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The ESG Interview: Gradually Greening the Bond Market

Hortense Bioy, Global Director of Sustainability Research at Morningstar, says the bond market increasingly offers impact, but data challenges still bedevil sovereigns.

It’s fast becoming a cliché to say ESG investing is more an equity than a fixed income activity. Shareholders typically have a closer relationship with investee companies than bondholders, potentially offering greater scope for engagement. But both investor types struggle to obtain decision-useful information about the ESG credentials of issuers (none more so than sovereigns, admittedly), and are forced to rely on a combination of skill, intuition and third-party data to evaluate their options.

Increasingly, help is at hand for the fixed-income investor, in the form of emerging disclosure standards, verification services, analysis frameworks and investment solutions. As investor appetite begins to prioritise outcomes, green and other sustainable bonds can offer greater certainty and transparency on impact, as shareholders wait for harmonised reporting and accounting rules to be developed.

Equities may still be an easier market in which to manage ESG risks, but fixed income is rapidly adding value for sustainability-focused asset owners. “Institutional investors can make an impact in the bond market, because they know what the proceeds will be used for and they can monitor how the issuer is doing,” says Hortense Bioy, Global Director of Sustainability Research at Morningstar.

Green bonds as an impact play

In a recent report, Morningstar noted investors’ increasing attraction to green bond investments as an impact play. Despite almost US$300 billion of green bonds being issued in 2020, the market is less than 15 years old. Although the market was started by multilateral development banks, today green bonds are more often issued by companies that do not have the highest ESG and / or credit ratings, but which are looking to invest in projects to help them transition to more sustainable business models.

At barely 1% of the size of the global bond market, green bonds do not have the scale or profile to substitute conventional bond portfolios. Swap your existing holdings for the green bonds of the same or similar issuers and you would end up with a less defensive, less US$-centric portfolio, with longer duration and higher credit risk.

Their appeal from an impact perspective comes from the level of detail on the projects the proceeds finance, and the incentives to meet targets over their lifetime. Green bonds can be certified by a third party such as the Climate Bonds Initiative, or verified via a second party opinion from an ESG analytics and ratings house, with reference to specific standards or principles, and / or accepted market practice.

Low-cost self-certified green bonds also exist, meaning investors must rely on their own or their asset managers’ expertise to compare and evaluate KPIs and outcomes. ESG bond funds can include fixed income instruments meeting differing criteria and standards, as well as bonds for which the ESG profile of the issuer is the defining factor.

“There are standards, but not all green bonds have a stamp of approval,” acknowledges Bioy.

Shades of green

Because the standards are voluntary and the market is immature and innovative, the differences and exceptions to the labelling of green and other sustainable bonds are many.

While the Climate Bonds Initiative certifies bonds using a taxonomy-based standard to ensure financed projects are consistent with the goals of the Paris Agreement, the green, social and sustainability bond principles administered by the International Capital Markets Association are focused on ensuring the transparency, accuracy and integrity of issuer disclosures. But there are different frameworks across market sub-sectors and geographies, including China where domestic green bonds are not expected to achieve international disclosure standards.

Existing frameworks will soon by joined by a voluntary new European green bond standard (EUGBS), details of which were released this week. Aimed at providing a “gold standard” for green bonds, EUGBS-certified instruments must allocate funds to EU Taxonomy-aligned projects, meet detailed reporting requirements, submit to external review, and be subject to supervision by the European Securities and Markets Authority.

Even so, like ratings, disclosure frameworks can only provide investors with a guide to the way the proceeds will be spent, the outcomes they will achieve and future sustainability and profitability of the issuer.

“It may be frustrating, but it’s the reality of the market that there are shades of green and there are sectors that are more sustainable than others. It reflects the different preferences out there in terms of sustainability,” says Bioy.

