Tuesday, 16 October 2018

IFR Green Bonds Roundtable 2017: Part 2

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Nick Herbert: That’s a very good point. At the end of last year it seemed we had a whole host of sovereigns waiting to launch. You had the Poland and the France deal. Sandrine, why haven’t we seen more sovereign issuance and are we going to get it?


Sandrine Enguehard: We all agree that it won’t be easy to reach the two-degree scenarios and even more difficult without the US - even if we know that there are a lot of initiatives at state level and in the corporate world.

Clearly we would like to see more from public entities with regard to Green bonds. The France issue was a good illustration as to how a government could not only promote Green bonds, but also set standards for other sovereign issuers in terms of the use of proceeds, impact evaluation and reporting. They decided to enter into an in-progress process of reporting.

I think that many sovereigns are now thinking about Green bonds, and consequently the commitments taken during COP21. They are reinforcing their policies already defined within state budgets to support the development of a greener economy. Clearly launching Green bonds gives them a great opportunity to communicate with the public on that subject - sizeable issuance linked to major projects is a good way to express their commitment to COP21 and COP22. I am sure we will see many new deals from sovereigns committed to climate change, but also other states’ sustainable challenges.


Nicholas Pfaff: I think it’s important to underline that issuing Green bonds for a sovereign isn’t an obvious exercise. Green bonds were designed originally for multilateral development banks, and were then issued by financial institutions, municipalities and, more recently corporates. More specifically, Green bonds are project-focused and involve the tracking of the use of funds. It’s a process that is not immediately applicable to the normal budgetary practices of most sovereigns. That doesn’t mean that issuing sovereign Green bonds can’t be terrifically relevant to sovereigns, for example in communicating a national transition story, focusing on key green infrastructure projects and diversifying investors.

We’ve had important dialogue with sovereigns on what can be done to facilitate and open up the Green Bond Principles for future issues and we’ve made two changes this year for that purpose. The first is that we’ve widened the notion of “project” to include all of its supporting expenditure. That may seem like semantics, but we aim to signal that, as with the French Green OAT, it’s okay to include in Green bonds use of proceeds expenditure, such as research and development and funding for green tax subsidies.

The second change relates to the tracking of funds. We thought we already had language there that was fairly flexible, but we’ve made it more explicit now by including identifying an equivalent amount to the bond‘s proceeds and tracking its use.

We’re stating the obvious. Money is fungible, so it’s really not a question of raising, say, €10bn for green projects and then having to go through the process of tracking exactly where that money is going. The point is to say, “You’re raising €10bn? Then let’s identify €10bn of projects and report on how an equivalent amount of funds is going into that”.

Hopefully, those two changes will respond to the most obvious issues or concerns of sovereigns, and will help facilitate further Green bond issuance from them.


Rahul Ghosh: I think sovereign Green bonds have to fit within the broader challenge of moving the Paris agreement from environment ministries to finance and economic ministries. What do I mean by that? It’s about how we translate country commitments into an actionable infrastructure pipeline.

Other policy initiatives can also be important for the sovereign Green bond market. If we use the French example again, developments such as Article 173 of the Energy Transition Law and what that means for reporting is significant. And what we’re seeing in Singapore with the Monetary Authority of Singapore subsidising external reviews for Green bond issuance is an interesting development.


Nick Herbert: I was wondering about the benefits of rewarding issuers to launch Green bonds. Given that climate risk is finance risk, is it time for some kind of green assessment to be included in the overall credit rating?


Rahul Ghosh: That’s a really interesting question. I think I need to answer that in the context of a credit rating agency’s role in the capital markets, which is to provide a forward-looking opinion on default risk and bring into account all the different factors that may influence the willingness and ability of issuers to repay debt in a timely fashion. Some of those factors may be financial in nature, others may relate to the issuer’s business profile or management quality, and others may be related to environmental risk.

We are focussed on articulating to the market and providing frameworks and tools for how they can think about environmental risk in the context of broader creditworthiness. About a year-and-a-half ago, we put out an extensive study where we assessed 86 sectors with US$68trn of outstanding debt for credit exposure to environmental risks. We looked at five different environmental risks, four of which were physical risks, with the fifth being transition risk. We identified which sectors we thought were most exposed to those risks, both in terms of materiality and timing.

There were 14 sectors where we saw very high or high exposure to carbon transition risk. For three of those sectors – unregulated utilities, coal mining and coal terminals – carbon transition is having a material impact on credit quality and ratings today.

There were another 11 sectors where we saw elevated risks which were likely to become material to credit quality over the next three to five years. These included integrated oil and gas companies, steel, building materials, and a host of different sectors. The next step will be to drill down further at an issuer level within these high or very high risk sectors to look at which issuers are best placed to mitigate climate risk and adapt and ultimately perhaps profit from the transition story, and which are most exposed.

