingness and ability to fulfill the obligation of supplement of incremental cash.
iv. the tranches of structured finance instruments: the structured finance instruments are usually divided into different tranches, through which the equity tranche will first impair from the risk in order to provide extra guarantee on the senior tranche. Form the point view of environment credit analysis, the effect of tranche setting or the credit enforcement on senior tranche from the cash flow generated by environment benefit can be evaluated as well.
SECTION VI ANALYSIS FRAMEWORK OF GREEN BOND CREDIT RATING
I. definition and characteristics of green bond
1. Green bond is the debt instrument that the raised fund can mainly be employed to improve, rehabilitate or protect (or restrain the damage to environment) the natural ecological environment such as the climate, air, water, soil, plants.
Compared to the non-green debt instrument, the characteristics of green bond can be recognized by the following three aspects.
i. the purpose of issuing green bond can only be constrained to improve, rehabilitate or protect the environment or to restrain the damage to environment, and must not raise fund for project through greenwash.
ii. The green bond could raise fund from the green investors who are put more focus on the environmental benefits through the investment on green bond.
iii. From the issuance and supervision, the rated issuer of green bond is required a redundant information disclosure of the greenness to authorities and investors in order to prove the appropriate use of raised fund on green project.
2. Type of green bonds
The green bonds currently issued in China capital market include the followings.
i. green finance bond: the securities issued by financial institutions from which the raised funds is invested to support green industries. The approval and supervise body is the People’s Bank of China.
ii. green enterprise bond: the raised funds are mainly applied to support Energy saving and emission reduction technology upgrading, green urbanization, clean and efficient use of energy, employment of new energy, development of cyclical economy, water saving and nonconventional water resource use, prevention of pollution, ecological agriculture and forestry, energy saving and environment protection industries, low carbon dioxide emission industries, ecological civilization. The National Development and Reform Commission (NDRC) is the regulate body for approval of issuance and consequent supervision.
iii. green corporate bond: corporate bond issued on exchanges and supporting green industries. The stock exchanges and China Securities Regulatory Commission (CSRC) are the approval body and the CSRC is the supervision body.
iv. green debt financing instruments for nonfinancial enterprises: this is registered with National Association of Financial Market Institutional Investors (NAFMII) and issued and traded on the interbank bond market.
v. green structured finance instruments: the asset backed securitization of green credit, the financing facilities backed by cash flow from green project.
As the green finance market develop further, the innovation on financing tools of green project will soon emerge.
II. The definition of green bond's credit rating
1. The method of green bond's credit rating is that Golden Credit employs credit rating grades to comprehensively measuring the credit risk of green bond's issuer and debt .
2. The core task of credit rating is measuring the coverage of the cash flow produced by the rating subject and bond transaction structure in the future to the debt service. For green bond, Golden Credit mainly focus on the substantial effect on the cash flow of the issuer or the financed green project from the internalization of environment benefits, based on which can judge the difference on the guarantee of repayment of the green bond from other debt instrument of the issuer under the consideration of environment benefits. In the Golden Credit rating method, the enforcement of the rated entity’s solvency and the guarantee on repayment under the cash flow from internalization of environment benefits will be conducive to improve the credit rating of the entity and the green bond, otherwise, it will have insignificant to the credit rating of the issuer and the green bond.
3. The functions of green bond's rating to green bond investors and other investors can be categorized as follows.
i. The credit rating attention on the cash flow generated by natural environment benefits and cost internalization is highly consistent to non green bond's investors.
ii. Although the green bond's investors is willing to pay for part of premium for the environment benefits, the green bond's investors would unlikely to give up the financial returns, the safety of debt service is still considerable to the green bond's investors. So the credit quality of bond issuer and guarantee degree of bond are still the important considerations for the green bond's investors making transaction decisions.
iii. Besides the safety of fund, the green bond's investors especially focus on whether the fund is invested on the project generating the environment benefits other than greenwash project. Also the green bond's investors would care the financial capital in the duration whether used for the purpose indicated in the prospectus rather than other projects. Essentially, it is determined by the willingness of the issuer to fulfill its obligation. The credit rating to the issuer by the credit rating agency is the comprehensive measure of the repaying willingness and the debtor solvency which is the coverage of cash flow to the debt repayment. And the weight of the credit record and repaying willingness in the rating model is increasing. So the rating result is useful for green bond investors to judge the credit of the issuer and debtor, and the fund can flow to issuer and debtor with higher credit rating.
III. The credit quality of rated entities
1. The underlying credit quality of rated entities
The underlying credit quality of rated entities depends on the debt solvency and paying willingness, applicable to various Golden Credit rating method on various rated entities.
2. The natural environment credit analysis of rated entities
The credit analysis of rated entities natural environment mainly analyzes whether cash flow produced by the internalization of environmental benefits make the underlying credit quality of rated entities significantly higher than the reference rating object.
IV. The credit quality of green bond
For further judging the guarantee degree of the green bond is remarkably above generally unsecured debt issued by the same issuer, the analysis of green bond's credit quality is based on the credit quality of its subject. And it’s divided into two aspects as follows.
1. The analysis of green bond natural environment’s credit quality
According to the types of green bond, Golden credit will adopt the corresponding environment analytical framework to judge that whether there is marked difference between green bond and other bond issued by the same issuer due to the environment factor.
2. Credit enforcement measures of green bond
Including conventional credit enforcement measures, the green bond may set specific credit enforcement measures to the green bond including but are not limited to the followings:
i. interest subsidy afforded by the government to the green bond
ii. fund support by the government green industry development fund
iii. green insurance
iv. pledge of carbon emission permit and other
Golden Credit will assess the credit rating of green bond comprehensively by evaluating the effect of all the credit enforcement measures on the green bond.
V. The credit rating report of green bond
The credit rating report of green bond reflects the credit rating result of the green bond. In order to reveal the credit risks of green bond issuer and green bond's natural environment’s risk, Golden Credit will attempt to separately disclose the impact on green bond and the rated entity from the natural environment factors, which can provide the respective reference for green investors and other investors.