ESG Focus | Jun 29 2021
FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
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Sustainability finance to take off in 2021
ESG finance is forecast to become a part of a business's licence to operate, transforming the world – and 2021/2022 is the pegged as the year of take-off.
– Prepare for the big boom – EU leads the charge
– ESG finance to become part of the licence to operate
– The concept of blended finance
– Beginners guide to ESG finance
By Sarah Mills
The ESG bond market has boomed in past five years (more than US$1.7trn ESG bonds are now on issue) and is expected to experience another sharp surge in demand as the green transition gets underway in 2022.
The lesser known ESG-linked or sustainability finance market (which includes bonds and loans) is forecast to go mainstream soon, as banks enter the market in force in the second half of 2021.
Some forecast that within a decade, sustainability finance will become part of the corporate and business licence to operate – in other words, nearly all financing will become sustainability financing.
So it seems an opportune time to address the ESG finance market.
This is the first in a series of four articles.
The first sets the stage – a 101 if you will, examining the history, economic rationale, challenges and future for the ESG finance market, as well as a beginner’s guide.
The second and third articles examine the ESG or green, social and sustainability (GSS) bond market, including the sovereign bond market. (ESG bonds refer to the entire universe of bonds that are structured as use-of-proceeds bonds that tie ESG goals to financial value.)
The fourth article examines the ESG-linked bond; sustainability-linked loan market and the impact bond market. (These debt instruments are typically pay-for-success structures, which also tie ESG goals to financial value.)
EU leads the charge
Leading the ESG finance charge is the European Union (EU).
The EU has been the major issuer of green bonds for the past decade; meaning global GSS issuance is dominated by the euro.
This fact has prompted The Economist to suggest that dominance of the green issuance market might improve the euro’s capacity to remount a challenge to the greenback.
The EU’s previous push to build global acceptance of the euro was scuppered by the global financial crisis, and the union now spies an opportunity to rebuild the euro’s credentials.
So the geopolitical significance of the ESG finance market and global currency markets should not be underestimated.
The EU formally adopted the European Taxonomy (the first serious attempt to develop market standards) on June 4, providing the market with clear criteria to qualify for Europe’s post-pandemic E1trn Green Deal – a sustainability-led recovery package.
It is expected that the taxonomy will provide a blueprint for other nations as they develop their own taxonomies; and also for the likely development of global standards.
The EU’s post-pandemic NextGenerationEU and green bonds aim to support the bloc’s economic recovery and build a greener, more digital and resilient future, as expressed in the bloc’s ‘Build Back Better’ slogan.
The emphasis here is on digital. The EU is prioritising digital initiatives with its NextGenerationEU bonds, suggesting issuance that is both sustainable and digital/innovative will find favour.
For brevity, we have coined the term "the ESG trinity" to describe the green, digital, and resilience/sustainability nexus, which recognises the important but oft-overlooked role that the fourth industrial revolution will play in ESG investing.
The blended finance concept
But first let’s take a step back.
Big capital is pushing investment funds, individual investors and companies to incorporate ESG into their investment portfolios or operations.
All ESG investing harks back to the relatively novel concept of blended finance – investing for both social (which includes environment) and financial gain.
The notion of blended value hit the investment scene in the 1990s and includes both equities and fixed-income investments.
By 2020, roughly 25% of money under professional management was invested in ESG funds seeking a financial return.
The blended finance concept differs from previous investment philosophies such as sector investing, which put financial gain front and centre but ignored pent-up demand for social and environmental innovation for reasons of expense, risk and convenience.
This occurred in an artificial bubble (separate from the society in which companies operate), and in the charitable absence of a user-pays environment for waste, water and carbon pollution; and alongside the gradual exhaustion of the productivity benefits to be yielded from the oil cycle.
One side effect was to stifle innovation and progress (which adds risk to operations), another, was environmental impact; and a third, as the oil cycle waned, was a narrowing of the growth window, thanks to the former issues.
So the argument now is that the fourth industrial revolution must be built on sustainable energy sources to fire growth and manage the environmental challenges posed by big capital’s commitment to continuous economic growth.
