The Climate of Business #52: The ESG bond market - low-risk, high-return?

Climate Change Reality

Damage assessments begin in flooded remote Alaska villages (AP News)

Hurricane Fiona grows into Category 4 storm (Yale Climate Connections)

World’s first public database on fossil fuels launched (Al Jazeera)

Massive methane leak found in Gulf of Mexico (Houston Chronicles)

Vulnerable countries demand global tax to pay for climate-led loss and damage (The Guardian)

Climate change alters battle against infectious diseases (Axios)

160 NGOs urge Egypt to serve plant-rich food at COP27 (Vegconomist)

Business Climate Reality

Denmark pledges €13M for climate damage funding (Politico Pro)

ESG’s beginning is messy, but it’s here to stay (Barrons)

German industry says decarbonisation targets remain unchanged despite crisis (Clean Energy Wire)

EU plans to upgrade its Paris Agreement climate target (Reuters)

ESG activists see executive pay as tool for raising standards (Financial Times)

‘World-first’ hydrogen project raises questions about its role in fuelling future homes (The Guardian)

The booming ESG bond that’s facing growing scepticism (Bloomberg)

Biodiversity quickly rises up the ESG investing agenda (Financial Times)

Fuel firms should pay for climate harm, UN leaders told (AP News)

Big fashion’s sustainability push has a huge hole (Bloomberg)

How the climate law may change energy storage (E&E News)

Promise and peril at the bottom of the sea (The New York Times)

The future is being rewritten by historic green investment and growing climate devastation (Time)

Carbon credits face scrutiny as a corporate path to ‘net zero’ (Financial Times)

Reality Check

The field of ESG bonds exploded in the last few years with growth of the sustainable bond market to over $1 trillion in outstanding issuance. Such trend is understandable. As a traditional financial mechanism, bonds have followed the overall ESG trend.

The global bond market is roughly?$100 trillion?globally–roughly three times the size of the EU and United States GDP combined –and it's been growing by a factor of ten since the early 1990s.?

But what is actually an ESG bond?

ESG bond is a type of debt security.?A debt security means that the issuer owes the holder a debt and is obligated to pay the principal and interest at a set maturity date.?Bonds are a type of fixed-income security, as the?bond interest is paid at set intervals.?The interest, payment intervals, and repayment terms are established at bond issuance. Bonds are generally considered a lower-risk investment.

ESG bonds share the same financial characteristics (structure, risk and returns) as traditional bonds, but are issued by companies or with projects that demonstrate alignment with high environmental, social and governance standards.

ESG bonds are used to raise capital to fund projects related to ESG objectives.?In the best case scenario these bonds both present investors with stable returns, as well as allow for evidence-based reporting about the use of the funds for ESG purposes.

Types of bonds related to ESG

Three types of bonds can be considered a sub-type of ESG bonds: green, social and sustainability bonds. Most are “use-of-proceeds” bonds and it’s here that their main difference lies, the allocation of proceeds.

Green Bonds

• Specifically focus on issues related to the climate and environment.
• Common themes include renewable energy, clean transportation, green buildings, wastewater management and climate change adaptation.
• Devoted to financing projects and activities, both new or existing with positive environmental impacts.
• Frameworks available for issuing: Green Bond Principles (GBP) from the International Capital Market Association (ICMA)
• Example in 2008 the World Bank issued almost 18 billion dollars in Green Bonds through over 200 bonds in 25 currencies.

Social Bonds

• The allocation of proceeds is exclusively applied to projects that deliver socially positive outcomes.
• Examples can include access to essential services (e.g. health, food, education and financial services), affordable housing, community development and micro-finance.
• They have a more direct target population such as people living below the poverty line, refugees or marginalised communities.
• They aren’t required to have a positive impact on the environment, it can be neutral.
• Frameworks available for issuing: Social Bond Principles (SBP) from the International Capital Market Association (ICMA)
• Less popular than green bonds, which can be explained by either their size of capital requirement.
• As they are projects focused on individuals or services, they don’t tend to require for a a lot of capital: ￡30m could represent a substantial amount for a social programme, while ￡300m is more the norm for a large renewable energy project. Plus lack of aggregators to bundle social bonds due to their thematic diversity
• Or also by the fact that the majority of organisations generating social benefit, usually have a charitable status, do not have the balance sheet to support borrowing at scale;
• Social bonds indicators are also more bespoke and more complex to analyse then green bonds.

Sustainability Bonds

• Can be seen as a combination of green and social bonds, as they are expected to provide both environmental and social benefits to a target population.
• Frameworks available for issuing: Sustainability Bond Principles (GBP) from the International Capital Market Association (ICMA)
• Examples can include: Education and Sustainability research, modernisation of education and public health facilities.
• They are linked to the performance to certain KPIs for a predefined set of SPTs, they are a forward-looking performance-based instrument.
• Are meant to complement green bonds, as traditionally the issuers of green bonds have heavy capital expenditure requirements in heavy industries such as renewable energy, utilities, green buildings and rail.
• A sub-type of sustainable bonds is the type called Sustainability-Linked Bond (SLBs) which requires issuers to make specific commitments on ESG objectives.
• If a stated ESG target is not achieved a penalty must be paid by the issuers.

Challenges related to ESG bond market

Reporting standards, metrics and transparency. Although the principles and methodology behind the standard for a bond type can be clear, transparent allocation of funds according to the standard can be a grey area.?Sometimes governmental frameworks leave it to the discretion of the issuer, its advisers, and the second opinion reviewer.?In some cases the issuer of the bond might also have their own criteria or definitions of what an eligible project would be.?Such ambiguity can challenge an investor to be certain the bond matches their own ESG, sustainability or social investment guidelines.

Benefits of ESG bonds

ESG bonds have several advantages over other types of corporate debt securities: more favourable tax treatment, intended greater transparency on financial information and performance aligned to environmental, social and governance criteria, higher credit ratings from rating agencies which can lead to lower interest rates for investors.

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