Sustainable finance is at an inflection point. It has enabled companies to fit their funding to tackling the critical challenges of the ongoing climate and biodiversity crises. Now, sovereign states, in issuing green bonds, are completing the mainstreaming of financial instruments whose pricing is connected to sustainability targets. This is an enormous step forward for the transition to a truly sustainable global economy, and one with huge ramifications for issuers and investors.
The impact of sovereigns, supranationals and agencies (SSAs) issuing sustainable bonds in volume will be transformative but these are markets evolving on almost every front. On top of the arrival of state issuers, corporate issuers and investors will have to respond to the development of credible science based sustainability KPIs, a surge in the volume of market participants and the standardisation of regulation and disclosure methodologies.
In a market moving this quickly, every quarter feels revolutionary and the next few months of 2021 will be particularly challenging.
Greening Governments
In November 2021, governments will convene at the 26th UN Climate Change Conference of the Parties (COP26) in Glasgow, UK. This is a critical moment in the world’s attempts to meet the Paris Accord and limit warming to 1.5 degrees Celsius. The urgency of the task is underscored almost daily as evidence of accelerating warming becomes more obvious and the impact – from anticipated droughts in Central Europe and the US, to ocean acidification and wildfires – alarmingly clear.
In the two years running up to COP26, the private sector has proved that there is huge investor demand for financing that aligns to carbon reduction measures and other attempts to mitigate the climate crisis. The credibility of credit linked to environmental or social targets (or both) has been further boosted by capital markets support for European bonds aimed at funding the response to Covid-19.
This has given sovereign states the confidence to enter the market and their impact will be extraordinary. Aligning their bonds to pre-defined emissions targets embedded into intended nationally determined contributions (INDCs) will create standards by which the rest of the market will be measured. From new pricing benchmarks, to widely accepted measures for assessing how well an issuer is meeting their commitments, they will act as stabilising influences which will play to exponentially increasing investor demand and further deepen the pools of capital searching for sustainable investments.
In 2020, Green SSA issuance reached €94bn, representing 8% of the SSA bond market. This has grown from just €16bn in 2015. Most recently, Italy (the co-host of COP26 with the UK) issued the world’s largest sovereign green bond. The €8.5bn transaction was more than nine-times oversubscribed, testimony to investors’ faith in Italy’s mission to put climate change on top of the agenda and align to the country’s commitment to the European Commission’s framework for achieving climate neutrality by 2050. The inter-play of state and bloc climate crisis measures – such as the European Green Deal or the UK’s aggressive carbon reduction target – and growing investor demand for credit linked to environmental, social and governance (ESG) targets creates real momentum.
“Italy enters the market of sovereign bonds that finance sustainable development through the issuance of the new “BTP Green“, widening the country’s commitment to the European Commission’s framework for achieving climate neutrality by 2050 and the goals set out in the European Green Deal” the Italian Ministry of Finance noted.
Emerging Markets sovereign issuance is beginning to pickup, especially in Latin America where Chile became the latest Lat Am government to issue. In some emerging markets, the development of sovereign sustainable issuance may open the gates for corporates to follow suit in jurisdictions where sustainable capital markets remain in their infancy.
The private sector has made sustainable finance a normalised part of the capital markets. Sovereigns will, in just a few months, embed it as a foundational element of markets worldwide.
The pace at which sustainable finance has moved from a niche to a completely mainstream activity has been extraordinary. Any notion that this pace would slow is about to be proved very wrong by the arrival of sovereign issuers in force
Constance Chalchat, Head of Company Engagement, BNP Paribas CIB
Embracing climate science
This will also help to stabilise one of the most controversial aspects of sustainable finance: the measures used to check whether issuers are keeping their promises (and therefore paying the right premium to their investors).
Within the past 12 months, the corporate funding space has begun to adopt scientific key performance indicators (KPIs). With investors increasingly more engaged with the integrity of corporate strategies to transition to carbon neutrality, KPIs have become integral to underpinning the momentum within sustainable finance. To maintain credibility with investors, sustainable finance KPIs need to be rapidly standardised and there is no more powerful force for standardisation than the state.
