Green bonds are a critical part of an evolving and expanding range of sustainable fixed-income investments. Frameworks and labels are valuable, but represent just one stage in investors’ due diligence.
In early September, ESG Investor brought together an experienced panel with diverse perspectives to discuss how green bonds can contribute to the efforts of asset owners to transition toward net zero fixed income portfolios.
The panel met a day after the Climate Bonds Initiative published its summary of green and sustainable bond market activity for 2021 and its predictions for the future. Based on strong H1 2021 growth across the sustainable bonds spectrum, it sees the market reaching volumes outstanding reaching US$1 trillion by 2023.
Strong levels of demand and supply, however, do not necessarily mean that investors and issuers are embracing green bonds wholeheartedly. It doesn’t mean that industry frameworks or bond structures are perfect and it doesn’t mean that the impact of green bonds necessarily aligns with the priorities of every asset owner.
In a discussion moderated by ESG Investor’s Founding Editor, Chris Hall, the panel addressed many of the factors affecting the dynamics at play in ESG finance. The participants looked at the market from the perspective of investors and issuers, and in terms of establishing the right frameworks to encourage, rather than hinder, the race to net-zero and a sustainable future.
The discussion began with an overview of institutional investors’ perspectives in incorporating ESG factors into their investment decisions.
“Asset owners globally have a range of motivations when it comes to sustainability,” said Kate Hollis, Senior Investment Consultant at Willis Towers Watson. “From those that believe sustainability is fundamental to reducing climate exposure in their portfolios, to those following their peers and regulators, to those that just don’t care.”
Constraints and considerations
It is not just the sustainability ambitions of a chief investment officer or trustee that count, Hollis noted. Whatever an asset owner may feel about climate change and the associated risk to portfolios, many have their choices constrained by regulation, by liability matching, the need for diversification, a view on governance and an assessment of a portfolio’s long-term resilience to multiple risks.
In addition, any measurement of climate exposure is problematic given the paucity of reliable data, particularly when it comes to measuring the Scope 3 GHG emissions of issuers. Target time frame is also important since asset owners target emission reductions in both the short- and long term. Green bonds, for instance, may not be the best instrument to use to realise long-term reduction targets.
While green bonds undoubtedly can contribute to future emission reductions, that can also be claimed for non-green bonds launched by issuers working towards science-based reduction targets.
“We support green bonds in principle, but they don’t necessarily reduce carbon emissions of the portfolio immediately,” said Hollis.
Money raised by a green bond to invest in a new green project, for instance, may not all be spent at once and any initial spending might increase Scope 3 emissions in the short term. The problem is compounded when it comes to green bonds issued by banks, where proceeds are on-lent to finance customers’ green projects. They do nothing for bank’s Scope 1 and 2 targets, and the impact on Scope 3 emissions is likely to be positive, but this is difficult to assess at the moment.
“Banks are poor at disclosing Scope 3 emissions of their loan books,” said Hollis. “We suspect they could be very large, given the global context in which they operate.”
There are many ways to skin a cat, or decarbonise a portfolio, and green bonds are just one of them. “We recommend clients use green, and social and other use-of-proceeds bonds alongside non-green bonds in their mandates but leave the choice of which bonds, when and how to use them to asset managers,” she added.
Some of the panel shy away from recommending ‘pure play’ use-of-proceeds funds due to the market’s lack of diversity; green and social bond markets may be growing quickly but they have tended to be the domain of well-rated issuers from developed countries, thus not yet fully reflecting the rich diversity of the fixed income universe.
Bond holdings should also be gauged against other asset classes, such as direct investment or equity, where an investor may get quicker and cleaner results for a portfolio.
Others were more sanguine.
“Diversification is increasing,” said François Millet, Head of ETF Strategy, ESG and Innovation at Lyxor ETF. “Now we have a real sovereign sector, as well as corporate and supranational segments. There is no excuse for a fixed-income manager not to hold a green bond element in a portfolio. There is enough diversity that you can still stick to a fund’s original design.”
This puts the onus on the asset manager. There are two approaches: passive and active.
Lyxor ETF, which launched the world’s first green bond ETF in 2017, falls into the first camp.
“We don’t advise clients on the composition of their portfolios,” said Millet. “But we provide the toolkit.”
And green bonds are a subset of that toolkit, forming part of an ecosystem of products needed to reduce carbon intensity and provide access to clean technologies or new energy.
Investors are changing their behaviour and their choices.
“In the race to net-zero, investors are judging the marginal contribution of each investment instrument to their emission reduction goals,” said Millet.
To help in their decision making, investors are increasingly using climate indices in equities and corporate bonds.
