Sustainable investing – which manager has the endurance?
The importance of sustainable investing has developed into a key thematic in recent years, as more investors increase their focus on sustainability and environmental, social and governance (ESG) issues in their portfolios. Demanding greater transparency and commitment from managers, we’ve observed a philosophical shift, as advisers seek greater alignment between funds and the preferences of their clients regarding values, impact or ESG.
ESG or sustainability aspects can be captured by managers in a multitude of ways ranging from traditional negative screening of undesirable industries (e.g. tobacco) through to sustainable investing, where the underlying securities are directly related to an environmental or social outcome.
In an Australian fixed interest (AFI) context, sustainable investing typically focuses on the purchase of green, social or sustainable bonds, where the cash proceeds of the bond are used to finance eligible environmental or social projects (or a combination of both). These bonds are typically issued by entities as part of broader funding programs.
We’ve observed an increase in AFI managers investing in sustainable bonds, both as part of traditional AFI portfolios and through dedicated sustainable or impact bond funds. So, do sustainable bonds exhibit more attractive risk/return characteristics compared to traditional or vanilla bonds? Does prioritising the sustainable sector introduce additional portfolio risks? And what are some of the additional considerations that advisers should be cognisant of when allocating to different managers?
Background
The history of sustainable bonds dates to 2007 when the European Investment Bank issued a Climate Awareness Bond, with the proceeds dedicated to renewable energy and energy efficiency projects. Since then, global issuance has increased at an exponential rate, with cumulative green bond issuance surpassing $US 1.23 trillion at the end of April 2021.[1]
Sustainable bonds ensure cash proceeds are used for the purpose of financing eligible environmental and/or social projects. While projects vary, bonds can be broadly categorised as follows:
- Green – where proceeds are exclusively applied to finance or re-finance projects or assets having environmental objectives, such as renewable energy, pollution prevention, clean transportation and sustainable water.
- Social – used to finance projects that achieve social outcomes, such as access to essential services, including education, affordable housing or micro-finance.
- Sustainability – proceeds from a bond may be applied to projects that have both positive environmental and social benefits.
Within each cohort, there are different types of bonds including general obligation bonds and asset-backed or secured bonds. General obligation bonds are backed by the general credit worthiness of the issuer and its ability to satisfy its coupon obligations from its revenues and cashflows.
Asset-backed or secured bonds are directly tied to the performance of the underlying assets, such as a wind farm or a solar project, with the assets typically held in a special purpose entity. Moreover, some bonds offer recourse to both the company and specified assets, with these bonds referred to as ‘dual recourse’.
Defining sustainable bonds
To be classified as a sustainable or green bond, companies generally follow a set of guidelines and disclosure principles that enable investors to determine if the bond is consistent with its respective environmental or social philosophy objectives. While the industry is self-regulated, most issuers comply with the International Capital Market Association (ICMA) which has codified a set of guidelines and level of disclosure that each issuer is expected to follow.
These principles are outlined in the ICMA Green Bond Principles 2018, the Sustainability Bond Guidelines 2018 and the Social Bond Principles 2020. The industry is also supported by several industry bodies and initiatives, such as the Climate Bond Initiative (CBI) that can provide external verification of each bond’s compliance with the relevant principles.
Across each set of principles, ICMA has outlined the following key components:
- Use of proceeds – the bond’s documentation should outline how the bond’s proceeds are to be applied and the corresponding environmental or social benefit. In the case of the Green Bond Principles, ICMA recognises several categories of eligibility for green projects, such as climate change mitigation, adaptation, natural resource and biodiversity conservation and pollution prevention. These are typically summarised into a list of Eligible Assets.
- Project evaluation and selection – issuers of sustainable bonds are expected to outline their environmental or social objectives, how these have been determined and how a project is consistent with the ‘use of proceeds’ categories detailed earlier.
- Management of proceeds – the proceeds from the bond issue should be segregated from the broader finances of the issuer, allowing tracking of the net proceeds and how these are being applied to ‘Eligible Assets’.
- Reporting – Issuers are expected to maintain up-to-date records on the use of proceeds, including an annual report summarising the green or social projects that have been financed. To align with best practice, issuers should disclose metrics (where practical) summarising the project benefits. This can include greenhouse gas emissions produced, electricity generation, energy capacity etc).
The ICMA principles play an important role in promoting consistency and transparency across the sustainable bond universe. Notwithstanding this, ‘green’ or ‘social washing’ remains an ongoing concern as corporates seek to align themselves with socially conscious investors, whilst allowing themselves maximum flexibility with respect to classifying projects.
Australian sustainable bond market
The Australian sustainable bond market has experienced strong growth as government authorities, financial institutions and companies issue a range of green, social and sustainable bonds. The expansion of the market has enabled these institutions to showcase their sustainable credentials and access the potential pricing and investor diversification benefits attributable to the asset class. As at the end of April 2021, the sustainable bond market has grown to $A 29 billion across 46 individual bonds.
Historically, global supra-nationals issuing kangaroo bonds have dominated the sector, however, as the focus on sustainable investing increases and state governments fund energy transition programs, we’ve observed a proportional increase of semi-government and corporate bonds.
Selecting the most appropriate sustainable or ESG strategy
Selecting the most appropriate ESG or sustainable strategy is a multi-faceted decision, typically combining philosophical considerations with traditional qualitative and quantitative inputs. For some clients, a sustainability or ESG decision can be the most important and primary screen, with only those funds passing the filter considered for investment. In our opinion, the current maturation of the sustainable bond universe has the potential to alter not only how some managers structure their portfolios, but the potential sources of excess returns captured.
By Rodney Sebire, Head of Alternatives & Global Fixed Income Research
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