Not all ESG bonds are created equal - here's why

“Going mainstream”, “reaching a tipping point”, these are some of the standard phrases heard in relation to green and sustainable investing today. And with justification. Adding weight to this is the growth of green, social and sustainable bonds.

In the last two years, the rate of issuance of these bonds has picked up speed, growing by about 50% in both 2019 and 2020, according to Moody’s. This has spread beyond the “traditional” Green Bond Frameworks.

Social bond issuance increased several times over in 2020, exceeding $100 billion and reflecting the response to the pandemic.

Sovereigns have taken advantage. Government green bond issuance doubled to over $40 billion, with proceeds going toward post-pandemic recovery plans and building back green. Germany, Italy and Sweden issued inaugural green bonds, while France and The Netherlands added to their existing range and the UK plans to debut in the market over the coming months. 

Green and social bond issuance is growing quickly in emerging markets too. Early adopters like Chile have increased the stock of outstanding green bonds to over $6 billion and launched its first social bond, as did Mexico.

The corporate sector saw a healthy flow of debut issues and from an increasingly wide range of industries, across developed and developing countries. We saw the first sustainable bonds from fashion retailers and food and beverage companies, a welcome development considering some of the controversies affecting these sectors in the past. 

It seems there has been a sharpening of focus, amid the catalyst of a global pandemic which has exacerbated existing social problems. The pressure to address the climate crisis is growing inexorably. COP26 takes place later this year, and countries and companies are aligning with the Paris Agreement commitments around carbon emissions reduction.

The evolution of ESG bonds  

Green bonds, the largest component of the environmental, social and governance (ESG) bond landscape, go back to 2007, and have been followed by various other types of ESG bonds.

While the specification and scope differ slightly for each, a common thread is the “use of proceeds” for financing social or green projects or initiatives. The issuer then reports on the management of proceeds to show they are being used properly.

Each category has principles, formulated by the International Capital Markets Association, which provide frameworks and form the basis for certification. The following are all use of proceeds bonds, where the fund raised are designated for specific purposes related to ESG.

  • Green bonds: proceeds used for environmental initiatives, renewable energy, improving energy efficiency, pollution prevention, sustainable raw materials.
  • Social bonds: providing financing for projects that will benefit sections of a population, such as basic infrastructure, affordable water or sanitation, expanding healthcare capacity.
  • Sustainability bonds: a mix of green and social objectives.

Another category, with a slight twist, is sustainability-linked bonds (SLBs). These bonds are linked to sustainability targets and carry a “step-up” clause. This means if the targets are not met by a certain date, the bond interest increases by a pre-set amount.

Living up to the hype?

Green bonds have sometimes been dismissed as a “greenwashing” tool, where the issuing company or government claims to have strong green, social or sustainability commitments, which it does not live up to. Most of the green issuance has come from sovereigns so far, which are not subject to the same standards or scrutiny from investors as those issued by companies.

In the case of SLBS, it has been argued it would be better for investors if a company missed its objective as it would result in a higher return. Another question is whether the targets linked to the SLBs are ambitious enough.

So the recent growth spurt in ESG bonds has attracted both enthusiasm and some scepticism.

On a longer-term view, there can certainly be advantages for companies to commit to positive environmental and social outcomes, and setting clear targets.

Companies which have integrated good ESG practices are less likely to be impacted by environmental taxes or increased regulation for instance. Albeit this does not eliminate risk or preclude the possibility of bad management in other areas. Business practices and operations which contribute to more coherent and robust societies, should result in more sustainable and durable sources of revenue and growth.

Beyond the label: active impact assessment is key

The growth in ESG bonds ultimately shows a willingness to address challenges and risks, which is welcome. As the market continues to grow, so should the knowledge and the robustness of frameworks improve, especially as we move toward standardisation. The EU, for example, is developing a green taxonomy and aims to establish a green bond standard in the future. The requirement for an independent second party opinion is an important source of credibility.

All that said, ESG bonds are not created equal. One might expect that a company issuing a green bond would be concerned with reducing carbon intensity (carbon emissions to revenue), but current green bond principles do not necessarily require this. We have seen issues from some sectors, like airports and agriculture, with laudable objectives, such as reducing waste, but we could not get past concerns over carbon intensity in aviation and monoculture crop production.

Being labelled green or social is no doubt a good start, but there is one vital measure for assessing an ESG bond: the strength of the positive impact the use of bond proceeds will make. This means close active impact analysis of the bond framework and the social or sustainability goals, and systematic monitoring. This, in conjunction with analysis of valuation and credit risk, is ultimately the best way to assess ESG bonds.

We think this is most effective if done independent of a benchmark and separate from portfolio management decisions. This separation of impact assessments reduces the possibility of the portfolio manager “marking their own homework" on impact. Having no benchmark means the universe is created bottom-up and based on sustainability or climate impact criteria and the credibility of the issuer, without considerations of benchmark weightings or relative quality.

Impact is especially relevant in emerging markets where climate change vulnerabilities and risks are most acute and widespread. Additionally, the fact that emerging economies are at an earlier stage of development means that the impact of each “green dollar” invested can be greater. Current themes key for us are flood protection, clean transport, bonds with water consumption and biodiversity targets, and renewable energy projects.

In our view, constructing a strong and resilient portfolio with diversification benefits is the best way to fully realise the advantages and potential of ESG bonds.

The views and opinions contained herein are those of Schroders’ investment teams and/or Economics Group, and do not necessarily represent Schroder Investment Management North America Inc.’s house views. These views are subject to change. This information is intended to be for information purposes only and it is not intended as promotional material in any respect.