“Through these indices, investors are, in effect, selecting companies tied to emission reduction targets,” said Millet. “So, you know the path you are buying into.”
Deeper engagement, greater scrutiny
In addition to direction and the choice of instrument, asset owners trying to decarbonise portfolios are demanding better levels of reporting from asset managers to help them make choices.
“We’re seeing clients asking for reporting on the output of their portfolio and the impact they’re having on the environment rather than worrying about how many green, social, or sustainability-linked bonds (SLBs) we’re putting into the portfolio,” said Liam Moore, Fixed Income Investment Specialist, JP Morgan Asset Management. “Better reporting enables clients to better assess the profile of their portfolio.”
Active managers have additional obligations to their clients, with the responsibilities of stewardship increasingly felt by bondholders as much as shareholders.
“Clients want us to engage with issuers,” said Moore. “Many of our clients are happy to buy the bonds of some of the heavier polluters, as long as we can show we are engaging with them and that they are charting a path to a greener, sustainable environment.”
Green bonds represent a sub-set of the overall ESG toolkit, but asset managers still need to look closely at every bond that comes with a green bond label, asking themselves both: how sustainable is this issue; and are we getting value for money?
In terms of assessing sustainability, the question must be asked whether the bond’s use of proceeds aligns with the client’s intended outcome for the portfolio.
And then there’s the question of additionality.
“We ask ourselves, would this project be happening anyway? And is the client asking us for a lower cost of credit by putting a label on it?” said Moore. “Are they effectively getting a free ride?”
For SLBs – instruments structured so that issuers potentially pay a penalty for missing pre-agreed carbon reduction targets – a broader view of the corporate issuer is required as well as the targets and penalties.
Are issuers really being held to account?
“Sometimes we feel companies are setting themselves targets which they’re already close to achieving,” said Moore. “A step-up coupon might be great, but does it offer real value, and is it commensurate with the cost of pollution if targets are missed?”
The panel reiterated the importance of transparency and standards to ESG bond markets, recognising the importance of industry bodies in raising standards and providing a framework to help satisfy both investor and issuer objectives.
Opportunity for impact
Establishing the right voluntary frameworks has helped fuel the rise in green and social bonds and is now supporting the development of SLBs, which is opening the market to a whole new class of issuer.
“The SLB market has grown really quickly,” said Ozgur Altun, Sustainable Finance Associate at ICMA, which last year added guidance on SLBs to its existing Green Bond Principles and Social Bond Principles. “SLBs create an opportunity to invest in a new impact product that is structurally different to green bonds, one that is mostly focused on climate transition and one that is flexible for issuers.”
With SLBs, companies don’t have to track the use of funds, they don’t have to identify projects before issuance, and they have freedom to use funds as they see fit – as long as they hit key performance indicators (KPIs) and sustainable performance targets (SPTs).
“The instrument may be more appealing for issuers that have not been able to join the green bond market before,” explained Altun. “It opens the doors of sustainable finance to new market participants and gives an opportunity to investors to diversify their sustainable finance investments.”
The product is in its infancy, however, and there are issues that need monitoring.
“There are three core requirements in the SLB principles,” said Altun. “The materiality of KPIs, the ambitiousness of SPTs, and the adequacy of the incentive mechanism. Investors need to look at what the issuer is committing to against its peers, past performance, and science-based targets.”
This flexibility is seen as an advantage in a nascent market as it is important to find the balance between security for investors and ease of compliance for issuers.
“If need be, we can issue additional guidance,” said Altun. “It’s a new market, it’s developing, and it’s bringing in a lot of new geographies and issuers to sustainable finance. And it has additionality in the fact that it focuses on entity-wide decarbonisation.”
More issuers are looking at the debt markets and there is more product for them to use. This is potentially good news for investors looking for diversification, but it needs a big commitment for a borrower to go green and doing so comes with risks.
“The biggest fear for an issuer deciding to issue green or social bonds, or SLBs, is reputation,” said Benedetta Pacifico, Senior Associate, Capital Markets, Sidley Austin. “In a rapidly evolving market, any sort of framework or label gives a level of assurance to the issuer because it gives them parameters within which they can move.”
The problem, again, is finding a framework that aligns itself to both investor and issuer requirements. And even then, there will still a requirement to delve deeper into sustainable credentials, not least due to the specific requirements of individual investors.
A label is good for an investor, and the more prescriptive the greater the certainty that certain protocols have been followed. The disadvantage for an investor, is that the label doesn’t necessarily guarantee that the borrower has a good ESG strategy. It simply means that the specific single instrument meets certain criteria.
And voluntary frameworks have no teeth.
“There is no event of default from non-compliance. There is no call, there is no put,” said Pacifico.
