Foreword
Some might argue that building a sustainable economy is a technological problem. It isn’t. The world is sufficiently stocked with greenhouse gas-reducing technologies such as renewable fuels, carbon capture and energy storage. What it lacks is capital. According to the International Energy Agency, investments in clean energy alone will have to rise to an annual USD 4 trillion by the end of this decade to keep global warming in check. Realistically, funding on that scale can only come from the financial market. Bond investors in particular.
Source: IIF, as of December 2021
Encouragingly, fixed income markets appear to be up to the task. As governments, corporations and investors ramp up their climate commitments, securities that embed environmental, social and governance (ESG) considerations are in the ascendancy.
Green fixed income securities with specific use-of-proceeds requirements, sustainability-linked bonds with coupons tied to issuers’ environmental credentials and social bonds that fund educational programmes are just some examples of the innovative structures vying to go mainstream. Investors have responded enthusiastically so far. In 2021, over USD 1.1 trillion of new sustainable bonds were successfully placed, taking the size of the ESG bond market to well above USD 2 trillion. Research undertaken for Pictet by the Institute of International Finance suggests issuance could reach an annual pace of USD 4.5 trillion per year by 2025.
While most of that capital will be raised in the developed world, much of it can also be expected to come in the form of emerging market ESG bonds. It is essential that it does. For developing economies, private finance is crucial if they are to fulfil the UN Sustainable Development Goals (SDGs) by 2030.
Yet for sustainable debt to become mainstream, several obstacles need to be negotiated. The immediate priority is universal rules and standards. Currently, the labelling and certification of sustainable bonds differs considerably from one country to another, while efforts to harmonise disclosure requirements haven’t met with much success.
Managing Director & Head of Sustainable Finance at the IIF and Chief Investment Officer - Fixed Income at Pictet Asset Management
An analysis of the ESG securities with the longest track record – green bonds – reveals other potential trade-offs. Green bonds have delivered similar returns to non-green debt, yet they trade a premium: their yields tend to be persistently lower than those of traditional securities. This is despite the fact that green bonds are less liquid. Our analysis shows that such securities trade less often, in some cases far less often, than conventional fixed income. This reinforces our belief that purchasers of green and sustainability- linked bonds tend to be ‘buy and hold’ institutional investors such as pension funds, insurance funds and sovereign wealth funds. What it also suggests, however, is that the secondary market for such debt is not mature enough to absorb large buy or sell orders without precipitating significant shifts in price.
Ultimately, none of these hurdles are insurmountable. If world leaders are genuinely committed to net zero, they will also recognise that these ambitions require capital to flow freely. Which is why, in the battle against climate change, bond investors could soon find themselves in the front line.
ESG bonds: too big to ignore
With environmental, social and governance (ESG) issues dominating the international policy agenda — and as investor demand for new ESG financial products and services continues to grow — global debt markets, and by extension fixed income portfolios, are about to undergo a radical transformation. The ESG debt universe is expanding rapidly, not only in size but also in terms of the variety of instruments it contains and the range of activities it finances.
It's an expansion that opens up new frontiers for investors. The opportunity now exists to build diversified portfolios that can fulfil both financial and non-financial goals – the mitigation of climate change, the protection of biodiversity and the promotion of social cohesion have become possible through bond investments.
At the same time, the growing importance of ESG factors has given both public and private sector borrowers unprecedented ability to tap sustainable debt markets and secure funding at attractive rates. With national and corporate net-zero commitments becoming more ambitious over the course of 2021, demand for low-carbon energy investments and technological innovation has boosted issuance of ESG securities.
Total ESG debt issuance (bond and loans) during the first three quarters of 2021 reached USD 1.1 trillion, exceeding totals for the whole of 2020.
Nevertheless, for all their dynamism, ESG debt markets have yet to acquire the scale required to finance the transition to a low-carbon economy.
For this to happen, further development of ESG debt markets is essential – and along several fronts. Progress towards greater harmonisation across sustainable finance taxonomies (ongoing efforts include the International Platform on Sustainable Finance) and ESG disclosures (notably the IFRS International Sustainability Standards Board) would foster more rapid market development.
In addition, greater transparency on how ESG rating agencies collect, analyse and calculate sovereign and corporate ESG metrics could also boost the demand for - and supply of - ESG debt securities.
Such changes would be transformational. They would alert bond investors to new investment opportunities while directly channeling private sector funding toward sustainable development goals (SDGs). Under this scenario, we believe global ESG-labelled bond issuance could reach an annual pace of USD 4.5 trillion in as little as five years. By 2030, the volume of ESG and climate-aligned bonds outstanding could reach USD 60 trillion, equivalent to approximately a third of the entire global bond market.
Taking all this into account, and assuming that governments and regulators will continue to focus on sustainability, our baseline estimates suggest that annual ESG-labelled bond issuance could climb over fourfold from some USD 525 billion in 2020 to over USD 2.3 trillion in 2025.
A richer hunting ground for investors
Source: IIF, data and forecast covering period 31.12.2019-31.12.2023
Role of supranationals in ESG bond market development
While corporations still dominate issuance in ESG-labelled bond markets, supranational agencies such as the European Investment Bank (EIB) and the Inter-American Development Bank (IADB) have increased their presence in recent years; together, they now account for over 17 per cent of annual issuance—up from 8 per cent in 2019. Supranationals have a crucial role to play in the development of ESG debt markets as they:
- step up support for mobilising capital towards ESG/SDG projects, particularly in developing countries
- enhance efforts to increase funds available for climate finance
- play a role in improving the quality of ESG data as well as its collection, reporting and dissemination
Emerging markets and climate capital
ESG integration in emerging market bonds has accelerated in 2021. At around USD 300 billion, ESG-labelled bonds represent 1 per cent of the market (vs 1.5 per cent for developed markets). Since the end of 2012, over half of ESG-labelled emerging market bonds have been issued by Chinese sovereign and corporate borrowers. Issuers from Chile, India, and Brazil are also well represented.
