ESG Focus | Jul 09 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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ESG Focus: The Name’s Bond – GSS Bond
The green, social and sustainable use-of-proceeds bonds market is staging an invasion of the traditional bond market and, while it’s early days, the bridgehead has been claimed.
–State of the GSS bond market
-The name’s bond – green bond
-Pricing, risk and the waning greenium
By Sarah Mills
The green, social and sustainability (GSS) use-of-proceeds bond markets have paved the way for the broader sustainability-linked finance market, which is expected to extend its tentacles across every business in the world over the next two decades.
Combined, the pair should transform the world’s finance markets into one that is permanently and inextricably linked with ESG priorities.
ESG finance is tipped to become the new normal; making the very terms “ESG”, or “green”, or “sustainable”, or “social”, redundant; the term being subsumed under the general finance banner to become business as usual – part of the licence to operate.
The world’s biggest capital holders are driving the change; and governments are largely aligned.
ESG finance is designed to underpin the fourth industrial revolution and the green transition, creating a new world that will be scarcely recognisable by 2050.
Great disruption breeds social upheaval, so social goals have been paired with environmental goals in a bid to smooth the path.
Even pre-pandemic, the UN estimated that meeting the 17 UN Sustainability Development Goals would require global investments of US$5trn to US$7trn a year through to 2030 – a huge funding gap requiring both public and private sectors.
Asia Pacific countries alone will have to invest 5% of GDP to achieve the UN SDGs, and another US$1trn a year to address climate change, according to the Asian Development Bank.
All this compares with official development assistance to the area of US$150bn a year, and workers remittances of US$450bn a year.
Post-covid, the cumulative loss in output from the pre-pandemic path is projected to grow from US$11trn over 2020-21 to more US$28trn over 2020-2025, according to the International Monetary Fund.
As a result, covid has advanced the “social” use-of-proceeds bond on to the scene with a bang, giving the market a massive leg up; and while cumulative volume and value is still only a fraction of the green bond market, it is expected to grow sharply over the next four years.
This article on use-of-proceeds bonds (which is one of a series of four on ESG finance) is divided into three parts.
The first concentrates on broad trends in GSS markets, then takes a dive into the green bond market.
The second examines transition and sovereign bonds; the third covers social and sustainability bonds.
Given all GSS bonds are likely to share certain characteristics, these are covered in this story given the green bond market is the most mature.
It will be accompanied by smaller stories on related subjects.
State of the green, social and sustainability (GSS) market
According to the Climate Bonds Initiative’s (CBI) Sustainable Debt – Global State of the Market 2020 report, cumulative green, social and sustainability (GSS) use-of-proceeds bonds issuance has hit US$1.7trn in labeled markets with almost 10,000 instruments issued under GSS labels since 2006.
GSS issuance is currently dominated by the euro, a factor The Economist suggests might improve the euro’s capacity to remount a challenge to the greenback – its previous push being scarpered by the global financial crisis.
Cumulative green issuance (the major market) has passed US$1trn. The CBI forecasts that 2021 is poised for another record high as money flows from Europe and the US into ESG projects.
Sustainability bonds hit US$316.8bn followed closely by social bonds at US$315.6bn. Social and sustainability themes achieved higher volumes in 2020 than all the previous years combined, a harbinger of the flood to come, courtesy of covid.
Sovereign GSS bond issuance hit US$97.7bn from 22 sources – again green themes dominated but sovereign social bonds were issued for the first time in 2020 by Chile, Ecuador, Guatemala and Luxembourg. Mexico and Thailand also introduced sustainability bonds.
Much of this investment has focused on middle and high-income emerging markets, further ostracising lower-income economies, but this is expected to change.
Outcomes are important for GSS bonds. They are typically use-of-proceeds bonds, in which the proceeds are earmarked for specific sustainability projects.
Covenants ideally include disclosure of corporate or government activities and use of proceeds. This is particularly important in developing markets in which transparency is poor.
A little background and recent developments
Big capital determined decades ago that one way to achieve the UN SDGs was to commit US dollars to public-private partnerships for infrastructure.
While this remains the goal, the US has been a bit slow on the uptake, creating a window of opportunity for Europe but the reluctance of US investors is to a large part understandable.
According to Responsible Investor, the UN SDG’s fail to include anything about return, let alone risk sharing, leaving everyone passing the buck.
It claims this lack of balance between risk and return is holding back private investment.
This is true to some extent and suggests there will be growing lobbying from some quarters to force governments to shoulder more risk.
But the funding-gap calculations suggest that it’s all hands on deck to get the transition and fourth industrial revolution safely to shore; that the lobbyists’ chances of success may be less than they might have been ten years ago; and that most will be swept up in the vast tide of capital regardless.
