Debt makes the world go round. It has built civilisations, funded technological and medical breakthroughs and kept armies stocked with the armaments that have changed the course of history.
Indeed, today the world’s debt pile stands at $307trn (£251trn), a figure which jumped by $10trn in the first half of this year. Lending money to corporates and governments has for centuries been used to change the world.
And it is needed once again, but this time to fund the most ambitious project we have ever faced – shifting the world o oil and gas and into cleaner alternatives, while trying to make the world fairer.
It’s not an easy task. Especially, when you read headlines claiming that it is too hot for solar panels to work or there’s not enough wind in the North Sea to drive the turbines. “Fixed-income markets are critical to funding the transition, as most of the funding will come from the debt markets, both sovereign and corporate,” says Scott Freedman, a fixed income portfolio manager at Newton Investment Management.
“This provides a growing number of opportunities for bond investors to help further the drive to achieve positive environmental and social objectives, even in an environment of several ESG headwinds,” he adds.
Historically, sustainability has been promoted in equity portfolios. However, this is changing as investors and their stake-holders believe that such a policy should stretch to all the assets they have exposure to. And different asset classes need different approaches.
“Although a lot of focus has been on the equity side, there are a number of tools on the debt side to do this. And those tools are becoming more sophisticated,” says Jonathan Lawrence, senior responsible investment analyst, active fixed income at Legal & General Investment Management (LGIM).
These include promoting decarbonisation and temperature-alignment pathways, while exclusions form a big part of how asset managers approach climate risk on the debt side.
“The other big tool, which is less appreciated, is engagement,” Lawrence says. “It’s important that we are engaging with companies in our debt portfolios to understand if they have a meaningful climate transition strategy in place.”
Not what it says on the tin
But debt which is labelled sustainable is not an end in itself. “We shouldn’t just look at a portfolio of sustainable debt and believe it is robust from a climate transition perspective,” Lawrence says.
“What it does is signpost that issuers are potentially moving in a certain direction, but we need to look at issuers in their entirety and not just their labelled debt,” he adds.
A portfolio of labelled debt cannot achieve net zero, Freedman says. “Labelled bonds, while an important and growing part of sustainable finance, must be considered on a case-by-case basis given greenwashing risks,” he adds. “They may not always provide credible and robust initiatives and targets.”
Many labelled bonds make furthering environmental objectives part of their framework, but other targets exist too, such as healthcare provision. “There is much more that needs to be done in order to try and achieve net zero, and shorter-term targets will be an important part of that,” Freedman says.
Yet just because a company has not issued any green bonds does not mean it isn’t mobilising capital into green projects. “That would be more important to consider than a brown issuer who uses a green bond to fund a small amount of capex,” Lawrence says.
In the conventional debt market, engagement sets the expectations for companies in terms of their strategy and making sure robust governance and accountability is in place. “That’s more important than the label on the bond,” Lawrence says.
Different shades of green
But could a portfolio of sustainably labelled debt make an investor appear to be greener than they actually are?
“That’s definitely a risk,” Lawrence says. “The tension in the market has always been around governance and whether or not the barriers to entry should be higher to issue sustainably labelled debt without hindering efforts to mobilise capital towards green activities.
“LGIM’s position has always been to focus the analysis at the issuer, not just the instrument, to make sure the bond, and the portfolio, reflect a genuine move towards the transition and not just a chance for greenwashing,” he adds.
Freedman says that it is “likely” sustainable labels make portfolios appear greener than they truly are, and warns: “You need to analyse issuers on a case-by-case basis,” he adds. “We need to be careful about label chasing.”
With a limited supply of green bonds, the main option for institutional investors is to make mainstream debt more sustainable. “Issuers, both sovereign and corporate, are under much greater scrutiny in terms of behaving as responsible citizens,” Freedman says. “This raises the level of granularity around sustainability initiatives that a broad range of stake- holders, including bond investors, expect to see.
“This introduces a greater level of accountability, a type of trust or covenant in place between issuers and investors. In turn, this leads to greater bondholder engagement, ESG analysis, tracking of ESG performance and will increasingly impact issuers’ cost of capital, especially for ‘sin’ sectors,” he adds.
