Sustainable debt today and tomorrow

Sustainability in the debt market is already too big a subject to ignore. To close the first-ever full-day KangaNews Sustainable Debt Summit, which took place in Sydney in March, a panel of market specialists discussed the purpose and prospects of their sector.

PARTICIPANTS

Pablo Berrutti Head of Responsible Investment, Asia Pacific COLONIAL FIRST STATE GLOBAL ASSET MANAGEMENT
Marcin Bill Senior Financial Officer INTERNATIONAL FINANCE CORPORATION
Katharine Tapley Head of Sustainable Finance ANZ

Sarah Thompson Senior Manager, Environmental Affairs ROYAL BANK OF CANADA
Amy West Director, Debt Capital Markets and Head of Socially Responsible Finance TD SECURITIES

MODERATOR

Laurence Davison Managing Editor KANGANEWS

PRIVATE-SECTOR DRIVERS

Davison The Australian political sphere is not exactly leading the way on environmental policy. Can we expect to see this transition to appropriately valuing externalities if we are solely reliant on the good faith of the private sector to do so?

TAPLEY I think there has to be a role for both the private and government sectors. Personally speaking, I think it would be great to have a bit more policy certainty in Australia – especially from an investment perspective. This gets talked about a lot.

On the positive side, I think there are winds of change in this regard. The Australian Prudential Regulation Authority (APRA) has made statements about sustainability, and I’m prepared to bet there will be some form of regulation coming from APRA in particular around low-carbon transition as a financial risk. APRA is also in conversation with other regulators about these issues.

There are potential incentives coming in the policy arena, and the private sector certainly can’t rest on its laurels. We have access to very large pools of liquidity as well as resources and expertise – all of which we need to leverage. We can do so a lot more efficiently than government, so I think we have a significant role to play.

BERRUTTI There is an onus on institutions that comes from a failure of governance and the deterioration of people’s faith in institutions to deliver the outcomes society increasingly expects. This is happening around the world, but you only have to look at the royal commission into the banking sector to see that it certainly applies in Australia too.

The private sector needs to lift its game, and as allocators of capital we have a very special responsibility and duty to direct capital to productive purposes. We learned during and after the financial crisis that this had not been happening, and the financial casino didn’t serve anyone’s interests – including, in the end, those of our own industry.

What I’m saying is that it goes beyond a good faith exercise. Australia has four major banks, and in this context the banks can no longer afford – if they want to maintain their social licence to operate – to assume that resolving ESG issues is the government’s problem. The banks, and markets, have to be a constructive partner.

“As allocators of capital we have a very special responsibility and duty to direct capital to productive purposes. We learned during and after the financial crisis that this had not been happening, and the financial casino didn’t serve anyone’s interests.”

WEST I completely agree – and I think we need to move away from any sense that government is going to solve these challenges. Globally, what has typically happened is that the private sector has led and government has followed. It’s rare to see a government coming up with an innovative solution that hasn’t already been proposed by the private sector.

If you believe, as a financial institution, that the greatest societal risk for the next 50 years is climate change you have to be doing something as an institution or you are doing something wrong. It has to become part of every firm’s DNA, and on this basis I think government will inevitably be struggling to keep up.

BILL I think it’s important in this context to note that I don’t believe the ESG market is in its early development stages anymore, though I agree that it still has a way to go. We are talking about a market in which there was US$130 billion of green bonds issued last year having seen its first issuance in 2007 – clearly it has evolved greatly.

The breadth of the market is important in this context. The supranational sector is now just 20 per cent of issuance, approximately, and we see significant volume now from corporate and financial-institution issuers and in asset-backed securities.

The bigger picture is how we use this market to tackle issues. With global warming, for instance, greenhouse-gas reduction clearly relies on sovereigns to develop and follow plans. There need to be broader incentives to allow the capital markets to play their role – for instance tax incentives or preferential capital treatment for lending directed at green or social projects.

But the best way to incentivise growth is market pricing. Contrary to some investor views, the cost of issuing green or social bonds isn’t just administrative. There is headline risk when you issue a green or social bond, because as an issuer you are exposing the projects you are financing in a very transparent way.

