ESG – the ascent continues

The global ESG movement is thriving and the market’s growth is expected to accelerate exponentially. The adoption of ESG among issuers – which until recently was seen by many in financial services as a tangential issue– is being fuelled by investor appetite, new regulations, risk management and the COVID-19 crisis. HSBC Issuer Services looks at how ESG and sustainability are changing market dynamics.

ESG momentum keeps building

Having undergone a meteoric rise in 2020 – ESG linked issuances are continuing to gather momentum. Reports indicate that sustainable finance bond issuances reached $777.6 billion in the first nine months of 2021, a record high. ¹ Of that total, green bond issues accounted for $362.06 billion and social bonds USD170.9 billion. ² Jamie Pratt, Regional Head of Issuer Services, Americas at HSBC, notes that in addition to sustainable bonds, there was a notable increase in sustainability linked loans (SLLs), - namely loans whereby the interest paid by the borrower is gradually reduced depending on whether they meet a set of pre-agreed sustainability KPIs (key performance indicators). Conversely, the rates on SLLs paid by borrowers will increase if they do not meet their KPIs. One of the reasons as to why SLLs are so popular is that they are more flexible than traditional green or social bonds as the use of proceeds do not need to be allocated by issuers to exclusively green or social projects.³ According to the Climate Bonds Initiative, SLL issuances reached USD202 billion in the first six months of 2021, surpassing green loans by some distance. Karen Lomax, Managing Director, Head of Issuer Services for Europe at HSBC, believes that SLLs will continue to enjoy robust growth moving forward.

Aside from clearly-defined green or social bonds, transition bonds are also generating interest. Transition bonds – as the name suggests – enables high carbon pollutant companies or sectors to obtain financing so that they can make their business operations and strategies more sustainable. Perhaps one of the most high profile transition bond issuances involved Snam, an energy infrastructure company in Italy, which issued a EUR750 million dual tranche bond with proceeds being used to fund emission reductions through renewable energy, energy efficiency, green construction projects and the retro-fitting of gas transmission networks to ensure they can operate using alternative energy sources such as hydrogen. ⁴

In terms of geographical location, the Climate Bonds Initiative notes the majority of green bond issues in 2020 took place in Europe, followed by North America whereas China, Japan and France were among the largest social bond issuers. ⁵ However, Asia-Pacific – led by China – is also seen as being an increasingly active green bond market. Nonetheless, the volume of issuances do tend to be skewed in favour of developed markets. Climate Bonds Initiative analysis found that developed markets accounted for 4/5s of all green bond volumes in 2020, while emerging markets comprised 16 per cent - a decline from 22 per cent in 2019. ⁶ Despite this, Pratt points out that HSBC Issuer Services is working with a number of major issuers in emerging markets supporting their various sustainability bond issuances.

Drivers for change

Chris Knowles, Global Head of Strategy and Product, Issuer Services at HSBC, says sustainability bond issuances are being driven by a combination of issuers reshaping their businesses towards net-zero, and the ESG investment demands coming from end investors. A survey by Russell Investments of 369 asset managers running $79.6 trillion found 82 per cent incorporate qualitative or quantitative ESG factor assessments into their investment processes in contrast to 78 per cent in 2020. ⁷ Investment firms are also throwing more resources at ESG with the survey indicating that fund managers are hiring growing numbers of ESG experts. For instance, it found that 55 per cent of managers now employ dedicated ESG professionals compared to 43 per cent in 2020. ⁸ So why are fund managers doing this? Firstly, many institutional investors’ (plus their own underlying stakeholders) want their returns to be sustainable. In addition, some investors argue ESG assets outperform non-ESG assets. This is a highly contentious and contested claim though – as different empirical studies have reached diametrically opposing conclusions about the performance of ESG assets relative to non-ESG assets. ⁹ While some companies raising funds via sustainable debt issuances can benefit from lower borrowing costs – otherwise known as the greenium – others argue investors are losing bps (basis points) of yield when purchasing green bonds versus non-green bonds.