As fragmentation gives way to harmonisation, she expects the green bond market to offer greater transparency and standardisation to investors. This will be further boosted as countries develop taxonomies covering a widening range of economic activities. The process is most advanced in Europe, where the European Commission’s newly updated ‘Strategy for Financing the Transition to a Sustainable Economy’, outlines plans for an extension of the EU Taxonomy to ‘intermediate-level’ activities and also commits to publishing a social taxonomy before the end of the year.

“We’re waiting for the EU taxonomy in Europe to give more guidance to investors. But today it’s really up to the investors and asset managers to define what is and is not acceptable, in terms of level of risk and greenness,” says Bioy.

Learning to fly

Asset owners looking for impact, but not yet ready to fly solo into the green bond universe, have a widening range of options in the ESG bond fund market. These can help investors diversify their exposure across a range of projects, companies and sectors, within specific sustainability-related objectives and criteria.

Some funds will only invest in bonds certified as meeting particular standards; others will rely on the manager’s expertise to make a judgement. “When reading fund prospectuses or talking to managers, investors need to understand the strategy and the type of bond that will make it into the portfolio,” says Bioy.

Still lagging sustainability-focused equity funds, the ESG bond fund market has nevertheless trebled to US$350 billion AUM over the three years to March 2021, according to another recent Morningstar report. There were 167 entrants to the ESG bond fund market last year – more than a quarter rebadged from existing conventional offerings – making for a 900+ fund universe.

Although Europe’s Sustainable Finance Disclosure Regulation is setting rules about the sustainability claims of investment solutions, there is no standard practice or process for greening an existing fund.

“It varies a lot,” says Bioy. In some cases, rebadging might mean adding a series of exclusions to a fund, for example avoiding issuers in violation of UN Global Compact principles, leaving the investment process otherwise untouched. Elsewhere, she says, portfolios have undergone more of a structural shift, with holdings divested and reweighted, augmented also with issues from firms with better ESG rankings. Beyond this, funds might experience “a total revamp”, reborn as a climate-focused thematic fund.

While such moves are intended to win new investors, Bioy says existing fund holders cannot be taken for granted, noting that some funds have faced difficulties introducing exclusions to long-established portfolios. “The bigger the fund, the more difficult it is to repurpose,” she says.

The rule of three

Most ESG bond funds are actively managed, with impact funds a small but growing sub-sector, reflecting desired outcomes beyond managing ESG risks or achieving sustainability-related alpha. Broadly, Morningstar splits the market into three sub-sectors: negative screening, positive screening and impact. Similar to the non-ESG market, investment grade corporate and diversified bonds account for three quarters of assets in ESG bond funds, with high-yield, emerging market and sovereign debt under-represented. Sole reliance on exclusions-based negative screening is less common, and is particularly problematic in the sovereign market, but new launches continue to attract assets.

Positive screening, or best-in-class, covers a spectrum, from tilts toward issuers with strong ESG scores or profiles, to thematic or momentum-based approaches, which focus on improvers rather than those with the highest ESG scores. “There is an argument that these potentially are the investments that will yield the best results financially, so it can be more about looking at the trajectory,” says Bioy.

Impact bond funds are likely to include a higher proportion of certified bonds financing sustainability-focused projects or outcomes, often aligned with UN Sustainable Development Goals (SDGs), but may also include conventional bond holdings augmented by an engagement strategy. Growing from a low base, impact bond fund offerings are already fairly diverse in terms of instruments and themes targeted.

Although Morningstar describes the passive ESG bond fund market as “embryonic”, it already has attracted US$49 billion AUM. But the challenges of accurately assessing the ESG profile of issuers, primarily around the lack of consistent and quality data, causes problems in certain subsectors, notably at the passive end. “While the lack of ESG data in some underlying sectors like sovereigns, securitized assets, and emerging markets did not prevent active managers from offering multisector and global sustainable offerings, it has delayed developing index and passive diversified bond offerings,” the report says.

Countering the wealth bias

Problems evaluating governments are a big contributor to the relative under-development of this sub-sector, with ESG-focused developed-government bond funds attracting just US$15 billion in assets by end-March.