And, in the spirit of the “Who Cares Wins” mantra of the transition architects, it is likely to be the early boats that catch this tide.
“Ecocide” – casting the criminal nets across boards and governments
Meanwhile, legal nets are being crafted and cast to aid the transition.
A definition of ecocide was drafted in June, which is to be considered by the International Criminal Court:
“Ecocide means unlawful or wanton acts committed with knowledge that there is a substantial likelihood of severe and either widespread or long-term damage to the environment being caused by those acts.”
This will have major ramifications for boards, corporationsa nd governments, and depending how far the law extends: individual directors and politicians (although this appears unlikely at this stage).
Where sovereign states fail, the international court is expected to prove the final arbiter, once ecocide gains the status of an international crime.
According to Comar Molle in Lexology, “serious allegations of ecocide could prove incredibly costly for any enterprise”.
Molle advises that corporate boards should work with ESG counsel to audit current business practices, review risk disclosures, and prepare a long-term, multi-jurisdictional ESG strategy.
Elsewhere, on June 28, the EU Council adopted the European climate law for the purpose of achieving a climate-neutral EU by 2050.
Environmental risks are rising for investors in the world’s capital markets and, at the very least, is likely to result in ratings imposts on corporations and other issuers.
Moody’s Investors Service recently estimated that ESG risks are a material credit consideration in 85% of its ratings decisions for private sector issuers in 2020, up from 32% in 2019.
Of the more than 8,700 rating actions analysed, 71% mentioned social risk factors, 53% referred to governance issues, and 13% cited environmental factors, with many containing references to more than one ESG consideration, reflecting the growth in social risks post pandemic.
Meanwhile, Responsible Investor notes the EU is likely to launch a consultation on the functioning of the ESG ratings market, alongside plans for the general financial sector.
In July, the Australian Federal Court gave final orders that entrenched into Australian Law a government minister's "duty of care" to avoid causing personal injury or death to Australian children when approving new coal projects.
Green bonds claim the bridgehead
Spearing the GSS bond market has been the green bond, establishing a bridgehead into traditional bond markets.
Green issuance funds projects that decarbonise industry and the environment and help mitigate climate change.
The market is set for profound transformation as investors begin to align strategies to net zero emissions ambitions across asset classes, says Morgan Stanley.
The Net Zero Asset Managers Initiative, launched six months ago in December 2020, has 128 signatories representing US$43trn in assets under management – nearly half the world's funds. Asset managers are signing up daily, more than US$1trn lobbing in in the first week of July alone.
Green bonds have dominated global GSS issuance for the past decade save for the covid-inspired leap in social issuance in 2020 and 2021; and are likely to regain ground once the global economy recovers and the green transition gets underway.
A record total of US$290bn green bonds were issued in 2020, up 9% on 2019, according to the CBI. The average size of instrument rose 19% to US$171m says CBI.
Yet this represents just 3% of global debt issuance, suggesting an avalanche of issuance to come.
According to Environmental Finance, green bonds are mostly used for refinancing. They are less flexible in terms of payment schedules and timing than bilateral loans, revolving credit facilities and other facilities.
The majority of green bonds are held in non-green bond funds and exchange-traded funds.
Meanwhile, the EU announced its sustainable finance strategy in July, setting out detailed milestones and measures for the financial sector, companies and households to reach the bloc's climate goal.
It hinted that mortgages may become the first asset class in the world to receive preferential capital requirements based on their green quotient – but that's for another story.
It also suggested it would crack down on greenwashing and loose ratings systems.
The fundamental things apply
The market has a mature and dedicated investor base and most green bond labels adhere to the Green Bond Principles (GBP).
Issuers must establish a Green Bond Framework (GBF) that states how the bond proceeds will be use, and which should be aligned with the principles.
The GBPs advise that the proceeds must:
– be used for environmentally sustainable activities;
– have a process for determining product eligibility;
– manage the proceeds in a transparent fashion that can be tracked and verified; and
– report annually on the use of proceeds – although some issuers report twice a year.
As noted in the previous article, Europe is leading the standards charge and the EU Taxonomy is likely to guide future national taxonomies.
The EU Green Bond Standard (GBS) is aligned with both the EU Taxonomy and the CBI’s framework.
The components of the EU Green Bond Standard are:
– Alignment of “use of proceeds” with the taxonomy;
– Publication by issuers of a Green Bond Framework;
– Mandatory reporting on “use-of-proceeds” (allocation reporting) and environmental impact (impact reporting);
– Independent verification of compliance by issuers with Green Bond Frameworks.
