ESG debt to play key role in financing sustainability
Sustainable debt issuance is expected to rise this year, but there are still hurdles to overcome
ESG-LABELLED debt, or bonds that embed environmental, social and governance (ESG) considerations, is set to play a key role in the transition to a more sustainable world, says Pictet Asset Management (PAM) investment manager Philipp Buff.
He said: “Sustainable credit is where the fixed-income market is headed, because most of the funding needed for sustainability will come from credit. I expect the market share of ESG-labelled debt to increase, although it’s not that large relative to the total market today.”
A joint report by PAM and the Institute of International Finance (IIF) Research projects global issuance of ESG-labelled bonds to triple to US$4.5 trillion annually by 2025. The size of the ESG bond market is estimated to be around US$2 trillion in 2021.
Debt issuance is expected to play a key role in helping to finance the United Nations Sustainable Development Goals. Among developing economies, the financing gap is estimated at US$2.5 trillion a year.
However, issuance of sustainable debt fell by an estimated 20 per cent last year, partly due to unfavourable market conditions such as higher inflation and interest rates and recession fears, which also hurt conventional bonds. S&P Global expects issuance to recover. It has forecast issuance to grow from US$850 billion in 2022 to between US$900 billion and US$1 trillion this year.
But there are a number of hurdles to overcome for ESG debt to become mainstream.
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One is the establishment of universal rules and standards, as the report by PAM and IIF, titled Bonds that Build Back Better, says. Labelling and certification of sustainable bonds differ across countries, and “efforts to harmonise disclosure requirements haven’t met with much success”, wrote PAM chief investment officer Raymond Sagayam and IIF managing director Sonja Gibbs in the foreword.
Agencies which assign bond ratings use varying methodologies, which may conflict with one another and are not wholly transparent.
A second hurdle is that investors need to be convinced that ESG debt is a viable alternative to traditional government and corporate debt. Due to their complexity, ESG securities tend to be costly to analyse, requiring far greater scrutiny than their conventional counterparts. They also do not fit neatly into traditional portfolio construction frameworks.
For investors, as the report points out, there are trade-offs. Yields on green bonds, for instance, tend to be persistently lower than traditional securities despite green bonds’ lower liquidity. For issuers, cost of issuance also tends to be higher because of the additional certification needed, although this may be offset by a lower yield.
Buff, who was in Singapore last month, said: “It’s hard to quantify the additional cost for issuers in terms of basis points, such as hiring more headcount and measuring ESG data points.
“However, these costs are probably largely one-off, associated with issuing a first green bond, and then the marginal cost of issuing more green bonds in the future (becomes) negligible. It is probably fair to say that the saving (for issuers) was 15 to 20 basis points (bps) in terms of the lower yield offered on the green bonds if we assume that the costs become irrelevant over time …”
Historically, the “greenium’‘ – or the amount by which the yield on a green instrument is lower than its conventional counterpart – was around 15 bps for US dollar and euro debt at different times, said Buff. “Since Q4 2022, we have been in a range of 5 to 10 bps for both currencies; today, they are at 7 bps and 8 bps in the euro and the US dollar, respectively.”
He said that it is important that investors be clear on the investment approach in ESG debt, and to look beyond the use of proceeds. “What’s important is for us to have our conviction or approach on how we define sustainable credit… We also look at the business profile of a company and how its revenues align with the social and green objectives.
“It’s important that we don’t look at these things in isolation… Because what matters is the language of the company, and where it is heading.”
He noted that the volatility of ESG debt appears to be lower than that for conventional paper. “That’s one form of risk mitigation that is important for fixed-income portfolios. I think the reason volatility is lower goes back to technical factors – that funds which invest into ESG debt are more stable and stickier. The funds are more committed from a flow perspective, so you don’t have the pressure of outflows and having to sell parts of your portfolio. There are fewer sellers of sustainable paper in general.”
The report expects ESG-labelled bonds to eventually play a bigger role in the emerging market sovereign and corporate debt markets. China, in particular, is expected to continue to play a major role. China accounts for some US$145 billion of green bonds outstanding, and is the third-largest green bond market after France and Germany.
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