Bioy points to the complexities of calculating the ESG profile of an entire country. Especially, but not exclusively, for emerging markets sovereign issuers, there can be tensions between investors’ social and environmental priorities. “Are you prepared to ignore a big chunk of the market and is that an acceptable choice?” she posits.

Asset owners are stepping up efforts to better understand the ESG profile of sovereign issuers’ ‘mainstream’ debt issuance. For example, an investor-led coalition recently announced plans to develop a new framework to better measure, monitor and compare sovereign issuers’ current and future climate change governance and performance.

Impact Cubed, an investment analytics and solutions provider, recently partnered with investment teams from ten asset managers to build a sovereign bond impact model aimed at countering a “wealth bias” toward mature sovereign bond issuers in many ESG country rankings.

Using 20 years of data, the model compares the rate of progress achieved by sovereign issuers against expected levels for 29 factors across the 17 SDGs, identifying strong improvements, even from low levels. Lithuania was shown to be a leader (above average on level and faster progress pathway) in the highest number of factors, while many mature economies stalled or lagged in a wide range of factors, notably the US.

The report concluded that the wealth bias of ESG risk scores makes current data “unactionable, as ESG scores are more correlated to income level than to impactful progress”, noting that evaluating SDG performance more strongly in ESG scores can also help investors to combine high yield with high impact.

Funding low-carbon transitions

This issue is likely to assume greater importance as governments ramp up their ability to tap the debt markets in coming years. Many intend to issue certified green and social bonds, but even use of these frameworks still entails significant due diligence for investors while fragmentation on standards persists.

Last week, for example, the UK government published new details about its first sovereign green bond, first announced last November. The programme will start with two green gilt issues this year, with £15 billion expected to be raised in the 2021-22 financial year. The UK is committed to reporting on the social co-benefits of the expenditure financed by its green gilts every two years.

According to a Green Financing Framework, six areas of expenditure have been earmarked: clean transport, renewable energy, energy efficiency, pollution prevention and control, natural resources and climate adaption. The framework is accompanied by a second party opinion from Vigeo Elris (VE), part of Moody’s ESG Solutions, and a pre-issuance impact report from the Carbon Trust, which comments on the alignment of the UK government’s green financing programme with its wider environmental policies and objectives.

Driven in no small part by the need to fund whole-economy low-carbon transitions over the next 30 years, European sovereigns have been highly active this year, with France issuing a 23-year green bond, Germany a 30-year bond, and Italy debuting with a 24-year issue in Q1 alone. As well as the UK’s impending green gilt programme, Germany and Spain will also issue before the end of the year. In parallel, the pandemic has resulted in a surge in social bond issuance, both from government and non-government issuers, to support recovery from the unequal economic impacts.

According to law firm Linklaters, 16 sovereigns have raised almost £100 billion globally through green bond issuance to date. Europe has been the epicentre, but issuers include Hong Kong, Indonesia, Chile, Nigeria and Fiji. Across all issuer types, more than 680 green and 130 social bonds were issued in 2020, raising around US$390 billion with the EU becoming the world’s largest social bond issuer, due to its €17 billion Covid-19 recovery bond in October.

Raised expectations

A growing response to the challenge of weighing up sovereign or corporate issuers’ mixed ESG records, says Bioy, is for sustainability-focused investors to favour funds with a greater weighting toward explicitly green bonds.

“We are seeing ESG funds allocating a sleeve – perhaps 20-25% to green or social or sustainability bonds – because their managers know the kind of activity they will finance, regardless of the rating of the issuing entity, government or a company,” she observes.

This reflects the growing appetite of asset owners to go beyond doing no harm. “Managing ESG risk is becoming a basic expectation like all other types of risk. We just need more disclosure from companies on where they think their ESG risks are, bearing in mind that this is always dynamic. More investors want an impact sleeve. Green bonds can serve that purpose if they are very targeted,” says Bioy.

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