Outcome Bonds: Seeing the Wood for the Trees on Greenwashing Risk

ESG in Action

Measuring the effectiveness of ESG-labeled bonds can be a challenge, particularly with “outcome bonds,” which have specific environmental or social goals but lack standardized assessment criteria. To mitigate risks such as greenwashing, investors need a systematic approach to assessing these bonds. A case study of a rainforest reforestation project illustrates such an approach and highlights the importance of thoroughly evaluating both economic returns and environmental impacts to ensure credible, effective investments.

Measuring the effectiveness of ESG-focused bond holdings can be a challenge, as such securities differ in how easily they can be evaluated, and how effectively they meet environmental or social goals. So-called outcome bonds offer well-defined objectives but are not covered by standard industry assessment criteria. Investors, in our view, need a systematic approach to evaluate them.

Fixed-income investors can invest in various securities to achieve positive social and environmental effects while also achieving financial objectives. The opportunities are considerable: the ESG-labeled bond market reached nearly US$6 trillion in size in 2024. But ESG-labeled bonds may differ in the way they are structured and how easily they can be evaluated. A comparison between three such kinds of bonds illustrates this (Display).

One difference lies in the extent to which the use of the bonds’ proceeds is specified. Issuers of green or social bonds can nominate projects they wish to fund, while issuers of sustainability-linked or KPI-linked bonds can be flexible in the use of proceeds, providing they help meet sustainability targets (for example, increasing the use of renewables in an issuer’s energy mix).

Both kinds of bonds can be evaluated according to special principles drawn up by organizations working to enhance the quality and consistency of reporting in environmental finance.

Outcome bonds, the third type of ESG-labeled bonds, are tied to specific projects and have well-defined goals. They typically appeal to investors who focus on a specific theme—reforestation, for example, or healthcare—or who want clear insight into their investment’s impact. But outcome bonds are not covered by specific principles or other standardized evaluation criteria.

This makes them harder to evaluate. As with other forms of sustainable financing, there may be scope for various risks, including greenwashing—the possibility that the beneficiaries of the funding might exaggerate the project’s environmental or social effectiveness. One way to guard against this, in our view, is for investors to evaluate the bonds systematically.  

Bondholder Economics Come First

Outcome bonds typically form part of a project-financing package known as blended finance, in which the role of bondholders is augmented by institutional development agencies, such as the World Bank, that provide finance at concessional rates. Other parties to the transaction are more directly involved in managing the project’s environmental or social impacts (Display).

In this example, investors buy bonds issued by the International Bank for Reconstruction and Development (IBRD), a World Bank entity. The IBRD uses the proceeds to fund eligible sustainable development projects but sets aside some of the cash flows that would normally have been paid as coupons to investors. It pays them instead to a rainforest reforestation project.

This project is managed by the contractor, which forms reforestation partnerships with owners of deforested land. The reforestation results in carbon removal units (CRUs) which are sold to the offtaker—in this case, a US tech company that wants CRUs to offset carbon dioxide emissions caused by the construction of its data-processing centers.

From an investor’s perspective, the transaction needs to be evaluated for economic return and environmental impact. In our view, bondholder economics are a foundational requirement. To our mind, if they don’t make sense (if the expected investment return in the rainforest transaction, for example, is no better than that offered by a regular World Bank bond) the deal should not be considered.

If the economics make sense, investors can focus on the greenwashing or other ESG-related risks. In the rainforest project, this means examining the ability and commitment of the contractor and offtaker to fulfill their respective obligations in creating the CRUs and applying them to offset emissions.

Removal Is Better than Avoidance

Investors can gain a sense of a project’s viability and environmental integrity by examining the agreement between contractor and offtaker. Terms to look for include, for example, the price negotiated for the offtaker, the effectiveness of the emissions mitigation strategy, the project’s effect on its immediate environment and local communities, and how the CRUs will be used (Display).

Each attribute can be assigned a score, based on specialized knowledge of environmental investing (an expertise some investors may have in-house, or that they may need to source from external parties). In this example, the price per ton for the CRUs is lower than the average for carbon allowances in the European Union’s Emissions Trading System, but well above prices paid in the voluntary carbon market. This bodes well for the project’s viability and rates a strong score.

Emissions-management strategies are, typically, avoidance (use of technologies that don’t emit greenhouse gases) and removal (partial mitigation of existing emissions). The rainforest CRUs count as removal, which has greater impact than avoidance.

While the durability and community outreach contract provisions rate medium scores, the fact that the offtaker will be retiring and cancelling the CRUs, rather than holding them on the balance sheet for possible future trading, is another positive, contributing to a high overall score.

ESG Track Record Matters

Evaluation of the offtaker should probe widely, in our view, and consider not only the intended use of the CRUs but also the company’s history of bond issuance, its environmental, social and governance (ESG) record and its plans for future emissions reductions. In this case, the offtaker has a high credit rating and ambitious plans to be carbon negative by 2030. By 2050, it aims to have removed more carbon dioxide than it has emitted over its entire history.

Its progress on emissions reduction has been good overall but faces short-term challenges. On Scope 1 and 2 emissions (respectively, those produced internally by the company’s own activities, and those attributable to its choice of external energy sources) the company has performed well. It sources more than 95% of its energy from renewables, and its data center efficiency, or power usage effectiveness, is about 1.18, compared with the global average of 1.5.

The challenges lie in its Scope 3 emissions, which are attributable to suppliers along the value chain. These are difficult for any company to control but, in the offtaker’s case, they increased 42% between 2020 and 2023 because of the rush, sparked by the AI revolution, to build more and bigger data centers. The challenge is compounded by the fact that emissions from steel, cement, aluminum and other construction-related sectors are notoriously hard to abate.

Against these negatives, investors can weigh the likelihood that the surge in data-center construction will be short-lived, together with evidence that the offtaker is proactive in reducing emissions. For example, the rise in its overall emissions between 2020 and 2030, once retired carbon removals are counted, was 29%—still significant, but much lower than the spike in its Scope 3 emissions, and testament to the effectiveness of the company’s carbon-reduction efforts.

This suggests, in our view, that the offtaker is committed to carbon reduction and will use the rainforest project CRUs appropriately.

Systematization Yields Sharper Insights

A systematic approach, applied consistently across outcome-bond opportunities, can enable comparisons. These, in turn, can lead to sharper research insights. Comparisons should be systematic too, in our view. For example, investors can use a matrix to plot the strengths and weaknesses of projects’ contracts and offtakers (Display).

The blended-finance market consisted of more than 1,100 projects in April 2024, worth US$213 billion. As the need for environmental financing continues to evolve, the investors best positioned to benefit, in our view, are those who analyze the risks and opportunities systematically.