There are also opportunity risks, because the reporting you are committing to takes a lot of time and scrutiny to prepare. There might be a window of opportunity in the market that would be perfect for a vanilla trade, but for a green or social bond we have to wait for a report prior to issuing – and the opportunity might have passed.

I would like it if investors took these factors into account more, especially given the outperformance we have seen in secondary pricing for ESG bonds. Investors are effectively buying ESG product in the primary market on par with vanilla bonds and expecting to make a bigger return from secondary outperformance.

We believe the role of the World Bank Group entities, including IFC, is through market creation and catalytical development, and also to promote awareness of outperformance and the additional risks on the issuer side. In this way, in the end the primary market will offer tighter pricing.

We are seeing this already in US dollars. We issued a US$1 billion green bond in October last year and achieved a price 1 basis point or so tighter than we would expect for a regular bond.

“There are wider pressures coming into the market that will in time drive investors away from companies that aren’t prepared to offer transparency. This is how we will get to the pricing advantage. I firmly believe that, in the long term, the ‘bad’ assets simply won’t get a price.”

Davison Why aren’t we seeing more pronounced improved pricing outcomes for green product if, as market participants say, there is more liquidity available for this type of security? When will supply and demand dynamics start to have a real, and significant, impact in the sense of providing cheaper and more abundant capital to ESG assets?

WEST I think this is already happening, though it depends on what market you look at. By all accounts, the ANZ Banking Group sustainable development goals (SDG) bond in Europe priced well through the bank’s curve – by 5-10 basis points. This isn’t a isolated result in Europe.

We are seeing the same thing in the US, though not yet to the same extent, and it’s also visible in the Nordic markets. It may not be happening as often in markets like Australia and Canada, but I think it will – provided demand continues to outpace supply.

BILL This matches our experience as an issuer. We also get access to maturities and currencies that might not otherwise be available. Obviously this is all subject to market conditions at the time of a specific bookbuild, but the trend is definitely there.

TAPLEY I should put the ANZ SDG pricing in context. We hadn’t issued a five-year, fixed-rate euro-denominated benchmark for 10 years and I don’t think any Australian bank had issued recently, so it is a little hard to draw strong conclusions about relative pricing. What I would say is that the deal priced a couple of basis points better than what we expected, and the that format was very well received.

As well as wanting to return to the European market, a key rationale for the deal was that we felt Europe would provide best access to specialist investors for a product with a broader scope than a green bond. We were looking for investors with a deep understanding of what we were doing and why we were doing it, including new investors – diversification is always a driver for these transactions. In the end, about half the book came from green or deeply green accounts, which was a really fantastic outcome.

The other main reason for issuing an SDG bond was the connectivity to our own business strategy, with which our sustainability strategy is intertwined. It’s all about who we’re banking and why, and mapping the pool of loan assets to the SDGs to demonstrate the impact we have with our core activities.

Davison Would an issuer like IFC ever require equivalent green-bond pricing from a market like Australia? In other words, it would only print if a jurisdiction could match global green pricing rather than just global levels for the mainstream curve.

BILL It depends. The Australian market is strategic for us and we will continue to print here regardless, barring unforeseen structural shifts like a mass departure of capital from the market. Otherwise, we would even be prepared to pay a small premium to maintain a curve in Australia.

In fact, as a supranational we are required from a ratings perspective to maintain at least two active yield curves. For some this means US dollars and euros but for many, including us, it is US dollars and Australian dollars or euros and Australia dollars.

We also have positive views on the development of the Australia market for ESG and thematic bonds. So we want to be in this space in Australia.

Davison There has been some recent research suggesting companies that are broadly perceived to be green or sustainable may get what’s called a “green halo” effect of better-priced debt across the business – whether or not it is specifically green labelled. Do panellists have any view on this concept?

TAPLEY I think a key advantage of issuing green bonds or loans is the fact that an issuer is going into the market with a clear statement of what it is and what it stands for, and of its willingness to provide additional transparency to prove it.

There are wider pressures coming into the market – things like the Task Force for Climate-Related Financial Disclosures and the European Commission’s action plan for sustainable finance – that will in time drive investors away from companies that aren’t prepared to offer that transparency.

This is how we will get to the pricing advantage. I firmly believe that, in the long term, the ‘bad’ assets simply won’t get a price.