To summarise, our underlying focus when it comes to environmental risks is materiality to credit. But clearly, in the post-Paris era, carbon transition will likely have an increasing credit impact for a number of industrial sectors. What we’re endeavouring to do is provide a framework so investors can see where such risks exist and how they filter through to creditworthiness.


Nick Herbert: Chris, as an investor, would the incorporation of some green assessment in credit ratings help your business?


Chris Wigley: Absolutely. I really do welcome what I’ve just heard there. Going back five years or so, there was a review of the rating agencies and their role in the financial crisis. Could they have done more? What I’ve just heard is music to my ears. Certain groups have been calling for the rating agencies to integrate ESG into their analysis and we’ve been highlighting ourselves the risk in certain sectors to those companies that do not adapt to the new environment.

We mentioned earlier the importance of transition. The coal industry in the US is a prime example of a financial risk to investors. That’s a very important point.

You mentioned earlier, pricing. I think that’s something worth dwelling on from an investor’s point of view because some people say, “Well, what are the benefits of Green bonds?” Of course, there’s a cost to a borrower from issuing a Green bond, but there’s also a cost to an investor in terms of the additional ESG analysis.

Some people say, “What are the positives for a borrower to issue a Green bond?” Some of those positives have been described as soft, such as the commitment to sustainability. Some issuers have reported, unexpectedly, that after they’ve issued a Green bond, morale within their entity has gone up because their employees have felt part of something.

A lot of the financial industry have asked, “What are the hard financial incentives for issuing a Green bond?” We’ve touched on one or two of them earlier, the fact that issuers can diversify their investor base, for instance. Additionally, Green bonds have been targeted to the responsible investment community, which tend to be long-term investors. The bonds tend to be placed in safer hands, if you like. Long-term investors don’t tend to react in a knee-jerk fashion to any news.

I think there are other attractions as well for issuers. For example, I think some medium-sized borrowers have found that they’ve been able to issue a slightly larger-sized bond if they’ve issued a Green bond versus a conventional bond. Similarly, some issuers have found that they’ve been able to issue a slightly longer maturity bond if they’ve been issuing a Green bond rather than a conventional bond. Also, some smaller companies with good credit metrics have been able to issue Green bonds. This all suggests that there are hard financial reasons or incentives to issue a Green bond.

In terms of pricing itself, most green projects are not normally the collateral. They are in a few cases, such as the Toyota Green ABS and the covered bonds that have been issued, but in most cases they are a use-of-proceeds type Green bond, which means that the issuing entity of the Green bond is the same as the issuing entity for the conventional bond. If the entity is the same, then the credit risk is the same. It follows that, if the credit risk is the same, then the returns should be the same. Certainly Green bonds shouldn’t yield any higher than conventional bonds. They should trade in line. The underwriting banks and the Green Bond Principles agree as well and they do price Green bonds flat to the conventional equivalent.


Nicholas Pfaff: I think what you were saying on confirming the hard benefits of Green bonds is very important because I don’t think we would have been able to be as explicit until fairly recently.

Nowadays, the decision for a company to issue a Green bond and the discussion between a treasurer, CFO and a CEO is facilitated by the fact that there is a real market track record. There is credibility in saying: “Well, actually there are real benefits for a company to issue a Green bond.”

On the wider question of incentives - and this could almost be a full panel topic in itself. There is a country where we have a full set of incentives: it’s China. China has rolled out tax breaks, subsidies for issuers, refinancing benefits etc. Some not only apply to Green bonds, but also to Green loans. It’ll be interesting to see the impact that these will have over time on the size of the Chinese Green bond market and generally on green finance in that country.

In other countries, there are debates on tax incentives for issuers. I don’t get a sense that this is something strongly requested by issuers. On the buyside, it’s very clear that there isn’t a problem with the amounts of money available. Quite the opposite. When you talk to investors they say, “Well, actually the problem is we don’t have enough projects”. Again, when you go back to the issuers they don’t say, “The reason there are not more projects is not necessarily because of a lack of tax incentives”. It’s more a question of figuring out what kind of project qualifies and looking at its feasibility.

To finish, there is a wider debate on possible incentives for Green bonds within the prudential framework.

When you speak to the policy community they say: “No, we can’t do that before you can prove to us that green assets are less risky” and “You need to give us 20 or 30 years of backdated data”. We say, “But the Green bond market is only 10 years old, and in any case climate change is a future event”.

It’s clear therefore that there are challenges to any green incentives being embedded in the future in the prudential framework, but if progress is made in integrating the impact of climate risk into credit ratings, for example, then that will perhaps help the debate move forward.

