Six months into 2021 and already Environmental, Social and Governance (ESG) labelled bond issuance has reached US$529B, just shy of the total issuance of 2020 ($556B). Is this another case of “irrational exuberance” which I experienced first-hand as a fixed interest fund manager in 1996, or can these ESG bonds provide executable insights as equity investors?
In this Arcus I will share some observations from recent ESG bond issuances and trends that will be of interest to us as panvestors.
Q- What is an ESG Bond?
Since 2010 we have seen Sovereigns, Supranational, Agencies (SSAs) and Corporates issue ESG bonds. These bonds come in the following general forms:
Green Bond - Proceeds to be used for a specific environmental investment
Social Bond - Proceeds to be used for a specific social investment (e.g., SDG linked bonds)
Sustainability Bond - Proceeds for a combo of green or social investments
Transition Bonds - Use of proceeds: dedicated to specific transition projects (e.g., gas transport infrastructure), No penalty/rewards or any sustainability KPIs
Sustainability Linked Bonds (SLB) – Proceeds can be used for anything. Issuer pays higher (lower) coupon if they fail (achieve) certain sustainability targets.
As can be seen below the latest craze seems to be in the Sustainability Linked Bonds (SLBs), which have rapidly gained in popularity, with issuance increasing 2.8x in the quarter, to $27.25B, up from $9.65B. Green, Social and Sustainability Bonds are also growing at a slower pace but on a higher base as shown below.
Source: Bloomberg, Morgan Stanley Research, July 2021.
Q- Why do Investors buy ESG Bonds?
So, they can green their bond portfolio and/or
So, they can make money and/or
So, they can have an actual impact.
The first two reasons are very subjective in terms of decision making and outside the scope of this Arcus, but the last of these is where a healthy objective debate is under way. For those who want to ensure an IMPACT of their ESG bond, they have two ways to make an impact:
Investor buys bonds (Green, Social and Sustainability) which require proceeds to be used for specific projects that investor/issuer agree upon.
Investor buys bonds (Sustainability linked) where proceeds can be used anyway the company wants as long as they deliver on pre agreed targets that improve their ESG scores, e.g., GHG Emissions, Gender Diversity, etc.
The first type of bonds is often issued by companies already highly rated in terms of sustainability while the latter are issued by companies that struggle to convince people of their ESG credentials and commitments. The graph below shows how environmentally challenged industries such as Energy, Basic Industries, Oil and Gas have been issuing SLBs with promises to improve themselves.
Q- ESG Bonds Impact – Carrot or the stick approach?
For impact, is it better to fund companies which want to make bigger and bolder sustainability investments or fund those who plan to change at the margin (from an unattractive position)?
To answer this question, one needs to review the incentive schemes being offered under the ESG Bonds. Green and Social bonds incentivize the issuer to make specific sustainable investments with cheaper funding, thus ensuring positive impact, the carrot approach. On the other hand, with SLBs the issuer spends the money as they see fit but must pay higher coupons if they don’t meet certain sustainability KPIs, the stick approach. For this latter approach it could be argued that regulatory and market forces (emission standards, taxes, etc) can prove to be a better stick to improve ESG standards and create impact.
Sustainability Linked Bond Case Study:
In June 2021 Australian conglomerate Wesfarmers issued its inaugural SLB, issuing a combined A$1Bn of 7-year and 10-year maturity instruments. The SLB commits to two sustainability performance targets, being:
Wesfarmers retail divisions (Bunnings, Kmart Group and Officeworks) to source 100% of electricity volume requirements from renewable sources as of 31 Dec 2025; and
Wesfarmers Chemical, Energy and Fertilisers Division (WesCEF) Nitric Acid Ammonium Nitrate (NAAN) facility to limit average emissions intensity to 0.25 tonne CO2e per tonne of ammonium nitrate produced during 1 Jan 2024 - 31 Dec 2025
In the event that these are not met the coupon rate will increase by 0.125% for each target. A stick approach to sustainability.
