Establishing global standards is crucial to avoid the fragmentation and tiering of different types of ESG bonds that could deter investors as issuance soars to fund the energy transition, according to Newton Investment Management.
“Our view is that the market needs a clear framework with consistent standards across regions of the world, which would help investors to compare and contrast issuers and bonds and better hold them to account,” said Scott Freedman, a fixed-income analyst and portfolio manager at Newton.
Regulators are driving the sustainability agenda by developing rules and taxonomies, but as policy evolves, there is a need to implement minimum standards as issuance continues to rise.
Standard Chartered expects annual issuance of green, social, sustainable and sustainability-linked bonds to reach US$1.7trn this year and US$4.2trn by 2025 while NN Investment Partners expects issuance of use-of-proceeds labelled bonds to hit €1.1trn this year.
Fragmentation and tiering is already being seen in some labelled bond categories – for example, between green bonds that are issued under the International Capital Market Association’s green bond principles and those issued under the European Union's Green Bond Standard (which is aligned with the EU Taxonomy).
A distinction is also emerging between sustainability-linked bonds that meet ICMA’s principles and SLBs with environmental science-based targets.
This divergence is creating problems as fund managers need more consistent frameworks and standards to benchmark and compare companies and sovereigns as taxonomies become increasingly political.
The impact of new criteria such as the EU Green Bond Standard on existing and new ESG portfolios is no less confusing.
“Do you grandfather the old green bond funds? Can you still market a structure that is not EU GBS but is within the EU under ICMA? Do new green bonds reference science-based targets now?,” Freedman said.
Newton is part of BNY Mellon Investment Management, which has US$2.4trn of assets under management.
Greenwashing risk
Developing more new ESG labels could increase the risk of greenwashing, particularly as green and social bonds are not yet linked to companies’ ESG strategies and do not carry penalties for failing to deliver.
“We think that if these bond structures contained some of the same covenant tests as the newer sustainability-linked bonds, the risk of greenwashing would be lower,” Freedman said.
Investors are looking for information on borrowers' funding rationale to avoid those merely paying lip service. “We have often heard a representative of company management, for example, comment on how the main driver for issuing a labelled bond is to attain a lower cost of funding owing to the halo effect of being considered a responsible corporate citizen,” Freedman said.
Investors are also following up and testing management teams and governments on sustainability pledges on a one-to-one basis but this engagement could be more effective if bond investors collaborate and work with equity investors' groups such as Climate Action 100+.
“We still do not see much progress from an industry-wide perspective in terms of credit and equity investors working together on ESG issues. ESG is where bond and equity investors align,” Freedman said.