Fears about climate change have helped propel environmental, social and governance (ESG) considerations across the world’s investment industry, but most of the progress remains focused on public equities. In the global bond market, it is a much more nascent conversation.
Most of the attention on the bond side has ended up focusing on green bonds, or debt issues which are used by borrowers to fund individual projects deemed to offer environmental benefits, in line with the Green Bond Principles (GBPs) of the International Capital Market Association (ICMA).
There are other ESG-related bond types too, such as sustainability bonds, which fund employee welfare projects or improve living conditions, while blue bonds support projects that aim to treat and clean water or improve ocean cleanliness.
These have offered fund managers and asset owners an easily understandable form of fixed income instrument to buttress their ESG efforts, and that is proving popular. According to the Bank of International Settlements (BIS), global green bond issuance surpassed $250 billion in 2019, while the total amount of outstanding green bonds is around $550 billion, larger than the €325 billion ($383.2 billion) of European high yield debt currently available.
Add into that the prospect that the European Union will fund around 30% of its coming seven-year budget and four-year recovery plan via green bonds, suggests a further €225 billion in risk-free green bond issuance over the next four years.
But while $500 billion in outstanding bond flow is nothing to be sneezed at, a total of $7.15 trillion in bonds was issued last year. For all of its growth, green bonds (and their cousins) will always be a small subset of the global bond market.
Added to that, there are signs that the impact of green bonds in shifting company behaviour is limited. Indeed, BIS noted this issue in its latest Quarterly Review, released last week. It included one area of discussion entitled ‘Green Bonds and carbon emissions: exploring the case for a rating system at the firm level’.
“Current labels for green bonds do not necessarily signal that issuers have a lower or decreasing carbon intensity, measured as emissions relative to revenue,” it noted.
Indeed, the report said that “the majority of firms with very high carbon intensities across all scopes are power producers. By contrast, financial firms, notably banks, have been the most active users of green bonds and populate the group of least carbon-intensive firms.”
In other words, the borrowers that most need to decarbonise are not the ones, in the main, issuing green bonds, while those least in need of doing so are. The green bond industry appears to be having a somewhat superficial direct impact on climate change.
A far more effective solution would be for borrowers to be assessed on the environmental footprint of their overall business, not just a few projects.
That is the solution that BIS proposes, and it is something that ESG-conscious fund managers, like Mitch Reznick, head of sustainable fixed income for the international business at Federated Hermes, have been advocating for some time too.
Back in March last year he told AsianInvestor that Hermes (as it was then called) sought to assess ESG integration considerations that affect company cash flows and therefore credit risk, and “place that on an equal footing in an investment decision with understanding and assessing a company’s operating and financial risk”.
RANKING FIRMS NOT DEALS
In response to the latest BIS report, Reznick told AsianInvestor that "we have no intention to downplay green bonds," noting that they help fund worthwhile projects and spread the message of sustainable investing to an array of investors.
He agreed, however, that they have their limits. "The key thing is that, as far as addressing the climate crisis is concerned, companies across all economic activities need to decarbonise while creating economic value that is growing faster than the economy, and thus helping economy itself decarbonise". Green bonds do not currently do that.
Encouraging all bond issuers to take decarbonisation seriously is a lot easier said than done. However, BIS suggested one initial means of doing so: measuring corporate borrowers on the carbon intensity of their operations – or the ratio of their carbon emissions to revenue.
Doing so makes it an easier task to compare direct rivals, as well as assessing companies in different sectors. And as it notes, carbon emission data for most large companies have become available, either because carbon emissions are mandatory in countries like the UK, or because companies have come under investor pressure “to publish information on their carbon footprint”. Added to this, independent organisations such as S&P Trucost check and verify emission claims.
Reznick agrees the carbon intensity principle offers a sensible way forward, but he suggests adding gross carbon emissions to carbon intensity, so that growing companies are incentivised to reduce their overall emission levels.
In addition, he believes forward-looking, qualitative assessments should be added; in effect an ESG integration approach. "We want to invest in a company’s future, not in its past," he said in his commentary.
"You need to take the bare numbers and look at a company's trajectory trend, its plans to reduce carbon and what a company is targeting," Reznick told AsianInvestor. "If a company is at 100 [in terms of carbon emissions] and wants to reduce to 50 in five years, then on an ex ante [forecast-based] perspective it scores really well."
But by adding into this ongoing or planned improvements, companies (and investors) could see forward-looking rankings. That would likely appeal to aspiring investors wanting an integration-like approach to ESG bond investing. It also opens up a far broader swathe of the corporate bond universe.
Green bonds will continue to attract investors, particularly those seeking a relatively simple means to demonstrate their ESG credentials. But for investors seeking to encourage real change on corporate emitters, a carbon intensity standard looks the smarter long-term prospect.