Blended finance aims to harness private capital towards unlocking this pent-up demand by shifting the risk profile to one that more accurately accounts for inputs and social and environmental impact.
Failing to unlock that pent-up social and environmental demand now carries significant risk, given it will be critical to propel the world through the fourth industrial revolution and into new energy sources.
It also requires greater standards of governance.
Blended finance also has an ideological basis in that it supports corporate provision of social and environmental services over government provision of social services, where possible.
This is an extension of the free market ideologies of the late 1900s (as championed by Milton Friedman and the Chicago School of Economics early in the century).
As Blackrock CEO Larry Fink wrote in 2018:
“To prosper over time, every company must not only deliver financial performance but also show how it makes a positive contribution to society. Companies must benefit all of their stakeholders, including shareholders, employees, customers, and the communities in which they operate.”
All of this has led some investors to complain that it will be investors that fund the transition.
But challengers say that if productivity gains, yielded in part by technological innovation and deployment, are high enough, then the transition has the potential to yield great profits.
They also point to the fact that governments will also be funding the push.
The rationale behind sustainability finance
ESG scepticism abounds and many investors have been dragged reluctantly to the table.
But assuming the architects of the transition to the fourth industrial revolution and the green transition are true of intent, it is in the best interest of corporations to get the jump on their competitors in the ESG arena.
By ensuring that corporate activities and financing are aligned with and support the EU taxonomy goals and conditions (outlined below), companies should be more competitive and sustainable in the long term.
Such companies are less likely to suffer regulatory and tax imposts on water and energy useage, resulting in more sustainable and durable sources of revenue and growth.
Such companies are more likely to yield the coveted sustainability premium, thereby attracting more capital, creating a virtuous investment cycle.
By linking all debt to sustainability criteria, which will happen progressively, a debt-fuelled world should be operating on a single, efficient economic model, although at this stage it is difficult to know if the best analogy is one of turning a ship, or jumping tracks.
Beginners guide to ESG finance
ICMA International Capital Market Association uses the term ESG bonds to describe the entire universe of bonds that aim to match ESG outcomes with financial return.
In essence, ESG bonds are sustainability bonds in that ESG is all about sustainability – environmental sustainability, social stability and financial/governance stability.
They are debt instruments that encourage investments based on the issuer addressing certain ESG criteria. In doing so, companies are encouraged to incorporate ESG into their operations.
I also use the term ESG bonds to avoid confusion given there are so many finance types which fall under the sustainability banner, many of which include the term sustainability.
Another catch-all phrase is the GSS market (green, social and sustainability) market.
Application of funds range from: reducing carbon intensity; waste management; water management, agriculture; recycling; improving gender diversity; education; and health – practically anything that aligns with the UN Sustainable Development Goals.
Following is an explanatory 101 section and assumes no prior knowledge on behalf of the reader, so skip through to the more serious sections if you think you have it covered.
Use-of-proceeds bonds vs sustainability-linked finance
There are two main types of bond structures: use of proceeds instruments (typically bonds); and pay-for-success finance (which generally come in the shape of loans and impact bonds).
Use-of-proceeds bonds are linked to the issuer typically achieving specific sustainability projects and can qualify as either senior debt or subordinated debt, depending on the issuance.
In 2020, Spanish bank BBVA became the first bank in the world to issue a green convertible contingent bond.
Use-of-proceeds bonds include green bonds; social bonds; blue bonds (which are sometimes lumped under green bonds); sustainability bonds; covid-19 bonds; and sometimes transition and impact bonds, although the latter two tend to be grouped under ESG-linked bonds.
We go into greater detail on bond types in our next stories.
Governments and supranational issuers tend to be first to market, followed by private financial and industrial issuers, then sovereign and treasury issuers.
Financial institutions make up the single largest private-sector source of supply in the social bond market at 16.2% globally, according to the Asian Development Bank (ADB).
Non-financial corporate issuers make up only a fraction of the market.
In the use-of-proceeds bond markets, particularly liquid green bonds, primary market pricing is on par with traditional non-green bonds, according to Nordea.
