Switch of focus from equity to debt will yield greater real-world impact on climate change mitigations, according to ISS ESG.
‘Debt-denying’ will increasingly drive up cost of capital for climate laggards and accelerate companies’ transition away carbon-intensive business models, predicts a new ISS ESG report.
To date, finance sector efforts to tackle climate change have largely focused on shareholders exerting influence on firms to reduce greenhouse gas emissions, but equity investors can only achieve impact in the real economy through engagement and voting, the report asserts, rather than divestment.
By declining to provide capital to firms with carbon-intensive processes and practices, switching funding instead to climate-positive business models, debt investors and financiers can play a major role in financing the net zero transition.
“The scope of climate action in finance is widening at breathtaking speed, from equity to debt,” the report says, adding, “The transition to a climate-friendlier world needs capital. Public equity investors don’t provide such capital to the real economy.”
ISS ESG describes green bonds and more recently developed instruments such as sustainability-linked bonds as “a small, but exploding part of the debt world”, which have evolved beyond the refinancing of green activities to supporting a wider range of social and sustainability goals.
“We are seeing new and creative approaches to leverage the dynamics of debt with a purpose,” said ISS ESG, the responsible investment services arm of Institutional Shareholder Services (ISS).
According to the Climate Bonds Initiative, cumulative green bond issuance topped US$1 trillion in December 2020, with the overall sustainable debt market totalling US$1.7 trillion by the end of last year. US$700 billion of green, social and sustainable debt instruments were issued in 2020, almost double 2019’s US$358 billion.
But the report suggests that the smaller green lending market could also become a significant driver of action on climate change. Only US$200 billion was raised in green syndicated loans last year across both ring-fenced used of proceeds transactions and KPI-linked structures.
Although ISS ESG identifies increasing innovation in product development, the report said central banks’ climate-related stress tests would be a bigger factor in the growth of green lending, by monitoring and reducing bank impacts on the climate system.
“With Net Zero pledges proliferating globally, there is a chance that corporate access to capital will require climate transparency in the future,” the report said. “This will not only accelerate the business of Green Bonds &Co. – it will also revolutionise banks’ lending practices.”
Misunderstanding market mechanics
ISS ESG’s commentary on green debt finance came in a new report drawing on the firm’s decade of experience helping investors to tackle climate risks.
Titled ‘A little Less Conversation, A Little More Action’, the report highlights ten lessons across three main themes, providing a critique of the progress of regulators, investors and their use of data and other resources to drive meaningful action on climate change.
Although ISS ESG insists that mandatory climate disclosures are required to provide the transparency required by investors, it warns that the significant changes imposed on the finance sector by regulators in Europe and elsewhere may have limited impact on climate change due to a “poor understanding of financial market mechanics”.
The report argues that divestment of stakes in carbon-emitting firms will not necessarily lead to real-world reductions in CO2 and that greater transparency, though important, will not necessarily channel money away from climate-harming activities, due partly to the fact that equities are largely traded in the secondary market.
This undermines the equity-focused approach of regulators, including the European Commission, says ISS ESG, which calls for a “more nuanced, asset class-specific approach” based on a clearer understanding of how a particular action or instrument impacts portfolio and real-world emissions.
The investor’s toolbox
However, by not participating in the issuance of bonds or not lending to companies due to their ESG performance, financial institutions can impact economic activity and provide cheaper capital to companies that achieve ESG targets, the report said.
“Only by making use of the entire investor’s toolbox, and by systematically and clearly evaluating the effects of each approach, can investors and regulators alike execute on their respective theories of risk or change.”
ISS ESG was formed in 2017 following the acquisition by ISS of the investment climate data division of South Pole Group, formed in Zurich in 2010 by Max Horster, who remains head of the business.