A test of quality
Transparency on non-financial factors by issuers varies, Freedman says. “As you would expect, there is a greater level of disclosure by listed companies and those in jurisdictions with stricter regulatory regimes.
“We also see pressure on asset managers to make disclosures that are not always being provided by underlying issuers in portfolios,” he adds.
Transparency on ESG performance is improving thanks to a “huge wave” of regulation, Lawrence says. “But we still have an issue with the consistency of reporting and the end-use case for the investor.
“Again, I would tie that back into the case for engagement where we need to understand the nuance and context of the business model and how a company plans to become more sustainable. Disclosure is necessary, but being an end in itself is not sufficient,” he adds.
An independent view
With the standard of disclosure needing to improve, it was dis- appointing to hear in August that S&P would no longer report
ESG scores alongside its credit ratings. Could this be a sign of how hard it remains to prove that investors cash is making a positive difference? “I don’t think so,” Lawrence says. “That probably represents more of a misunderstanding of what ESG ratings are there to do. In the case of S&P, they are a credit rating agency and their decision to remove the ratings reflects their ability to translate ESG data into a material credit rating impact. What they have done is kept their qualitative analysis in terms of explaining where ESG risks could potentially impact the rating.”
The bigger challenge is people’s understanding of what ESG ratings are, how they’re constructed and how to use them. For Lawrence, ESG ratings are a subjective analysis of how companies are managing sustainability risks and opportunities. “But where these ratings become hardwired into portfolios, then we need to take care with how the rating has been constructed, what is the methodology.”
While such data can be useful, perhaps this is a positive move, in that the lack of consensus among providers could be confusing. Freedman says that such divergence among ESG rating providers mean that you cannot take such ratings seriously. “It is just part of the mosaic of information.
“We do not rely on data providers’ methodology but on raw data, and then draw our own conclusions,” he adds.
“The unfortunate thing about a conventional credit rating agency no longer reporting ESG scores alongside its debt ratings is the message this gives to issuers,” Freedman says. “Having that data published increases the level of scrutiny and accountability on issuers – and having a more explicit link between ESG factors and a conventional-credit rating does impact market pricing, thereby encouraging issuers to strive to be an ESG leader if it results in a possible lower cost of capital.”
For investors with sustainable goals, their debt portfolios must reflect them, matter who they are lending to. This includes corporates or sovereigns, which have similarities but offer investors different exposures.
First of all, the number of sovereigns is fixed, unlike in the corporate world, which is constantly changing. “We have a lot more information about the world’s sovereigns and there’s lots of ESG data that has existed for a long time. In a sense, measuring ESG risk for sovereigns is easier than for corporates,” Lawrence says.
“Where it gets trickier for investors is on the engagement side. As a significant holder of sovereign debt, we are an important stakeholder to governments. We can therefore use this leverage to influence policymakers to address ESG risks and opportunities. However, there are challenges which can limit our influence, including structural features of the sovereign debt market.”
And investors need to have influence over governments if they are using their money. “There are challenges and barriers that we need to overcome in the sovereign market with respect to what sovereigns are doing on the ESG side,” Lawrence says.
Behind the rate
Have rising interest rates had an impact on the sustainable terms of debt? “Not really. Issuance looks quite robust,” Lawrence says.
In September, labelled debt on the active side of LGIM’s investment universe was about 8% of the index. In 2020, it was around 2% to 3%.
“When issuers come to market, we are seeing a lot of momentum behind the labels. So, the macro conditions could play through in terms of issuance trends in general,” Lawrence says. “But we are seeing a lot of appetite to use the labels on bonds, and increasingly, a greater breadth of issuers are coming to market with this form of debt.”
However, Freedman says the volatility in the bond market resulting from the fast pace of rate hikes by central banks has led to a slower pace of sustainable and broader bond issuance.
“As we have seen lately, there is a gradual realisation amongst companies and governments that decarbonisation ambitions are important but not at any cost,” Freedman says. “We are seeing timeframes therefore extend and policy-backtrack from governments. The cost of achieving the transition has been increasing not only due to higher funding costs from higher rates, but also from persistently higher inflation. Within this is more acceptance of the need for climate adaptation as well as mitigation.”
When it comes to lending your capital to corporates or governments, the important point is that it is not about where they are today, but where the capital they receive will take them.