What is driving growth in ESG-labelled bond issuance?
Growth in ESG-labelled bond issuance and a growing awareness of the importance of fixed income in responsible investing are creating both new market opportunity and challenges, writes Newton portfolio manager Scott Freedman.
Over the last two years we have seen a giant leap forward in environmental, social and governance (ESG) milestones, driven in part by the health and economic crisis induced by the global pandemic.
The role fixed-income markets have in funding the journey towards a better environmental and social future is crucial, as the majority required is expected to come from debt issuance. This is very much a ‘journey’, as a large range of stakeholders will take time not only to agree on the roadmap and how best to achieve it in our lifetime, but also on how to put their plans into action.
Regulators have continued to work hard on developing sustainable rules and taxonomies, and, in our view, are the single biggest driver of shaping the sustainability journey. As policy evolves, there is a need for the development of local regulations to keep pace by implementing minimum standards and encouraging the expansion of ESG products to finance the transition.
There is work underway globally on a number of taxonomies, with Europe continuing to lead the way. However, certain sectors of sustainable fixed income have yet to be covered in the European Union (EU) classification.
This year we may see the formal adoption of the EU’s Complementary Delegated Act, which means the EU taxonomy will include specific nuclear and gas-energy operations within the list of economic activities covered. We may also see the adoption of the EU Green Bond Standard. This comprises rules on how issuers can use green bonds to finance ambitious investments, while simultaneously meeting tough sustainability requirements and minimum standards to protect investors and reduce the risk of greenwashing.
In the US, it appears the current focus is on improving disclosures rather than introducing new ESG legislation. Still, even that has the potential to drive a significant shift in mindset and activity towards more sustainable objectives, certainly by the private sector.
The COP26 announcement of the creation of the International Sustainability Standards Board (ISSB) was particularly noteworthy. The standards will provide the foundation for consistent global ESG reporting standards (IFRS Sustainability Disclosure Standards) that will enable companies to report on ESG factors affecting their business. The expectation is that the ISSB will carry out a thorough public consultation in 2022, to give all stakeholders across the world an opportunity to provide feedback. This includes the consideration of work involving both thematic and industry-based requirements.
Further details on the EU’s social taxonomy should be expected later this year, but this may take some time to agree, given the varying social constructs of different regions and countries, which means authorities may have diverse priorities.
We expect to see a continued growth in ESG-labelled bond issuance after 2021 set new records, albeit the US$1.6 trillion (per ICE Green, Social & Sustainable Bond Index) is still a small amount in the context of the overall size of the global bond market today. Labelled bonds are also often an area of the market that creates much debate and receives much commentary.
In 2021, US investment grade bonds saw significant issuance of US$97bn versus European investment-grade issuance of €136bn. In high-yield bonds, the US and Europe saw US$16bn and US$28bn of issuance respectively, from close to zero in the previous year. However, what is notable is that in the high-yield area this represented 15% and 9% respectively of total bond supply.
As central banks start to tighten monetary policy, and in some cases talk of reversing quantitative easing (QE), the reduced amount of fiscal stimulus means that some of the emergency-induced bond supply is unlikely to reoccur. This issuance has acted as an extra catalyst for growth in labelled bonds, often driven by governments and agencies. That said, we still expect governments to be the largest issuers of labelled bonds globally.
We would also expect to see a continued broadening out of sectors as issuance is still quite concentrated in the finance, utility and real-estate sectors.
There is a risk that fragmentation and tiering begin to appear in some labelled bonds, such as new-format green bonds for example, with environmental targets within some sustainability-linked bonds starting to reference science-based targets.
Our view is that the market needs a clear framework with consistent standards across regions of the world, which would help investors to compare and contrast issuers and bonds and better hold them to account. New labels may also be developed, but we believe that this could run the danger of creating ‘label fatigue’ and increasing the risk of so-called greenwashing or making exaggerated claims about the responsible investment credentials of products.
The investment community recognises the importance of focusing on social challenges, especially in the aftermath of the global pandemic. We don’t believe environmental and social factors should always be separated. It is important to remember there are social consequences to funding the climate transition, such as the change in profile of workforce skills required and the robustness of ethics within new supply chains, i.e., ensuring an environmental focus does not cause any significant harm to any social factors.
This concept lends itself to sustainability-linked bonds which incorporate a broader range of key performance indicators (KPIs) – and include social targets for which the issuer should be held accountable.
Sustainability-linked bonds contain covenants, which create penalties for the issuer if they do not meet set targets within a determined timeframe. The severity of the penalties continues to be debated, and some issuers have tried to establish loopholes at the outset.
It is clear the market would benefit from greater consistency around bond documentation and robust incentives for management teams to deliver on credible and stretching targets, both because they recognise the importance of being responsible citizens, and because the penalties are material enough to encourage a behavioural change.
Whereas some green and social-bond issuers are to be commended for having a genuine focus on improving environmental and social outcomes, there exists a standout flaw. There is no penalty for not delivering on intentions set out within green and social-bond issues.
It is not unreasonable to suggest that if these bond structures contained some of the same covenant tests as the newer sustainability-linked bonds, the risk of greenwashing would be lower.
There is the risk that a slight premium that can exist for green bonds today could potentially limit the growth of the market, but the demand for green products continues to grow. Over the next few years, there should be less need for bond issuance to be in labelled-bond form. The increasing accountability of all stakeholders, including governments, companies, investors and asset owners, should mean less need for labels but more emphasis on differences in the cost of capital between issuers.
While investors cannot rely on the sheer size of climate spending required being absorbed by the labelled bond market but, with greater accountability from many stakeholders, it doesn’t need to be.
Although a lack of questioning of management teams around ESG topics persists, there is a growing sense that issuers are becoming more cognisant of the higher expectations placed on them and the need to demonstrate the efficacy of their ESG strategy.
From an environmental perspective, issuers will likely come under more pressure to have an emission-reduction strategy.
From a broader responsible investment perspective, issuers will increasingly need to demonstrate their ESG strategy, as well as considering assets at risk and mitigation strategies. We believe investors will also follow up with increasingly informed testing of management teams and governments on sustainability issues.
While progress from an industry-wide perspective in terms of credit and equity investors working together on ESG issues still appears somewhat limited, the level of accountability faced by issuers does look set to rise. We believe this could result in a more resilient and effective business model and governance structure, and, ultimately, improved societal and environmental outcomes.