Robust and relevant data, transparent and timely disclosure and a high level of trust placed in underlying sustainability credentials will become ever more important. Sovereigns will provide the measures by which those critical elements are judged, beginning the process of focusing the markets on the best solutions in the current bewildering array of competing standards, methodologies and reporting practices.
Making this work as required will mean integrating sector-specific knowledge from outside finance, as issuers will need to set material KPIs that genuinely transition their business, and investors will need to easily harmonise these disclosures across portfolios.
We expect to see a pricing advantage for issuers that have ambitious sustainability targets, backed by widely understood metrics, embedded into their finance offer.
Central banks are another supporting factor in the development of the KPI linked bond market, and the European Central Bank recently included sustainability-linked bonds (SLBs) as eligible collateral in their asset purchase programmes; a further sign of broad market acceptance.
As legacy sustainability-linked funding from the previous three years draws to maturity, the coming months will also be an infant acid test for understanding whether the legacy KPIs created when the market first developed are leading to tangible action on ESG from an issuer perspective.
Investors fuelling market momentum
The acceleration of corporate and sovereign sustainable finance commitments are ultimately facilitated through a mass mobilisation of investor capital. ESG is the new normal for many investors. The evidence is undeniable, and 2020 saw record ESG investor inflows and green bonds are increasingly oversubscribed – on average, by a factor of four in 2020.
Several drivers are at play, notably a thirst for investing in strategic sustainable finance opportunities facilitated through increased corporate disclosures, regulation and finally risk management. Investors like the novelty of ESG innovations that tackle everything from circular economy and carbon emissions to vaccines and gender equality – the demand for sustainability-linked finance integrating such mechanisms has never been stronger.
Put simply, the global investor community has grasped the scale of the challenges facing humanity and wants to contribute by backing debt that genuinely helps.
On the regulation front, the EU is developing a taxonomy covering technical sustainability criteria, which classifies over 60 activities, categorised into seven sectors. These range from agriculture, electricity, water and transport to real estate, IT and manufacturing accounting for over 90% of greenhouse gas emissions in the EU. This is not, unsurprisingly, without its controversies but investors will turn to the taxonomy for guidance on what is genuinely sustainable.
The reckoning of risks
Finally, risk management will remain an ongoing driver of ESG activity for investors in the months ahead. A recent BNP Paribas ESG survey of hedge funds found that 48% integrating ESG into their investment strategies are driven by the belief that it will improve their risk-return profile.
On the other end of the investor spectrum, insurance companies are acutely aware of how climate risk (and more recently nature-based risk) will influence their portfolios, and are scaling up capital markets activity towards the adaptation and mitigation of these risks.
A new Cambridge University Institute for Sustainability Leadership (CISL) handbook on ‘nature-related financial risk’ mapped physical risks – including species loss, water security, pollution, climate change – against the resulting market disruptions and financial impact, highlighting how financial industry experts need to integrate the understanding of these issues into their decision making.
The well-established Taskforce on Climate Related Financial Disclosures (TCFD) and more recent Taskforce on Nature-related Financial Disclosures (TNFD) will certainly also accelerate how these risks are managed and ultimately speed up investor contribution to the transition to a sustainable global economy.
Managing through a maturing market
The pace at which sustainable finance has moved from a niche to a completely mainstream activity has been extraordinary. Any notion that this pace would slow is about to be proved very wrong by the arrival of sovereign issuers in force.
For investors and many issuers, this simply underlines the extent to which they were right to drive sustainable finance forward. For others, it will provide the confidence they need to get involved.
However, it will also raise material risks for some. Sovereign issuers tend – due to their scale and status as bellwethers for wider economic concerns – to become pricing benchmarks. The standards and measures that sovereigns choose to apply to their KPIs are also likely to become the basis for activity across markets. Deals based on other measures may suffer as investors steer clear of non-standard KPIs.
Successfully navigating a market maturing as rapidly as this one will require genuine, proven expertise both in finance and in sustainability (and, increasingly, areas like social impact and human rights). There is a fine line between a successful issuance and one bearing reputational risk. Getting this right, choosing material KPIs, and leveraging on sustainable finance to deliver additionality means choosing partners with extensive knowledge, proven reliability and, crucially, real credibility in investor and issuer networks.