The EU taxonomy also sets our criteria for certain water infrastructure.
The growing demand for certification
Green bond certification, such as that provided by the CBI, is becoming increasingly common
While voluntary, certification is expected to soon become a de-facto requirement for issuers.
It may also one day be used to transform the vanilla bond market (as we discuss below).
Certification requires greater specificity within the above GBP parameters, including accounting methodology and qualifying investments.
The CBI notes certification is growing with US$51.5bn in issuance certified in 2020, taking cumulate certified issuance to US$154.7bn by the end of that year.
According to the CBI Green Bond Summary H1202, certification grew 6% to roughly 25% of green bond issuance.
There is pre-issue certification and post-issue certification.
The CBI has certification criteria for standard green energy generation; energy efficient transport; and low-carbon building investment.
Certification for other industries are in the pipeline; including hydropower, bioenergy, wave and tidal energy, recycling, disposal of waste; and pollution control; nature based assets such as lands, forestry and coastal infrastructure; and green and hybrid water infrastructure.
The EU goes one step further on the certification front with its EU green bond standard which links eligibility to criteria listed in its EU taxonomy, and demands third-party opinions.
Meanwhile, in a potentially transformative experiment, the Danish government is linking green certification to traditional vanilla bonds, which if adopted could have flow-on affects. We discuss this in a separate article.
Decarbonising is a systemic challenge
When it comes to decarbonising, there are three types of emissions that companies need to consider:
– Scope 1 emissions are emissions from owned or controlled resources of a firm;
– Scope 2 emissions refer to indirect emissions from the generation of purchased energy such as gas or electricity; and
– Scope 3 emissions include all other indirect emissions that occur in a firm’s value chain from upstream inputs such as resources, present stream such as employee travel, and downstream emissions through its distribution chain.
At present, most issuance revolves around Scope 1 emissions, in one particular area of a firm.
But increasingly, green bond issuance is likely to be tied to reductions in company-wide emissions, and an entity’s entire carbon footprint.
Pricing, risk and the green premium
According to CBI Green Bond Pricing the Primary Market, H2 2020 report, there was evidence of a growing “greenium” in both public and private issuance but the picture is shifting rapidly.
“On average both Euro and USD green bonds gained high book cover and greater spread compression than vanilla equivalents, and green investors were allocated a greater percentage of deals (56%) than ever on average, demonstrating that treasurers attach value to the diverse investor base that green bonds are known to attractive.” says the report.
But this reflected partly on the rush to green assets as a safe-haven during the covid crash, and greeniums are on the wane.
Nordea Bank finds that green bond outperform in risk-off periods when they offer greater resilience than vanilla bonds, but warns of nuances.
The bank says this reflects that issuers have been large, stable and forward-looking entities with established governance structure; that green bonds are rarely issued by oil companies which took the worst hit; and that buyers are largely long-term investors such as pension funds and insurance companies that hold to maturity.
So while dedicated green bonds should provide a cushion for sell-offs, the Association for Financial markets in Europe points out greeniums are on the decline, thanks to record issuance.
The greenium fell from roughly 9 basis points in 2020 to virtually nil in April of 2021.
“The number and diversity of green bonds have reached levels that make the behaviour of green and non-green bonds similar,” says Nordea. “Green bond indices can now be compared to non-green bond indices.”
Baker McKenzie notes green bonds may attract a small premium in the secondary market.
According to the Asian Development Bank:
“ESG bonds tend to trade closely with conventional bond counterparts as mainstream investors are generally unwilling to pay for an ESG label on pari passu assets.
“In fact, an ESG premium on such issuance, while no doubt attractive to bond issuers and possibly capable of incentivising new supply, would likely be offset by the corresponding reduction of investment attractiveness for bond buyers.
“Rather, several countries, including Japan have established subsidy programs to offset the additional costs to issuers of preparing green or social bond frameworks such as consulting and ratings expenses.”
Goldman Sachs notes that in the less liquid US-dollar market, green issuers are commanding a greenium of about 10 basis points.
But the bank says that both in Europe and the US, the scarcity premium is shifting to social and sustainability bonds, which are offering at 20 basis point average premium in euros, and about 36 basis points in US dollars.
Still, it’s not all about the money for green issuers. There’s reputation, credentialing and positioning to consider, and this is forecast to be sufficient to continue to drive strong demand.
All eyes peeled to carbon intensity
This article has been divided into two for ease of reading. The next half delves into global developments around the bid to create a liquid, fungible green bond market
Carbon intensity is likely to emerge as the global-benchmark hero, while experimentation with green certification in vanilla bond market could transform capital markets.
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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