This will likely change as ESG bonds become the norm rather than the exception, and become more liquid and fungible.
Green bonds achieve slightly better pricing in the secondary market but they only make up a fraction of global fixed-income issuance.
Green bonds demonstrated through covid that they perform better during crises, increasing their safe-haven potential.
The weighted average credit rating of the global social bond market is AA, compared with a weighted average of A+ in the global green bond market and AA- in the global sustainability bond market, according to the Asian Development Bank.
Social impact bonds may have a guarantee of principal but ESG bonds usually have no guarantees, according to the ADB.
ESG-linked bonds and sustainability loans directly link agreed company sustainability performance targets (SPTs) and key performance indicators (KPIs) to interest-rate discounts and penalties, depending on whether a company either achieves or fails to meet its targets.
ESG-linked finance typically includes sustainability-linked bonds, sustainability-linked loans, and social-impact bonds and loans, and development impact loans. Again, we will examine these loan types in separate stories.
One significant difference between use-of-proceeds bonds and ESG-linked structures is that generally while the former tends to relate directly to achieving projects, ESG-linked debt ties the whole company to achieving sustainability targets, even if it only has one sustainable debt instrument.
The Wall Street Journal says the penalties and benefits attached can be as small as 0.025 percentage points for the annual interest for each target, compared with typical savings of 0.25 percentage points for reducing debt-to-earnings multiples by the equivalent of one-quarter of annual earnings.
At the moment, the reputational risk of failing to meet targets is more significant than penalties or rewards as it affects a company’s ability to attract more capital – particularly as the reporting and disclosure nets tighten.
This applies to use-of-proceeds bonds as well as ESG-linked finance but penalties across both classes are likely to rise over time.
The European Banking Agency recently opined that it did not believe ESG-linked bonds could be used as a capital buffer, as opposed to some use-of-proceeds bonds.
At the moment, no company actually defaults on a loan if they miss use-of-proceeds or ESG-linked sustainability targets or KPIs, regulators fearing that this could hamper market growth. This too is likely to change over time.
Both use-of-proceeds bonds and ESG-linked bonds can also be linked to achieving social targets such as board diversity.
Investors straddling the ESG see-saw
For investors, the proposition is a little more tricky than for corporations.
To some extent, an inverse relationship exists between the ESG finance market and the ESG equity market, particularly in the pay for success market – let’s call it the ESG financing see-saw.
Pay-for-success structures typically involve step-up interest payments (and sometimes penalties) in the event an issuer fails to meet the sustainability pledges outlined in the contract.
Some say pay-for success instruments favour bond investors and lenders in that these investors make more money if a company fails to meet targets. On the flipside, equity investors in the stumbling company are penalised.
This is not so cut and dried, and depends on the investor, and as we noted above, the current penalties are mild.
An ESG fund manager, for example, may have to dissolve the fund if the investments do not meet fund criteria; or be subject to capital shifting away from their management.
A bank in contrast would enjoy increased margins and fees should the company fail to meet targets (a bit like failing on the monthly credit card payments).
Portfolio hedging can help to overcome some of the margin variation risks.
The ideal position for a long-term hedged investor is to lend money to a company that is inclined to meet its targets (hence reputation is critical), while investing in the sustainably competent company, in order to gain the sustainability premium – this is the ESG sweet spot.
Short-to-medium term investors might have a different take on this.
Use of proceeds bonds, in contrast, have no step-up payments or penalties, which, in the event of missed targets, means investors may have accepted a discount on their loan for no result, and no ESG brownie points.
Again, in the case of ESG fund managers, missed targets could result in capital deprivation or even dissolution of the fund.
Banks are the piggy in the middle
The sustainability market has major implications for the banking and finance industry, which will be the major drivers of the shift to sustainability.
At a Bloomberg banking panel on sustainable finance, ANZ Bank’s director sustainable finance, Tessa Dann, forecast sustainability-linked funding would take off in the second half of 2021.
All panelists sited the lack of qualified staff as a key challenge, adding to the other complexities banks will have to navigate.