China leads the pack
Source: IIF. Data covering period 31.12.2014 - 31.10.2021
ESG bonds should become bigger features of emerging sovereign and corporate debt markets. It is vital that they do. Private capital is crucial to achieving the United Nations’ Sustainable Development Goals (SDGs) by 2030. The “SDG financing gap” – the difference between what emerging nations need and what they currently receive in investment - is estimated to be USD 2.5 trillion per year.
As the Covid pandemic drags on, many emerging economies are finding it increasingly difficult to secure the finance they need to meet SDGs. Domestic sources of investment are limited. Here is where green and social bonds could make a real difference, providing developing world sovereigns and corporations with the means to transform their economies. The Institute of International Finance’s baseline projection suggests that ESG-labelled bond issuance in emerging markets will increase from some USD 50 billion per year in 2020 to USD 360 billion by 2023.
Green bonds as portfolio investments
As calls for action to mitigate global warming grow more urgent, the importance of ESG bond markets as a potential source of climate capital has grown substantially in recent years. Yet for the market to evolve into a strategic asset class, investors need to be convinced that it represents a viable alternative to conventional bonds. An analysis of the ESG securities with the longest track record and representing about 55 per cent of ESG-labelled bond markets – green bonds – reveals some potential trade-offs for bondholders.
- Performance
Green bonds have exhibited similar - or better - performance than non-green peers.
For government bonds, returns on green bonds have outpaced those on conventional benchmarks since end-2017, with an average monthly excess return of over 1 basis point.
Geographic variation - while EUR-denominated green corporate bonds have outperformed broad EUR-denominated corporate bond benchmarks, excess monthly returns on USD-denominated green corporate bonds have been lower than their conventional counterparts.
- Volatility
Green bond indices have been more volatile than their conventional counterparts.
Sector variation - in government fixed-income markets, green bonds have been more volatile than nominal bond indices, resulting to slightly lower information ratio. In corporate green bonds, the volatility remains below that of conventional bonds, particularly for USD-denominated green corporate bonds.
- Liquidity
Green bond markets are relatively small, representing less than 1 per cent of global bond markets, and not especially diversified.
Most issuance is in EUR and USD and is largely concentrated in a few mature economies, with very limited activity in emerging market economies ex-China.
Investor behavior is also hampering market liquidity as they tend to take a “buy and hold” approach, keeping green bonds until maturity.
Strong appetite for green bonds appears to have translated into lower borrowing costs for some issuers, also called “greenium”. This solid demand has been evident in both primary and secondary bond markets, leading to a small price premium for green bonds over conventional bonds.
Glossary
Different types of ESG bonds:
- Green bonds
Green bonds are green fixed income securities with specific use-of-proceeds requirements. They have the longest track record out of other ESG securities and represent about more than half of ESG-labelled bond markets.
- Transition bonds
Transition bonds are designed to help firms with high greenhouse gas (GHG) emissions to finance a transition to greener or lower-carbon activities or methods of production. Successfully completing the climate transition depends on bridging the funding gap for the development of commercially viable sustainable infrastructure and new technologies. Many climate technologies such as renewable hydrogen, direct air capture, and green fuel are currently in the experimental or prototype phase and require significant additional research and development (R&D) investment to achieve the technological and cost-efficiency improvements needed for full commercialisation.
- Social bonds
Fixed-income instrument whose proceeds go towards projects with positive social outcomes. Such social projects include—but are not limited to— affordable basic infrastructure (e.g., clean drinking water), access to essential services (e.g., health, education, etc.), social and economic empowerment, affordable housing, employment generation (via small and medium-sized enterprise financing and micro-finance) and food security.
- Sustainability bonds
Fixed income instrument whose proceeds are applied to the delivery of environmentally sustainable outcomes or some combination of green and social projects for an identified target population. Such projects can include education, sustainability research, modernisation of public health facilities, climate change, and biodiversity.
- Sustainability-linked bonds
Sustainability-linked bonds are general-purpose instruments that—unlike use-of-proceeds debt such as green bonds—don’t compel issuers to direct all proceeds to pre-defined sustainability projects. Instead, the borrower commits to achieving a sustainability performance target.
Guidance to promote transparency and disclosure
The Principles, formulated by the International Capital Market Association (ICMA), are guidelines that recommend transparency and disclosure and promote the integrity of sustainable bond market. ICMA also provides guidance to evaluate the financing objectives of a green, social or sustainability bond against sustainable development goals (SGDs). These guidelines are a collection of frameworks dedicated to different segments of sustainable bond markets: the Green Bond Principles (GBP), the Social Bond Principles (SBP), the Sustainability Bond Guidelines (SBG) and the Sustainability-Linked Bond Principles (SLBP).
The EU Sustainable Finance Disclosures Regulation (SFDR) aims to alleviate the risk of greenwashing by promoting greater transparency on the impact of funds on the environment and society. It sets mandatory disclosure standards for funds available for sale in the EU, classifying them into three categories: Articles 9, 8 and 6.