Which is better for stamping out greenwashing and transparently arresting climate change? A sustainable finance bond market like the current one, plagued by greenwashing and other forms of deception, with easy-to-manipulate voluntary guidelines and where proper impact assessments are hard to come by, but a market that is big in dollar terms?
Or a market that operates on the basis of mandatory standards and disclosure, with externally verified and audited reporting, where issuers of labelled sustainable bonds are bound by regulatory requirements and investors can be much more certain about the environmental impact they are funding, but a market that is smaller is dollar terms?
The bond market should surely be aiming for the second option if the primary concern is about facilitating climate-change mitigation and pushing out greenwashing.
But do I read it right that international bond underwriters would prefer a green bond market that is big but which is increasingly being seen as being seriously flawed? Well, that’s my reading of the feedback from the International Capital Market Association (ICMA, the bond underwriting community’s trade body) to the European Parliament’s November 30 amendments to the European Commission’s proposed Green Bond Regulation legislative text. The European Union is shifting to a regulated approach over a voluntary one, with mandatory requirements for sustainable bonds and issuers that are aligned with the EU Taxonomy and punitive measures slapped on malefactors.
As an underwriter, I get you want a big market because big market = big deal flow = big fees = big opportunity for league-table glory = global bragging rights. As such, pushing back on anything that might detract from the interests of underwriters is a predictable (if dispiriting) response. But going all out for size over substance is a backward step.
Bond underwriters, independently and through the ICMA, have consistently adopted an anti-regulation stance for green bonds, whereas I’ve steadfastly held on to my long-held view that the ESG-labelled market must be regulated if it stands any chance of being seen as a credible facilitator of lasting climate-change mitigation free of skulduggery. The European covered bond label has been enshrined at EU level through the harmonization directive. Why not the ESG bond market?
So to the EU’s move, I say: bring it on! It’s time for the market’s voluntary guidelines to be phased out. They are no longer fit for purpose. We need proper rules with deterrents and sanctions.
The ICMA’s pushback comes across, alas, as rather tone-deaf and self-serving – to itself (as administrator of the family of voluntary ESG bond principles) and the investment banks that fund it. It rests on scaremongering, appeals to European political triumphalism, and pokes the nest of regional tribalism. It just smacks of an inability to read the room; the room being how to address genuine concerns about greenwashing and create a functioning bond market that funds projects and activities that transparently seek to arrest climate change with integrity.
The ICMA reckons adding mandatory reporting, external verification and other requirements to gain the European green bond label will add an unsustainable level of cost and liability for issuers without counterbalancing incentives, hence, would hinder uptake of the label. Mandatory requirements, it believes, will force issuers to switch to other sources of European market or bank finance or access sustainable finance from other jurisdictions; they will end the EU’s current undisputed leadership in international sustainable capital markets; and undermine the inclusive, voluntary and aspirational nature of the European sustainable bond market. Voluntary and aspirational? Give me a break. It’s voluntary guidance that has led us down the dark alley of large-scale greenwashing claims.
SLBs rendered bogus
Just to take one segment that relies on voluntary guidance: sustainability-linked bonds (SLBs). They are a fabulous idea in principle, offering flexibility and latitude to issuers to fast-track credible transition. Issuance hit around the US$100-billion mark in 2021 and some see that doubling this year. The Sustainability-Linked Bond Principles are full of what should happen around issuance, disclosure, key performance indicators (KPIs), sustainability performance targets (SPTs) and target-setting exercises; participants are encouraged to do some things; it is recommended they do other things. So what’s the problem?
The problem is, recommending that issuers adopt aspirational KPIs and other elements is the language of space cowboys. To be credible, KPIs must be science-based and built around regulatory standards. Reporting must be externally audited.
Amid rapidly-growing alarm about a greenwashing epidemic across all sustainable finance formats, it is claimed by many that general obligation SLBs have, in their short lifespan, been gamed by issuers and by fee-chasing underwriters. And they have been condemned by a wide range of ESG and conventional institutional investors as having been manipulated and undermined by mediocre issuer-defined KPIs.
Corporate disclosure is poor, and it is impossible to compare SLBs between issuers across industry segments or within industry segments as there is an absence of standardization or standard presentation of targets. Negligible coupon step-ups in the lowest yield and credit spread environment in a generation offer zero incentive for management to act. But the perverse incentive structure on most issues sees investors offered tawdry bribes in the guise of coupon step-ups for having been greenwashed if KPIs are not met.
The extent to which investors may be being greenwashed every single day may not be known for years depending on the deal structure. And who really knows anyway on the basis of unaudited issuer-defined reporting that large institutional investors have said they can’t trust? Yet despite all of the above, issuers still get to bask in sustainability virtue-signalling.
Ditch step-ups
I dislike the coupon step-up structure. It’s a red herring that detracts from the main purpose of the exercise: meeting ESG targets. If, despite externally reviewed, monitored and audited genuine best efforts, issuers miss targets, issuers could as standard take funds accumulated in a sinking fund not to bribe bondholders but to fund relevant research, buy carbon offsets or make contributions to relevant NGOs, as some issuers have done. And if they fail to meet targets, investors should naturally screen them out of future labelled issuance.
Etihad Airways (United Arab Emirates, October 2020); Nanyang Technological University (Singapore, October 2021); and chemicals company Indorama Ventures (Thailand, November 2021) all made documented commitments to buy carbon offsets if SPTs are not met.
Indorama had initially also included a coupon step-down, but this was removed after pushback from investors. Why haven’t we seen more step-downs? They would enable issuers to benefit from striving to meet tough KPIs rather than having investors benefit from issuers failing to meet them. As far as I can ascertain, the only straight bonds in the public market with step-down features are Thai Union’s 11 billion baht (roughly US$340 million) in SLBs of June and November 2021. (Bank of China’s US$300 million sustainability re-linked bond of October 2021 includes potential downward coupon adjustments linked to margins on a portfolio of eligible sustainability-linked loans extended by BoC, but this is more akin to a structured loan pass-through).
Coupon step-downs could create real incentives for issuers to meet performance targets – especially as rates start to head north. A recent World Bank report proposing a design framework for sovereign sustainability-linked bonds says sovereign SLBs are likely to be structured with step-downs.
Investors have long pushed back on accepting a lower all-in return for holding ESG bonds over conventional bonds for the same credit risk. But as green bonds of the same issuer now consistently print and trade through conventional bonds (given demand and other factors), the ship of that objection has long sailed.