Back to bonds, in the event of a crisis, regulators could force banks that issue green bonds to absorb those bond losses and write-downs on all assets, pointing to a clash between sustainability objectives and prudential regulation, and these rulings will develop as the market matures.
On the flipside, as the market develops for sustainability-linked finance – particularly on the penalties front – loan impairments may come to the fore, or windfalls.
As Westpac group head of sustainability said at a recent Bloomberg panel on sustainable finance, the most important thing for the banks is “to get it right”.
The EU taxonomy
The EU taxonomy will likely form the blueprint for all national taxonomy and eventual international standards.
The EU Parliament now has four months to hear objections, and, if the proposal survives, the taxonomy will apply to the global euro market from January 1, 2022.
The EU requires mandatory disclosure of sustainability metrics to qualify for funding access.
Taxonomy nuts and bolts
The EU taxonomy identifies six goals:
– climate change mitigation;
– climate change adaptation;
– sustainable use and protection of water and marine resources;
– transition to a circular economy;
– pollution prevention and control; and
– protection and restoration of biodiversity and ecosystems
The taxonomy will develop over time but the first Delegated Act focuses on the first two climate objectives.
The Platform on Sustainable Finance still needs to publish recommendations on the technical screening criteria for the other four environmental objectives in the taxonomy.
The Commission is required to assess by the end of 2021 whether and how regulation can be extended to non-climate objectives, including social objectives.
In the meantime, it is up to the canny investor to pre-empt the taxonomy by looking for investments that meet as many criteria as possible, and for the canny corporation to prepare for disclosure on as many criteria as possible.
The EU also sets four conditions that an economic activity has to meet to be recognised as taxonomy aligned:
– making a substantial contribution to at least one environmental objective;
– doing no significant harm to any other environmental objective;
– complying with minimum social safeguards; and
– complying with the technical screening.
For those seeking more information about the taxonomy, this link provides information.
Covid provides social bond impetus
BloombergNEF, notes annual ESG issuance hit US$732bn in 2020 across both bond and loan formats, up 29% on 2019 levels, thanks largely to government and supranational issues raising additional funds for covid-19 relief.
This is reflected in the breakdown: green bond issuance rose just 13% to US$305bn in 2020, while social bonds jumped sevenfold to US$147.7bn. Sustainability bond issuance rose 81% to US$68.7bn.
Sustainability-linked loans and green loans fell 15%, to US$119.5bn and US$80.3bn respectively.
The average size of green bond instruments was US$171m; sustainability bonds US$630m; and social bonds US$273m, according to the Climate Bonds Initiative.
International Investment expects 2021 will be another record year for GSS, forecasting at least US$600bn of issuance in 2021, thanks largely to the EU and other government issuers.
ESG trading instruments and standards
At the moment, the sustainability market is loosely defined. There is no sense of relative quality or fungibility in the sense that even in the relatively liquid green bond market, each issuance is generally earmarked for individual projects.
So nearly all sustainable investment is based on the UN SDGs.
As noted, the EU taxonomy represents the gold standard for ESG investment criteria but global standards are on the way.
The first green bond indices were launched in 2014 but there are no social indices to date.
This reflects the fact that green bonds can be tied to agreed projects and climate goals while there is still a lack of consensus and standardisation around social bonds.
Verification of adherence to commitments remains a key challenge for the market, requiring second-party assessment, and what has come to be known as third-party opinions to ensure independence.
There are various existing bond frameworks and principles, which we discuss in later articles.
Detailed analysis of bond frameworks, sustainability target and systematic monitoring is also required – separate from standard portfolio management and benchmarking – which makes an investor’s task laborious.
Most investors are likely to access the ESG bond market through fixed-income funds and exchange-traded funds.
These funds are mostly green funds, and offer very little by way of social exposures, although there appears to be demand given the IIX Women’s Livelihood Bond Series (linked to creating sustainable livelihoods for more than two million women in Asia and rather green in that is linked to climate change) was three times oversubscribed.
A plethora of different instruments are likely to hit the market in the next decade and investors are likely to be spoilt for choice once the market matures.
Of course, with choice comes risk. Bon appetit!
FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/
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