When considering impact, the first question to ask is the quality of the targets. In the above case Wesfarmer’s 100% renewable energy on retail business only represents 37% of their total Scope 1 & 2 Emissions, which in total represent less than 7% of their overall Co2 emissions (2019 estimates). The best potential impact of their SLB’s 1st KPI is only a 1.8% reduction in Total Co2 emission by 2025. A worthy target? The second KPI for the SLB is the Co2 intensity reduction to 0.25 tonne for ammonium nitrate production which does seem to be a commendable target given EU average is 0.77 tonne Co2 per tonne of ammonium nitrate.
The second challenge for investors wanting impact is the use of the proceeds. In the case at hand, the $1bn proceeds Wesfarmers has raised from this SLB will be used to “support the Group’s strategy to pre-fund upcoming bond maturities, ensure appropriate balance sheet flexibility and maintain a presence in key credit markets”. There are no specific environmental or sustainability investments identified. How does one ensure Wesfarmers uses these funds consistent to an investors overall sustainability commitments?
The third issue to be considered is that there is an impact and funding duration mismatch. The bonds are 2028 and 2031 maturity, while the sustainability KPIs’ expire in 2025. Should a company benefit from a SLB funding beyond their impact promises?
The last SLB issue for impact investors is whether the penalty for failure on the KPIs is punitive enough to ensure compliance, and by accepting a higher coupon in case of non-delivery, is the investor sending a message to companies that you can continue to ignore your responsibilities (in this case to the environment) as long as you pay a higher coupon. Is this hush money?
To counter the above arguments against SLBs, the 2.5 times oversubscription of Wesfarmers SLB shows that investors (55% from Australia and 62% Asset Managers/Institutions) must accept the stick approach for impact. This could be justified in the context that Wesfarmers still has much to prove in terms of their environmental credentials. Wesfarmers has estimated its Total Co2 emissions (Scope1,2& 3) to be c22mn tn pa and they do have a 2050 Net zero target. However, as the table below shows as recently as 2019, 2020 they were still increasing their scope 1 & 2 emissions due to profitable production increases. Also, Wesfarmers used to disclose under CDP reporting since 2010, however stopped responding to CDP in 2019 and 2020. Can this SLB and associated environmental KPI’s turn around this shareholder driven company to become a stakeholder respecting one?
Source: Wesfarmers 2020 Climate Related Disclosures
Q- Can ESG Bonds guide to opportunities in equities?
Equity investors have always looked to bond markets to provide guidance on inflation, monetary policy, FX moves and even equity valuations. Can we now look to the bond market for guidance on sustainable and ESG investing?
Increasingly we are seeing not insignificant signs that ESG and Sustainability is being priced into bonds. Companies issuing ESG bonds can claim to either achieve a lower interest expense or receive lower risk premium, both also having potential equity valuation impact for the companies.
In a recent JPM Global Credit Research piece, they found
ESG has more impact on corporate funding costs in Europe than US, with post 2015 Paris climate agreement era showing increased statistical significance of this impact.
Funding differential (cost of debt) between best and worst in class in European investment grade bonds is significant.
Within EM, Asia ex China has the strongest ESG spread impact.
Environmental credentials have the strongest pricing impact within DM and EM bonds.
For us as equity investors what was of interest was the fact that within highly rated ESG sectors and where there is a wide spread between best and worst companies on ESG, companies have the most to gain from their ESG initiatives. This means that a high ESG rated company in a high scoring sector will get cheaper cost of funding compared to a high rated issuer in a low scoring sector. This also means that, a low scoring company in a high scoring sector faces more challenges compared to a low scored issuer in a low scoring sector.
To help us identify the sectors where companies will get the best bang for their ESG initiatives we share JPM’s ESG Spread per sectors vs Sector ESG scores of European Investment Grade bonds in the graph below. Their analysis would suggest that good ESG companies within Utilities, Capital Goods and Industrials will get ESG pricing benefits for bonds and we believe potentially equities as well. ESG efforts in Healthcare and Energy are not being rewarded yet, as ESG credentials are similar within the sectors with no ability for investors to differentiate.
As panvestors curating an equity portfolio of global names, we are always trying to understand how to measure, monitor and incentivize companies for impact. We are also trying to show causation between their sustainability efforts and their equity market valuations. Given equity and bonds are tied at the hip, we do find the developments in the ESG bonds space of interest and hope to use some of their experiences to sharpen our own process and investments. Intend to keep you all posted on our learnings as well.