Regulation and public policy is incentivising organisations to issue more ESG -linked bonds. Knowles says that the recent COP26 Climate Change Conference in Glasgow – together with some of the government targets on meeting net zero - are compelling more companies to seek out funding to help them green their businesses. The imposition of ESG regulation on investors is forcing change as well. The EU – through its Sustainable Finance Disclosure Regulation (SFDR) – along with markets such as the UK, Hong Kong and Singapore – are introducing ESG reporting rules for investors, which is encouraging them to build up their exposures to ESG assets. The current US administration is also taking climate change seriously - with the Securities and Exchange Commission (SEC) poised to introduce mandatory ESG reporting rules for companies. ¹¹ Regulation will be a big driver behind issuance activity.

Risk management considerations are another factor pushing corporates into issuing sustainable bonds, says Fenocchi. Firstly, COVID-19 has served as a wake-up call for corporates, reminding them of the importance of sustainable growth together with the risks which natural disasters can pose to their businesses. In fact, the pandemic has triggered a wave of sustainable bond issuances over the last two years. Longer-term climate risks are also prompting companies to issue sustainable bonds. Fossil fuel producers or those heavily reliant on fossil fuels as a means of production face existential challenges - especially if adoption of renewables becomes increasingly widespread. In order to future-proof their businesses, these high carbon companies will need to adapt, something which can be enabled through issuing sustainable bonds or leveraging SLLs. Doing nothing is simply not a feasible option, especially as more global investors are beginning to divest from companies which they believe are not making enough progress on mitigating climate change. Major institutions including Norway’s oil fund and pension fund ABP have outlined their divestment plans while Aviva recently warned a number of companies that it would start selling down its investments in them if firm action is not taken to significantly reduce their carbon emissions.¹²

A market ripe for improvement

As a fairly nascent market, ESG – as an asset class – is still developing. One of the biggest barriers faced by corporates and investors alike is that there is a lack of joined-up regulation, which is contributing to widespread uncertainty. Take the UK and EU, for example. Although the UK pledged to mirror a lot of the existing EU rules, it has notably diverged on ESG. Firstly, it did not onshore the SFDR, while it has only retained the high-level requirements contained in the Taxonomy Regulation – an EU classification system detailing which economic activities are sustainable. ¹³ The UK has also said it will introduce its own disclosure regime, investment labelling and taxonomy. ¹⁴ Even within the EU, different regulators are adopting their own tailored ESG rules causing further confusion. ¹⁵ On a global level, the regulatory divergences are even more pronounced. The absence of any global regulatory consensus – especially on taxonomies - means investors and issuers will need to comply with different ESG rules on a cross-border basis. In addition to creating complexity for all parties involved, the lack of standardised rules also increases the risk of greenwashing – a situation whereby issuers and investors make misrepresentations–willing or otherwise-about their green policies and achievements.

Aside from inconsistencies around global regulations, Knowles highlights there is also a lack of agreed upon ESG standards. The problem lies with there being too many standards and ESG scoring systems being adopted by supranational bodies, ratings agencies and industry groups. One of the most commonly used ESG metrics is the FSB’s (Financial Stability Board’s) TCFD (Task Force on Climate-related Financial Disclosures), a template designed to improve and increase climate related financial reporting by corporates and investors. Other popular standards include the UN’s SDGs (Sustainable Development Goals), the GHG (Greenhouse Gas) Protocol and the SASB (Sustainable Accounting Standards Board). In the green bond market, metrics such as ICMA’s (International Capital Market Association) Green Bond Principles and the EU Green Bond Standard are also widely leveraged. The abundance of all of these different standards makes it hard for issuers and investors alike to know which benchmark(s) to follow. In the case of ratings agencies, many providers adopt tailored methodologies when scoring issuers on ESG – which leads to major divergences. In some cases, different ratings agencies will assign contradictory ESG scores to the same company or issues. According to MIT, ESG scores by ratings agencies are aligned with each other only 60 per cent of the time. ¹⁶ This makes it more challenging for investors to obtain good quality or accurate ESG data from issuers.

Supporting a growing sector

HSBC Issuer Services is at the forefront of supporting a number of major ESG linked transactions, according to Lomax. The bank has participated in a number of high-profile green deals in the last year.

ESG is now firmly engrained in the industry and issuances – together with investor appetite globally – are projected to grow significantly. It is vital issuers engage with counterparties boasting extensive experience and global reach on ESG matters if they are to meet their various sustainability objectives.

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