The other way of looking at it is to say, “Well, shouldn’t we be focusing on possible prudential disincentives for brown assets that will be negatively impacted by climate change or otherwise at risk of becoming stranded?” That is consistent with the prudential framework‘s focus on risk. On the other hand, implementing disincentives for financing brown projects or companies will raise other concerns and objections.


Nick Herbert: Robert, you wanted to come in on this one.


Robert Scharfe: Let me just add a word of caution here. From the viewpoint of exchanges, we spend a lot of time with the ESG profiles of companies and issuing guidance with respect to the UN-sponsored initiative on Sustainable Stock Exchanges. We are introducing our internal rules and regulations - minimum standards if you like - as to what companies need to comply with in respect to ESG criteria.

Mixing up ESG profiles of companies with Green bonds is where it gets tricky because with Green bonds we are not evaluating the ‘greenness’ or the overall sustainability of companies, we are evaluating the projects that are being financed. We have to be careful that we’re not mixing things here. I think we risk losing the investor in that process. The story is already complex enough for everybody when having to make an investment decision.


Nick Herbert: As you say, climate change is a forward issue. I would like to find out how we measure the impact of these projects and how do we compare across projects. Chris, what do you think on this? What’s the right measurement of impact reporting?


Chris Wigley: I think it’s very interesting that the Green Bond Principles this year have issued guidance on impact reporting for water because that is an area that wasn’t covered before. That’s a step in the right direction, but I think the key thing for us has been the development in carbon methodology. You may know that it’s law in France now for institutional investors and asset managers to report the carbon footprint of their portfolios.

We’ve developed a methodology, initially rolled out for equities and corporate bonds, but has more recently been applied to Green bonds, which has become a very useful tool for me as a portfolio manager. It’s thrown up some very interesting data.

We worked together with a carbon specialist in Paris called Carbone 4 and they did some number crunching to end up with figures for induced emissions, that is total emissions, and avoided emissions. The induced emissions are encapsulated in Scopes 1, 2 and 3. Essentially, Scope 1 is the production of a product, such as a car, Scope 2 is the energy involved in the production, and Scope 3 is the emissions involved in the raw materials and also the use of the car.

Induced emissions are just not enough on their own, however. If a portfolio manager wants a portfolio of low emission assets they could have a portfolio of financials or tech stocks. That’s not going to be in their interest. It’s not going to provide them with the sufficient diversification that they need, for example. Avoided emissions are crucial here.

Also, the data that were generated was interesting in that they showed us that the Green bond funds we manage are consistent with the plus-two-degree world, which is the commitment of most nations following the Paris agreement in 2015. However, comparing that with a mainstream index, such as the Barclays Global Aggregate, our team calculated that that index is consistent with a plus-four degree world. There’s some important information there for investors who have a choice between products.

Drilling down a little bit further, if we look at just induced emissions, we found that our fund was temporarily higher than the indices. That could be explained in terms of Green bonds and not just to do with carbon as they’re also to do with water and biodiversity as well, for example. In terms of avoided emissions, our team calculated that the Barclays Global Aggregate was responsible for about nine tonnes of CO2 per €1m invested. That’s just nine tonnes, whereas a Green Bond fund amounted to 212 tonnes of CO2 per €1m in terms of avoided emissions. That’s very significant.

Also, if we look into the numbers even further, we can see that of our top-five carbon emitters some were utilities, but there are also some utilities in our top-five avoiders as well. It demonstrated that the top three in the avoiders list were further down the road in terms of energy transition.

The last thing that it threw up was that we had an investment that was both the top emitter and the top avoider. That looks like a contradiction, but when you analyse it you can see the granularity of the approach and that, in some cases, bonds fund green transport. Green transport could include hybrid buses, which are better than diesel buses, but not as good as electric buses; hence the higher emissions. Then again, the issuer may also be funding renewable energy and energy efficiency, which is also high in avoiding emissions.

For an asset manager such as ourselves, security selection is very important and this is very useful additional information. We’re trying to construct portfolios of good credit quality, high quality ESG scores and good market returns, but ones with low emissions as well.


Nick Herbert: Thank you very much. Impact reporting, how much a part of that does it play in your business, Harald?


Harald Lund: We have for a long time encouraged impact reporting. It’s important for trust in the market. To us, what’s important is to have transparency on this in order to show progress towards the low-carbon and climate-resilient future. We see a lot of initiatives. We see that ICMA is facilitating discussions in this area. You also see that issuers are grouping together to discuss how they can do this. We think this is a great development.

The first initiatives created some indicators for how to report renewable energy. There are two sets of indicators: one on renewable energy capacity generation and one on emission reductions, but reporting on both is encouraged. I think that’s valid as we very much agree that keeping track of emission reductions is important.