Defining sustainability

At this relatively early stage of its development, the sustainable debt market continues to hone its precise purpose and goals. The highest-level question is, quite simply, ‘what is this for?’

DAVISON It seems to me that if we wanted to come up with a single theme or title that captured everything going on in the sustainable finance world we might not be able to do any better than ‘internalising externalities’. I’d like to start by asking panellists what they think of this hypothesis.

BERRUTTI That’s always the way I’ve thought about it. As various issues begin to bite, and to do so in a very serious way, the ability for private organisations to externalise costs onto society reduces. Eventually, it will be put an end to entirely – whether it be through consumer preference change, regulation or some other means.

This view hasn’t been fully embraced by the industry – it’s still very much about valuing the impact of a particular environmental, social and governance (ESG) issue. But we are starting to see the interconnected nature of these issues, particularly for highly diversified investors like ourselves, making it harder to divorce the impact of externalities from portfolio performance.

THOMPSON I think understanding second and third order effects of what we are doing boils down to good risk management. Pricing risk is one way of internalising externalities from a corporate sustainability perspective.

WEST When we’re talking about pricing risk in capital markets, there is a key argument in the sustainability space that we won’t reach our goals if we make it just about green, social or sustainable bonds – it has to be more holistic.

As it becomes so, sustainability becomes central to how we price risk and how we think about it. So far, I don’t think we have appropriately factored in the nature of the risks we are talking about – on either the issuer or investor side.

TRANSITION FINANCE

Davison How do panellists think about transition in the sustainable-finance realm? Should we be ‘rewarding’, for instance, companies that are currently large-scale polluters but have clear and credible transition plans in place?

THOMPSON Our environmental strategy has a significant focus on how we can support clients in the transition. Canada, like Australia, is a resources-based economy with a very important energy sector, and Royal Bank of Canada is Canada’s leading energy bank – so we can’t just walk away from the sector.

What we want to do is work with our clients to identify which are appropriately identifying risk and managing opportunity, deepening our relationship with these clients to help move them along the transition.

The focus is, and should be, very much on the ‘middle piece’ – transition – for companies within climate-sensitive sectors, versus focusing exclusively on the ‘end state’ of clean companies. Of course we want to engage with those companies and reward them, but we don’t want to focus on them to the exclusion of the middle.

BERRUTTI Our clients are largely institutional so we haven’t been subjected to divestment campaigns, at least not directly – though our clients have, and we have been asked questions as a result.

We have had a global resources team for the past 20 years, and over the past three or four there has been a marked change in the way it approaches investing in resources companies. It has completely stopped investing in pure-play coal companies, for instance, and started investing more in resources linked to energy transition. The opportunities being sought are those that come from a very significant transition in our economy.

We talk to our clients about this all the time, but we have to be able to demonstrate it through the makeup of portfolios and how we vote as shareholders at company meetings.

The same applies to the composition of bond portfolios. Our fixed-income team has put in place a stranded-asset test, because even though bond investments are for a fixed term we recognised that some longer-tenor investments are starting to have significant stranded-asset risks. Pricing doesn’t really encapsulate this risk at the moment, so we put in place an additional test that comes up as a red flag when portfolio managers are taking risk decisions.

These examples and other ways we show our clients what we are doing are all about having good processes in place and good governance around them, being able to demonstrate that these form part of our decision-making process and the nature of our engagement with the companies in which we invest.

There is a tendency to try to make things seem a bit ‘greener’ than they really are in the industry, but we try to keep perception and reality as close together as possible. We have to be humble in this respect from a reputational perspective, making sure we aren’t overstating our progress.

“The focus is, and should be, very much on the ‘middle piece’ – transition – for companies within climate-sensitive sectors, versus focusing exclusively on the ‘end state’ of clean companies.”

Davison Is it harder to martial capital for a coal mine that wants to become a wind farm than it is for a wind farm – and should it be?

TAPLEY I don’t think it is, and in fact I think there is great awareness among institutional investors about the importance of investing in transition. Investors ask us a lot if they can see more of this sort of opportunity, because they want to be stewards of capital and have engagement with the transition story. Green and sustainability bonds allow investors to have this engagement, and in general my sense is that transition is highly investable.

WEST The challenge right now is that when you talk about the green market to the utilities and energy sector there is still a focus on the renewables portfolio. We have to shift the conversation from financing a company’s renewables portfolio to financing its whole portfolio.

