The growth of ESG in fixed income

In a series of roundtables hosted by Lloyds, Sustainalytics and the PRI, fixed income issuers and investors discussed the growth of ESG in the market. The main discussion points were:

On the importance of ESG in fixed income:

  • Evidence that ESG is here to stay in fixed income:
    • It has now reached too great a critical mass and gathered too much momentum to be a passing phase.
    • Equity came to ESG sooner than fixed income and is still seeing growth.
    • The next generation of asset owners place greater importance on ESG than their predecessors.
    • ESG considerations are already more prevalent than they might appear, as portfolio managers will often price in ESG risks without explicitly labelling it as an ESG decision.
  • Within ESG, governance risks have historically been the ones most linked to returns, but environmental risks are seen as the biggest future concern.

What investors want from ESG bonds:

  • To buy into a philosophy, rather than a one-off project. They are looking for bonds from ESG-aware issuers, rather than isolated ESG bonds from otherwise uninterested companies. There is disagreement on whether this should extend as far as blacklisting certain sectors (e.g. coal, oil, gas), or whether an ESG bond from such a company should be supported.
  • A clear and detailed explanation of how the use of proceeds relates to ESG:
    • What type of ESG impact will be delivered?
    • How important is the bond to this happening? Ideally investors want projects that would not have happened at all without the bond financing.
    • How big is the ESG impact proportional to the issuer’s respective activities? e.g. How much of a CO2 saving compared to the company’s overall CO2 output?
    • Does the bond represent a wider transition towards the issuer considering ESG factors?
  • Easy access to information from issuers, particularly regarding targets.

Benefits for issuers from ESG bonds:

  • Lower funding costs in the long term. Investors will increasingly consider issuers who have not taken ESG factors into account to be by definition riskier.
  • A diversified investor base.
  • An opportunity to engage with investors on ESG factors.
  • Greater internal discussion of ESG considerations.

Threats to ESG in fixed income:

  • Price – Some investors worry that lower returns are inherent to ESG bonds due to the additional compliance involved for issuers. Others attribute any price difference to current supply and demand levels. Either way, investors say fiduciary duty means they cannot justify lower returns purely for ESG reasons.
  • Greenwashing – Investors fear reputational risk from investing in ESG bonds that do not meet specified standards. Standardising documentation, processes, reporting and benchmarks is seen as the key preventative measure, which could be paired with the option to penalise issuers with margin step-ups if they don’t follow through on their commitments.
  • Reporting Methods – Social and governance factors can be difficult to measure, and for some factors, particularly environmental ones, there can be differences of opinion e.g. is nuclear power green?
  • Communication – Issuers say they generally don’t know if a bond’s lack of ESG compliance has caused an investor to turn it down. They also suspect that investors often don’t read their reports.
  • Credit Rating Agencies – The rating agencies do not explicitly report on ESG as a category. Individual risks get considered, but the attention paid varies by sector e.g. for high yield credits, governance factors may be considered more fully, while for utilities, environmental impact may be. The agencies are working on standardising ESG ratings.
  • Integration – There is a difference of opinion over to what extent ESG bonds should be shaped into a distinct asset class, and to what extent ESG considerations should be integrated into business as usual.