The Growing Opportunity in ESG-Linked Bonds
One of the most important developments in global credit markets has been the exponential growth of ESG-linked instruments that have been issued across many sectors and from companies at different stages of their ESG development. We have seen sustainable finance grow from a nascent market to a fully-fledged part of many issuers’ capital structures, and the trend is expected to continue.
The reasoning is clear – through these instruments, corporations can:
- fund projects that align with the interests of their stakeholders (shareholders and debt holders);
- often gain a funding advantage as many ESG-linked bonds carry a lower cost versus the conventional bonds of the same issuer;
- take advantage of the growth in demand from investors as ESG-linked strategies proliferate
Defining ESG-Linked Instruments
- Green Bonds – Use of proceeds are dedicated to financing new and existing projects with environmental benefits. Examples include the financing of renewable energy projects (wind & solar) or the construction of energy-efficient buildings.
- Social Bonds - Use of proceeds are dedicated to financing new and existing projects with positive social outcomes. Examples include the financing of affordable housing or lending for minority-owned businesses.
- Sustainable Bonds – Use of proceeds is a combination of both Green and Social projects as defined above.
- Sustainability Linked Bonds – Use of proceeds from these bonds can be used for any corporate purpose. However, the interest cost of these bonds is tied to environmental, social, and/or governance targets that must be achieved or the issuer will face an increase in their funding cost.
Exponential Growth in ESG-Linked Borrowing Driven by Demand from Investors
% of Total AUM Linked to ESG Consideration
The Fine Line Between ESG-Linked Bonds and Greenwashing
In theory, these bonds should create clear alignments between the ESG outcomes we target for our investors and the issuer’s operations. However, as part of our ongoing ESG analysis, we try to ensure that the companies we may invest in are not engaging in increased “greenwashing” through these ESG-linked instruments. We define greenwashing as a generalized term for companies that claim to be furthering green and social causes but are simply trying to achieve lower borrowing costs or appear environmentally or socially conscious. Importantly, we believe that the pricing of the new securities should only be advantageous to the issuer if the use of proceeds reflects the genuine desire and ability to effect change from an ESG perspective or improve its contribution in the future.
We are committed to finding a reliable way to avoid investments in “greenwashing” and aim to ensure that our analysis includes an in-depth understanding of the level of ambition driving a management team’s motivation to issue these instruments.
We define ambition as the level to which the ESG-bond is financing incremental or future environmental, social, or governance impact. In other words, does the company intend to effect change through this new financing, or are the proceeds from the bond issuance being used for “business as usual” or previously financed activities?
Of course, we would prefer to see a company use this issuance to effect change or set more ambitious targets for improving its ESG profile. However, we are also looking to identify companies that are simply seeking a lower cost of debt without meaningfully impacting change in operations. If the latter is indeed the case, then we believe that the company’s borrowing rate should be “business as usual” as well. Simply labeling a bond as Green, Social, or Sustainable by meeting minimum requirements on activities already undertaken by the company is not enough to ensure a funding advantage for the issuer in our view. We would advocate for additional targets for new activity when the issuer subsequently accesses the bond market.
We have also raised concerns to companies about their Green, Social, and Sustainable bond reporting. These issuers meet the minimum (current) guidelines which only require them to report on the use of proceeds one year after issuance if the proceeds are fully allocated. This means that low-ambition issuers who allocate all proceeds to refinance existing projects will only be required to disclose the actual ESG impact in a single reporting period. As a result, there are no disclosures in any subsequent periods, even if the bond is a longer-duration instrument. This structure is concerning and does not align with market convention in more established asset classes of the credit market. For example, in the asset-backed security market, issuers must report on the allocation of proceeds on a regular and reoccurring basis. We believe that it is incumbent on the management of each company to go beyond meeting minimum guidelines and consider what would be the best practice and in the best interest of stakeholders over the short and long term.
Finding Ambition at the Heart of SLBs
We often find SLBs provide the best exposure to more ambitious ESG factors. We recognize that the use of the proceeds is not limited to eligible Green or Social projects, introducing a level of ambiguity that some ESG-focused investors may not be comfortable with. However, the structure of SLBs, which tie funding costs to hitting specific improvements in Environmental, Social, or Governance factors, gets to the core of our definition of ambition. SLBS can incentivize issuers to enact incremental change in their operations. The growth in the SLB market reflects our views, with an increase from $5bn USD of issuance in 2017 to nearly $250bn USD of issuance year to date in 2021 and representing 44% of all ESG-linked issuance. This focus on changes also makes the ESG-linked bond space more inclusive as issuers can access capital that recognizes their commitment to positive future impact rather than continuing with business as usual.
As with other ESG-linked bonds, we remain vigilant for the materiality of an SLB’s key performance indicators and attempts by management to put in place easy-to-reach targets. To this end, we have actively engaged with Canadian issuers to help bring their first SLBs to market, utilizing our experience in US and European issuance and promoting the highest feasible levels of ambition and materiality for these issues. By participating, we try to ensure that our pricing suggestions reflected the relative level of ambition we believe the issuers were setting.
As the ESG-linked bond space grows, our investment team stays updated and attentive so that we are not making investment decisions based on market labels. Instead, we continue to focus on ambition as the key pillar for defining “true” ESG-linked instruments and will aim to ensure that the pricing of these securities is assessed accordingly.