There is also a lingering sense that issuers have to ‘fit the box’ – for instance that if you are a utility or energy company coming to the capital market you have to do so with a green bond. I would love to see a company from this sector come to market with a transition bond. This would be something we could easily report on and measure the impact of, and the product doesn’t have to be all or nothing.

It’s also a bigger story than just the energy sector. We are so apt to pick on energy, and yet this sector in my experience actually has some of the best developed plans to manage transition to a two-degree world. If you look at some of the other sectors – like West Coast tech in the US – there is no plan. They just view themselves as ‘progressive’. A lot of industries have room for improvement.

TAPLEY This is a great point, and it’s where I think morphing beyond green and low-carbon transition to sustainability more generally is really helpful. Whether it be through SDGs or the social-bond principles, this will allow a lot more issuers to come to capital markets and a lot more scrutiny beyond the energy sector.

BERRUTTI Just to pick up on the example in the question, I have to say that it would be mad to give money to a coal miner to become a wind farmer. You have to look at the skills and governance of the organisation to gauge its ability to make such a radical transformation. I think one of the big debates we are going to have over the next decade is about whether certain companies should just give capital back to shareholders rather than burning it looking for more fossil fuel reserves or attempting to fundamentally change the nature of their business – away from its skill set – which just doesn’t make any sense.

This isn’t the same for all companies, and utilities are a great example of a sector with the flexibility to transition its energy portfolio from fossil fuels to renewables. This is a much better story and one to which investors should be more comfortable allocating capital.

NEXT STEPS

Davison What do panellists think will emerge in the sustainable-finance space in the next 12 months that may not be on the radar right now?

TAPLEY I think the green-loan market is about to catch fire. Interestingly, we’re seeing a lot of the driving force for this coming out of Asia. In the last 3-6 weeks we have seen large syndicates pricing loans with – small – step-down incentives for achieving sustainability outcomes over the period of the loan. There are also some requirements around transparency and disclosure.

The Loan Market Association is just about to release its green-loan principles, which are being formulated based on the green-bond principles. I think these will take hold quickly when they are published, because banks are also looking at ways to demonstrate that they are lending to the right industries and companies – that they are, in effect, cleaning up their balance sheets.

WEST I agree that green loans is a really good one to watch. I also think green mortgages are interesting. Not necessarily at covered-bond level, but working towards being able to determine at a base level whether a mortgage is green. The standards will vary from country to country, but if we can crack the code on this I think it will unlock a whole new segment of the debt market that we haven’t quite been able to access in scale as yet.

“We are so apt to pick on energy, and yet this sector in my experience actually has some of the best developed plans to manage transition to a two-degree world. If you look at some of the other sectors – like West Coast tech in the US – there is no plan. They just view themselves as ‘progressive’.”

BILL I am looking at harmonisation of guidelines, green policy support, more sovereign issuers – and hence more transparency and visibility of the asset class – and, hopefully, more countries declaring greenhouse-gas reduction strategies. I would also like to see more tax incentives, which I think will make a big difference.

BERRUTTI I have two. One is cracking the nut of aggregating small assets and social impact efficiently, and being able to issue bonds of the back of that. We have various systems, including but not limited to energy, that are moving from centralised to distributed, and as yet no-one has worked out how we can we can finance distributed solutions at scale. Doing so is critical to achieving the sustainable development goals and having something for us to invest in.

The other point is the growing diversity of issuance. We are starting to see this with things like gender or SDG-aligned bonds, and I think we will increasingly break out beyond the green prism.

THOMPSON I love the possibilities of green loans, but when I think about RBC’s perspective what sits front and centre is innovation and technology, and how we can bring the capabilities we are developing as a bank to the table in environmental and societal challenges. We sit on a huge amount of data as a bank, so we are exploring how we can use things like machine learning, artificial intelligence and blockchain to better serve our clients and also, more interestingly, to provide better advice.

We are looking at things like climate-risk analytics, using geospatial data to help our clients better understand their own climate risk. The possibilities are very exciting.

“Contrary to some investor views, the cost of issuing green or social bonds isn’t just administrative. I would like it if investors took these factors into account more, especially given the outperformance we have seen in secondary pricing for ESG bonds.”