Europe’s green bonds are gaining marketshare, but there are obstacles to overcome, according to the latest The Cerulli Edge—Europe Edition. These include “greenwashing,” whereby products are labeled as eco-friendly, but there is no independent way for investors to determine exactly what the label stands for.

“Regulation is needed, but it is crucial that the right balance is struck: too harsh and it will dampen demand, too soft and the sector’s credibility is at risk,” says Justina Deveikyte, associate director, European institutional research at Cerulli Associates, a global research and consulting firm.

Green bonds are a way for issuers to raise money specifically for eco-friendly projects. As Europe’s market for these fixed-income instruments grows, so does the importance of quantity and quality. Fund managers want more benchmark sovereign issuance, diversity, and liquidity, along with legislation on standards and uniformity to counter greenwashing.

The European green bond market will get a significant boost when the German government sells an expected €8 billion (US$8.8 billion) to €12 billion of green bonds at its 2020 mid-year auctions. The much-anticipated debut offering by the eurozone’s benchmark issuer will follow green issuances by France, the Netherlands, and Poland. A raft of other European countries, including Spain, Sweden, and Denmark, are expected to follow suit.

One sovereign is noticeably absent. The U.K. reaffirmed last July that it has no plans to issue a benchmark green bond. However, with Brexit “done,” fund managers are quietly hopeful that this policy is set to change.

“More sovereign issuance could help fix the lack of European corporate diversity and resulting illiquidity in the market,” says Deveikyte. “Fund managers want to ensure their green portfolios have a broad risk exposure across technology, healthcare, and consumer staples. Yet too many green bonds are issued by utility companies and European countries and prolific Chinese issuance does not match many European investors’ currency exposure.”

She notes that there are signs that diversification is improving, with new issuers such as banks and telecoms firms arriving on the scene.

Transition bonds could also help build diversity. These bonds, of which there are only a handful so far, could be issued by the much larger universe of “brown” industries on the promise that the funds will go toward greening their activities, providing the diversity the market needs, and helping finance greener activities among polluters.

Quality is also key to the market’s success. The biggest challenge is “additionality,” the question of whether the green bond does in fact add to the amount of capital allocated to green projects.

Cerulli is expecting the launch of a wave of funds structured to meet new European regulation covering green bonds and eco labels, due to be introduced this year. The rules are part of the EU’s Sustainable Finance Action Plan, which is designed to encourage the flow of capital into sustainable investment and stop greenwashing. New frameworks include (voluntary) guidelines on green bond issuance drawn up by the EU’s Technical Expert Group. The guidelines detail what kind of corporate projects align with the EU’s green taxonomy or classification system and suggest reporting frameworks.

Cerulli is in favor of market standardization, but stresses that any regulation needs to be balanced.

Other Findings:

• European retail and institutional investors using bonds to provide income and portfolio protection are suffering from the unintended consequences of the cautious policies of the world’s major central banks. With the era of negative yields set to continue for some time, investors are looking elsewhere—but compromises are required, says Cerulli.

• Smart beta fixed-income exchange-traded funds enjoyed a sharp increase in demand in 2019. The momentum can be maintained, says Cerulli, but education will be required to achieve significant adoption. More investors need to be made aware of how factor investing in general applies to fixed income as an asset class.