ESG Growing Pains

Maturing standards are raising the issuance bar.

Staving off climate change while improving communities and migrating energy sources comes with a steep bill, and most corporations are turning to the debt markets to finance their goals. However, issuing bonds likely will become more difficult as the standards mature for socially responsible investing (SRI) and investing focused on environmental, social and governance (ESG) issues.

In early July, the European Commission (EC), the EU’s executive arm, adopted a new sustainable finance strategy to increase investment tackling climate change. Among other provisions, the EC announced a green bond standard and a disclosure mandate.

“Sometimes new standards are stricter in interpreting what is green than what was considered green two years ago,” says Anne van Riel, head of Sustainable Finance Capital Markets Americas at BNP Paribas.

Nevertheless, issuers and investors have only increased their appetite for ESG-linked debt. “Everyone realizes that ESG risks are real and can impact your bottom line, whether it is a global pandemic, wildfires, floods or other social and governance issues challenging us currently,” van Riel says. “People are definitely more focused on it from both the issuer and the investor sides. You see that in the double-digit growth as equity and fixed-income funds have some kind of ESG integration.”

Some estimates put ESG assets up a third from 2016 to 2020 to $35 trillion, or no less than 36% of total professionally managed assets, write Sirio Aramonte and Anna Zabai, economists at the Bank for International Settlements (BIS), in the September BIS Quarterly Review. The authors further note that ESG/SRI bond funds “represent only about 1% of total bond portfolios for both US insurance companies and European banks,” and that about 4% of US pension funds’ credit exposure now comes from green bonds.

Moody’s estimates that by the end of 2021, ESG-related bond issuance could near $1 trillion. Green bonds and social bonds, whose proceeds go to specific projects, are expected to generate $450 billion and $200 billion, respectively; while sustainable bonds, which mix green and social purpose, are expected to raise $200 billion. A newer class of sustainability-linked bonds, which can be used to finance anything but tie preferable terms to meeting sustainability targets, is expected to reach as much as $100 billion, estimates Matt Kuchtyak, vice president of ESG Outreach and Research at Moody’s ESG Solutions.

The types of issuers are also changing, as the EU’s approximately €800 billion (about $930 billion) next-generation recovery plan is expected to consist 30% of green bonds, further increasing the market, he adds.

Despite the growing variety of credible ESG-linked bonds, green bonds remain a perennial favorite. Such bonds have been around for more than a decade and their metrics for success are easier to measure.

In the Japanese market, environmentally linked bonds are more mature than other ESG-based offerings, according to Keiichi Aritomo, executive director at the Organization of Global Financial City Tokyo (FinCity.Tokyo), an organization that boosts the city’s profile as an international financial hub.

“The government’s commitment to become carbon neutral by 2050 is a major driver,” he says. “Japanese corporations are putting real effort into decarbonizing their operations and shifting to more-sustainable business practices. Japan, of course, has a massive industrial base; so this will take time, effort and funds. On the other hand, the scale of the effort is opening up opportunities that global investors are now noticing.”

Another sign of maturity for ESG-linked bonds is the increasing spectrum of risk profiles and credit ratings the instruments have, as more issuers come from outside the most developed markets.

“We have seen a bit more diversification in these very early days of the sustainability-linked bond market—for example, there are more sub-investment grade issuers in the market,” says Kuchtyak. “However, it’s too soon to say whether that will be a lasting trend.”

Standards Ho!

As yet, sustainable finance remains a sea of competing standards, from the Climate Disclosure Standards Board to the United Nations Global Compact. But efforts are driving toward a global standard. According to Alex Friedman, CEO of ESG-reporting platform provider Novata, the trend is driven by private equity firms that want to get ahead of ESG reporting trends and by institutional investors under pressure from their stakeholders, as well as public companies responding to shareholder requests to demonstrate ESG commitment.

Friedman views the current environment as the sustainable finance market waiting for its version of generally accepted accounting principles (GAAP). “Beforehand, there were a lot of different ways to report,” he says. “Afterward, there was a generally accepted one; though there are differences in different parts of the world, of course.”

In some cases, two standards may coexist. In May, Japan’s Ministry of Economy, Trade and Industry released its Basic Guidelines on Climate Transition Finance, which it had jointly developed with the Financial Services Agency and the Ministry of the Environment. “I think Japan’s ratings will be important from a Japanese point of view,” says FinCity.Tokyo’s Aritomo. “But when it comes to attracting international investors to Japan, the key is to meet already developed global standards. There already are global ESG ratings. There is no need to reinvent the wheel, as long as we target the right stakeholders.”

Friedman recommends that regulators consider the differences between public and private companies when developing their reporting frameworks. “Most of the world’s economic activity takes place in the private markets, not the public markets,” he points out. “Additionally, large public companies that are making net-zero commitments cannot really make them if they cannot demonstrate what their supply chain is doing. Those supply chains consist mostly of private companies.”

Public companies already have a wealth of ESG data, like the EEO-1 reports in which the US Equal Employment Opportunity Commission requires “all private sector employers with 100 or more employees, and federal contractors with 50 or more employees meeting certain criteria, to submit demographic workforce data, including data by race/ethnicity, sex and job categories,” according to Lorraine Spradley Wilson, chief impact officer and head of ESG Methodology at Novata.

Whereas public equity investors have ramped up requests for increased and standardized data, the private market has yet to see the same momentum, she says. “A lot of that information is being collected in spreadsheets somewhere, and you don’t have investor campaigns targeting specific companies to release it in the same way that you see with large public businesses.”

Bubble Ahead

Fast-moving transformative markets have historically fed financial bubbles: railroads in the 19th century; mortgage-backed securities in the 21st. Will the ESG debt market follow suit?

“If you read all the forecasts on how much capital is needed for energy transition, it runs into the trillions of dollars,” says BNP Paribas’ van Riel. “It’s a lot of capital that needs to be deployed. There should be enough to feed the demand for green or sustainable assets, but somehow there is a bit of a mismatch of the capital that is available going to the right assets or the same risk profile. That is a little bit of a conundrum that needs to be solved.”

The market isn’t holding back, but much of it is driven by governments and large multinationals with relatively easy access to funds, who can clean up their first- and second-tier suppliers, notes Aritomo. Having the third- and fourth-tier suppliers hew to rising standards proves challenging, due to a lack of effective disclosures and of resources and experience in communicating with international investors.

“Only 12% of listed firms in Japan are disclosing in a comprehensive manner, including both financial and nonfinancial disclosure in English,” says Aritomo. “This means 88% are not ‘known’ to international investors. Among them are many hidden gems that do a lot of interesting innovation; but they need to communicate better based on internationally accepted frameworks.”

As a result, FinCity.Tokyo launched Disclosure G, an initiative that helps those companies that have difficulties making disclosures in English improve their effectiveness and provide investors with insights into the entire supply chain.

Despite the hype that surrounds ESG, the market is on the right track, Aritomo adds. “At first, ESG is new and there’s a lot of hype; then the amount of data increases, and investors become more adept at interpreting it and making the right decisions. Looking forward, we’ll probably see more scrutiny and tighter rules; but that is just part of the process.”