Nevertheless, measuring emission reductions can be quite difficult. The methodologies that are used are complicated and in addition, the more indirect the emission reductions are, the more complicated it becomes.

What we see and what we encourage is to use what we call “green indicators” such as indicators for renewable energy and also for transportation. Measuring in these sectors raises issues; for example, should we have indicators on how many people are transported on emission-free transportation solutions, etc.? In the fossil fuel sector, you already know direct emissions and it’s therefore easier to calculate and report on the emission reductions.

For renewable energy, if you are part of a grid, which grid factor are you going to use? For example, if you talk about the Scandinavian countries or the Scandinavian region, is it the European region, or is it the country-specific grid? What kind of investments are required in order for to make the European electricity market to be a completely emission free market? You will need infrastructure investments and there are many actors that could claim emission reductions. If you are calculating emission reductions for more renewable energy you need to be transparent on the methodologies that you’re using. The more indirect the emission reductions, the more important it is to be transparent on methods used.

In addition, for small issuers it’s important that we don’t overcomplicate things and demand that they build up a lot of capacity on reporting. We should really try to show whether we are achieving some progress towards the transition, rather than force small firms to outsource reporting. One of the strengths of the Green bond market is actually that issuers are building capacity within the organisations and we want to encourage more of this.

That discussion is also a positive by-product of impact reporting. You are supposed to report towards some goals that have been set internally and then you need to understand what you’re reporting on. Dialogue is starting between the environmental and finance departments in these companies, sometimes for the first time. We’ve seen a lot of progress on how to make this work.


Sandrine Enguehard: It’s very interesting to see that we have an investor saying that through our portfolio of investment, we are measuring on impact and CO2 emissions, CO2 avoidance. Banks like Societe Generale have also made some commitments regarding their financing portfolio to the green scenario with regards to the two-degree target.

In the financial sector, more and more investors are measuring their carbon footprint, and it’s an even more complicated process to measure CO2 avoidance within a portfolio of investment than through a portfolio of projects. Every time we meet clients that want to launch Green bonds, and we are asked how do we measure and report on our CO2 impact, we reply: “Keep it simple, keep it very simple”.

The important point is to be transparent, clearly transparent. Keep it as simple as possible. Use some simple methodology to explain how you measure your impact, even if it’s not the most precise information. It brings confirmation of the positive impact. You should keep it transparent to allow investors to understand the way it has been done. The financial sector is already measuring and monitoring its carbon footprint. Clearly, it would be even easier to measure that on a portfolio of assets for a Green bond. That is the key point of the Green bond.


Nick Herbert: I’d just like to squeeze in another quick question on fragmentation. Is the rise of social and sustainable bonds a distraction from the ultimate aim of limiting climate change?


Sandrine Enguehard: We undoubtedly have clients in areas that present strong social benefits. Clearly, it’s something in which we want to support them and we want to help them to finance these kinds of project. It’s good to see that we have some Social Bond Principles. On the banking sector, financing SMEs, financing schools, education, etc. is an important activity for us. No, I don’t think it’s a distraction. Let’s just say all the investors are buying into it.


Robert Scharfe: I think that what you need to realise is what’s really going on in the market. When you’re looking at Green bonds or social bonds - and tomorrow we could be talking about blue bonds or any colour bond - basically what’s happening is we are raising capital in the markets and telling investors what is happening with the proceeds. You’re looking at the US$100trn fixed income market, one in which I spent a lot of my professional life. For those of you who have ever looked at the prospectus of a bond, you will have noticed the section: “use of proceeds”. The traditional response to this is “general corporate purposes”.

Now, for the first time here we are asking, “where is the money going?” Whether you call these social bonds or any other name, investors are basically asking this type of question.

It’s more than just a diversion from the climate finance-related issues. This is a new trend in the market. I think that soon, and I don’t know whether it will be in five years or in 10 years down the road, there won’t be any issuers that can raise money in capital markets without saying very clearly what’s going to happen with the money they want to raise.


Nicholas Pfaff: No, social bonds are an important and growing new market with dedicated and active issuers. Green projects also often have social co-benefits and vice-versa. That’s actually now explicitly reflected in the Green Bond Principles and the Social Bond Principles.

A number of issuers have also approached us and said, “Well, we do green, we do social. We’d like to bundle.” The Sustainability Bond Guidelines address this because they enable an issuer to put together in one transaction both green and social projects. This also drives market growth as it allows issuers that don’t have a critical mass of either green or social projects to achieve a threshold deal size to access the bond markets in one combined transaction.


Nick Herbert: I have the feeling there’s a lot more to say on everything we’ve discussed, but let’s bring this particular conversation to a close for now. Thank you all for your participation. 


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