Environmental, Social and Governance (“ESG”) is in the press lately and, in most instances, for all the wrong reasons. Respected commentators, as well as market participants, are casting doubt on the fundamental logic underlying this new market. This note briefly explores the challenges facing this nascent asset class through the lens of global bond markets. What are the implications for bond market pricing if the current understanding of ESG was to be reformed? And with global markets operating on very different bases with respect to ESG, what might that mean for bond market integrity?
ESG criteria are designed to assess investments beyond financial goals, focussing on responsible and sustainable business practices. ESG considerations have worked their way into every part of financial markets with an unstoppable momentum. By 2025, according to Bloomberg Intelligence, ESG assets will exceed USD 50 trillion and would then represent more than a third of the USD 140.5 trillion total assets under management globally. ESG is the fastest growing segment of the asset management industry, bar none. Corporate credit bond markets have been in the vanguard of this sustainable funding charge. Corporate bond issuers agree to route debt proceeds to internal ESG activities, thus allowing investors to badge their investments as sustainable. Reuters calculates that sustainable finance bond issuance in 2021 totalled USD 859 billion, up 61% on 2020. In the Euro markets alone, 26% of the corporate investment grade new issuance bonds in 2021 were badged as sustainable.
It is not only care for the planet, and society more generally, that is driving this momentum. The premia on bond spreads for ESG issuance is growing. Bank of America estimates that investment grade ESG bonds have, on average, priced 2.4 basis points tighter in the primary market compared to non-ESG bonds over the last four years, a substantial saving in interest payments. In other words, bond investors are prepared to accept lower coupons for ESG debt versus non-ESG debt, a significant financial consideration for the bond issuer.
Recently, however, doubts have been cast on the fundamental logic underlying this new market. Extreme views continue to question even the science behind climate change. More moderate voices express concern that the flexibility in ESG definitions results in ambiguity which then erodes confidence. This in turn leads to accusations of greenwashing.
A confusing picture – ESG in question
On April 21st this year, the Governor and legislature of the State of Utah, plus two US senators, penned a letter to S&P Global Ratings (a credit rating agency), referencing the inclusion of ESG credit indicators in Utah’s credit rating. They demanded that ESG factors and considerations be excluded from their credit rating saying that they were “demonstrably unproven” and legitimised “a dubious and unproven exercise in developing a political ratings system that is based on indeterminate factors”. The letter further commented that ESG issues “are not technocratic questions; they are normative questions…no financial firm should substitute its political judgments for objective financial analysis”.
The State of Idaho issued their own letter on May 18th stating that “ESG credit indicators and their methodology reveals an opaque process that is impossible for any government or political subdivision to objectively evaluate”. The Republican party has recently said that if they take back control of Congress in the upcoming mid-term elections, they will immediately introduce legislation against ESG to encourage financial markets to re-embrace fossil fuels.
Meanwhile in Europe, the direction of travel couldn’t be more different. The Sustainable Financial Disclosure Regulation (“SFDR”), which started to apply from March 2021, imposes mandatory ESG disclosure obligations on asset managers and other market participants. The EU’s new Taxonomy Regulation acts as a prescribed manual as to what is and what is not ESG. In other words, an official classification of economic activities that are deemed environmentally sustainable by the EU.
If market participants thought that they could ‘dabble’ in ESG without any consequences, they were mistaken. On May 31st, 50 German police officers turned up to the offices of DWS, the tenth largest asset manager in the world, to investigate what Frankfurt public prosecutors’ office called “prospectus fraud” because of greenwashing allegations.
So what are the implications for asset managers who are organised globally and the broker dealers who negotiate and execute new bond deals? With global markets operating on very different bases with respect to ESG, and with varying rates of adoption, the risk of market disruption is real. Different countries, social and political ecosystems have very different views on this subject. It can lead bond market participants to feel that they are stuck between a rock and a very hard place.
Bond markets – sustainable arbitrage
Bond markets function efficiently when: 1) there is a common and shared understanding among all participants of the rules of engagement; and 2) when there is an equal and unfettered access to information as to factors which might affect the initial and ongoing pricing of a bond.
In the bond new issue stage, this second point includes the independence of credit ratings, all aspects of the bond documentation as well as the primary pricing dynamics. Initial pricing is critical as it establishes a framework of credit peers against which the new bond issue fits. Aside from pure credit considerations, structural aspects such as debt ranking and subordination also matter. ESG factors bring an additional layer of structural complexity to primary pricing considerations. Without clear or globally uniform methods of assessing ESG factors, there is a real risk to bond market integrity.
The International Capital Markets Association (“ICMA”), through its Sustainable Bond Principles, has gone some way to standardise new issuance principles. This ambition to create a level playing field among the very broad range of ESG considerations is laudable. A critical problem emerges when investors in the secondary markets require detailed reporting as to whether a company is actually delivering on those commitments. Have my investment funds actually been deployed as promised and what impact are they having? To date, this information is patchy and of questionable quality with much industry and regional variance.
Secondary bond trading markets, which typically serve as an efficient ‘clearing house’ of arising news on an individual company, can find it difficult to accurately price in progress towards sustainable commitments. This in turn has a direct bearing on market integrity. Furthermore, US credit markets do not have such issuance principles and, in the absence of a globally recognised baseline for sustainability standards, there is a risk that regional anomalies in bond pricing emerge.
When a certain group of investors support and endorse an ESG approach, and another group doesn’t, and when a patchy information flow exists to validate ESG commitments, there is a real risk of ‘sustainable arbitrage’.
The case for ongoing reform
There has been a rush, at times an undignified rush, among investors and issuers to get on the correct ethical side of arbitrarily defined ESG lines and perimeters. These activities are now being called into question owing to inconsistent monitoring of commitments and varied reporting regimes. There is a pressing need to formalise the bases for ESG issuing and investing and have them globally accepted. Otherwise, markets will undervalue ESG factors in bond valuations which could ultimately lead to discouraging issuers from raising the very large sums that are so necessary for climate change transition financing.
There is a small but growing view that the ESG project has maybe been too ambitious in its objectives from the outset. One solution might be to split apart the E, the S, and the G to analyse and score company adherence on separate bases. After all, these are very complex categories in their own right. Assigning one ESG score on matters as diverse as a company’s carbon footprint to the gender and ethnicity makeup of its board members is a very blunt instrument.
Nonetheless, there are some positive signs emerging. The International Sustainability Standards Board (“ISSB”) was established at COP26 in Glasgow in November 2021. Their remit is to establish a comprehensive global baseline of sustainability disclosures focussed on the needs of investors and the financial markets. While the EU is leading the debate, the US Securities and Exchange Commission (“SEC”) has also proposed disclosure requirements. However, measures need to be agreed globally, so that they all apply equally in every financial market jurisdiction and can be policed and regulated in order to mandate adherence.
Given the polarising nature of the global ESG debate, it will not be easy to secure universal acceptance of one set of ‘true north’ principles, yet it is vital that agreement is quickly found. McKinsey calculates that spending on physical assets between now and 2050 to achieve net-zero emissions will be an additional USD 3.5 trillion annually. Financial markets urgently need a stable foundation from which to embark on this herculean fundraising challenge.