ESG Bonds: New Tools Needed for Investors and Stakeholders
Alla Liberman
July 19th, 2021
For a long time, the corporate world has been debating what the purpose of a corporation should look like. In 1970, renowned economist Milton Friedman wrote an essay for the New York Times, “A Friedman Doctrine: The Social Responsibility of Business is to Increase Its Profits.” The Friedman Doctrine, also known as shareholder theory, became a staple for capitalism and business ethics. However, as the business world evolved to become more complicated and intertwined with local communities, governments, and social developments, business principles started to transform. From social responsibility to the environment and climate change to thinking of appropriate governance models and employee relationships, numerous forces began to influence intangible corporate assets. Naturally, investors began casting doubt on whether companies should be creating immediate value to their shareholders at any cost versus creating long-term value to their shareholders by paying closer attention to the corporate impact on the world around them.
We hear about sustainability in many aspects of life: in 2015, the UN introduced Sustainable Developments Goals of 2030; in 2020, China, South Korea, Japan and the EU pledged to reach net-zero emissions by 2050, and in April of this year, U.S. Treasury Secretary Janet Yellen made a point of discussing climate-related risks in her remarks to the Institute of International Finance. When world leaders speak, the investing world listens. ESG has evolved from impact investing (making the world a better place) to sustainable investing (do not make the world worse) and risk mitigation (do not make my company worse).
2020 was a year of epic historic consequences – the Covid-19 pandemic, social justice, and economic disparities brought to light the considerable importance of social responsibility and the ever-increasing role strong governance plays in any company’s success. As such, we have seen a tremendous increase in money flowing into ESG funds. According to analysis performed by Blackrock, inflows into sustainable assets globally exceeded $280B in 2020, and this represented a nearly 100% increase compared to 2019.
The bond market has also been at the forefront of ESG investing. According to the Environmental Finance Bond Database, green, social, sustainability, and sustainability-linked (GSSS) bond issuance crossed $600 billion in 2020, up from $326 billion (almost double!) in 2019 and $214 billion in 2018. Therefore, any fixed-income investor must understand the types of GSSS bonds out there.
Green bonds were the original ESG bonds of their kind, coming to the market in 2007. The World Bank was the first entity to issue green bonds. These are project-based bonds, and their proceeds are intended to finance “green projects”; Social bonds are similar to green bonds as they are also project-based, but their proceeds finance projects with social impact. Sustainability bonds and Sustainable Development Goals bonds (SDG) fund both social and environmental projects, with SDG bonds aligned with the UN Sustainable Development goals mentioned earlier. The new kids on the block are KPI-linked bonds and Transition bonds. KPI-linked bonds are not project-based. Unlike the traditional green, social, and sustainability bonds whose proceeds are earmarked for specific ESG projects, the proceeds from KPI-linked bonds benefit general corporate purposes. Their coupon/cost of financing is determined by a company’s ability to achieve sustainability-linked KPIs within a specified time frame. Lastly, transition bonds are different from the rest in that, unlike other ESG bonds that finance only green sectors, transition bonds help polluting sectors (such as chemicals and mining) finance their sustainability initiatives.
There are many advantages for investors to invest in ESG/GSSS bonds. First and foremost, they provide a tax advantage to incentivize stakeholders to impact the environment, sustainability, and governance positively. Secondly, according to Barclays research, ESG bonds give investors a small but steady performance advantage. Interestingly, Barclays also found that out of E, S, and G, the most significant positive performance factor is Governance (G), and the smallest positive performance contributor is the Social (S) aspect of ESG.
KPI-linked bonds create another level of attractiveness –unlike other GSSS bonds that target specific projects, many aspects of the issuing companies’ activities will be touched by ESG and can have long-lasting benefits on the issuing company as a whole. Additionally, these bonds can provide enticing payout structures for investors via coupon step-ups if companies fail to deliver on the predetermined measures.
Given the wide variability of ESG bonds, understanding all the implications embedded in the structures and getting the correct pricing becomes imperative. Even starting with the most straightforward structure, green bonds, the variability of pricing can be significant depending on the tax incentive of a bond. For example, in some bonds, investors receive a tax credit instead of interest payments (tax credit bonds), whereas in others, they do not pay tax on any interest they receive (tax-exempt bonds). Having models to equate the yield to maturity on those bonds, given the investor’s particular tax situation, helps determine the value of the bond.
For sustainability bonds and KPI-linked bonds, the reliance on pricing models increases even further as financial and/or trigger events need to be priced. Firstly, investors need adequate modeling of potential variation of coupon payments and how those payments are determined. Then there has to be a process of pricing the fallback language if the sustainability performance targets cannot be determined, which would only then be followed by modeling the tax implications, if any. The next level of modeling would be estimating the relative allocation of E versus S versus G of every bond and predicting which bonds should trade richer than others, given the ESG aspect they finance.
The ESG bond market has been increasingly growing in popularity. We expect the trend to continue and for the market to mature and gain liquidity. Much work has been done in pricing ESG risk in issuer credit analysis or stock-valuation analysis, but we are just at the beginning stages of thinking through all the issues facing the valuation of ESG bonds. As such, investors will need proper modeling tools to evaluate ESG bonds to understand how they stack up against the rest of their fixed income portfolios.