The investor still needs to do a lot of work irrespective of labels.
“A label is good,” said Pacifico. “But it’s what’s behind the label that needs to be worked on. You can be a very brown company with an awful sustainability strategy, and – purely from the point of view of these frameworks – still issue a green bond. That would be greenwashing. Issuers shouldn’t just issue a green bond in isolation from a company’s strategy.”
Investors may find security from more prescriptive frameworks, but the problem for issuers is that overburdening them with regulation and reporting obligations risks excluding them from the market.
“It’s very difficult for regulators, and industry bodies such as ICMA, to find a balance between having a label sufficiently prescriptive to give certainty to investors but not overly burdensome to issuers, because the risk of over-burdening issuers is that they’ll just stop using the instruments,” said Pacifico.
Frameworks have been evolving in the right direction but going too fast risks losing participants and shutting down the market. Perhaps it’s outside of the framework where issuers find the biggest incentive to live up to ESG promises.
“Greenwashing will badly affect your reputation and make it very difficult to return to the markets,” said Pacifico. “Issuers are very aware of that.”
Education and acceleration
There are many complex issues around the financial markets funding the transition to net-zero and sustainability – financial returns from investments, the merits of labelling, and definitions of sustainability. But these discussions must be placed in a real-world context.
“The biggest issue we’ve got is education,” said Paul Camp, Co-founder and Head of Transaction Management, Climate Solutions. “A lot of companies understand ‘business as usual’, but many have no idea of business as it could be.”
Both lenders and investors have a role in this process, providing advice and incentives to the firms they fund, helping them to appreciate the urgency of the need for transition to low-carbon business models and to grasp the opportunities. This has some particularly critical implications for banks, said Camp, given their exposure to certain hard-to-abate and heavy-emitting sectors of the global economy.
“The next banking crisis will begin within the oil and gas sector. At some point, a top oil and gas analyst is going to work out that these companies are sitting on assets in the ground that have a net present value close to zero,” said Camp. “Oil and gas companies are a systemic risk to the banking system, and the financial system as a whole.”
Banks need to look at their loan books in detail just as investors in green bonds need to judge them in terms of an issuer’s overall strategy and in terms of the global imperative. They should not be considered in isolation.
“There’s not enough linkage,” said Camp. “And we’re running out of time. Things must accelerate. We need additionality, abatement, recuperation and repair for the planet. We are at existential risk as a species.”
Ozgur Altun, Sustainable Finance Associate at the International Capital Markets Association, works on all aspects of the association’s sustainable finance policies and frameworks. He is a lawyer with an international background and previously worked at the Council of Europe Development Bank, law firms in Istanbul and Brussels gaining experience in capital markets and financial regulation as well as EU law, and the European Investment Bank.
Paul Camp, Co-founder and Head of Transaction Management, Climate Solutions, created the world’s first green bond under the global Climate Bonds Initiative (CBI) in 2014. Paul has extensive clean energy transaction and strategic advisory experience, including at global solar, battery developer and EPC Belectric (now RWE Innogy), and as an advisor to the UK Cabinet Office on energy and to CBI on green securitisations.
Kate Hollis, Senior Investment Consultant at Willis Towers Watson, has global knowledge of all asset classes, particularly fixed-income and liquid alternatives. Kate has deep experience in sales, trading and research and a track record in identifying, classifying and researching new types of funds to enable investors to make better-informed decisions. She was previously Global Head of Fixed Income/Alternatives Fund Management Research at S&P Capital IQ and has worked at several hedge funds and financial institutions.
François Millet, Head of ETF Strategy, ESG and Innovation at Lyxor ETF, oversees business strategy and development in ETFs, passive solutions and ESG on a global basis. He joined Lyxor in 2009 as Head of Index and Quantitative Fund Development and was previously Director of Index Funds & ETFs at Societe Generale Asset Management AI, where he developed the index management business including passive funds, ETFs, index-enhanced and alternative beta products.
Liam Moore, Fixed Income Investment Specialist, JP Morgan Asset Management, covers unconstrained fixed income for both prospective and existing clients, with responsibilities across client relationships, product development and research. Liam is closely involved with the active management of a key sustainable fixed income strategy, as well as the development of sustainable investing solutions across the fixed income platform.
Benedetta Pacifico, Senior Associate, Capital Markets, Sidley Austin, has extensive experience of acting for issuers and arrangers on transactions including regulatory and hybrid capital instruments, debt restructurings, exchange offers, other liability management transactions and the establishment and update of EMTN and GMTN programmes. With a strong interest and focus on ESG, Benedetta has experience of listings on regulated and non-regulated markets including in London, Luxembourg and Ireland.