Sustainable or ESG (environmental, social, and governance) bonds are fixed-income instruments where the proceeds are used to finance or refinance projects with positive environmental and/or social impacts.
The sustainable bond market has experienced rapid growth in recent years as investors increasingly seek out sustainable investments. However, these instruments also come with their own complexities and data challenges for investors to understand.
What are Sustainable Bonds?
Sustainable bonds are fixed-income instruments where the proceeds are used to finance or refinance green and social projects with positive environmental and societal outcomes. Unlike regular bonds, sustainable bonds have to meet certain ESG criteria. The most common types are green bonds, social bonds and sustainability bonds.
Green bonds fund projects with climate or environmental benefits, such as renewable energy, clean transportation and pollution prevention. Social bonds finance projects aimed at socioeconomic advancement and empowerment. Sustainability bonds have both green and social objectives.
The sustainable bond market data has expanded rapidly from just $3 billion in 2012 to over $850 billion in 2021. As per Moody’s, global green, social and sustainability bond issuance could top $1 trillion in 2022. This growth is being driven by increasing issuer diversity and innovation in structures and use-of-proceeds.
The ESG Data Challenge
The sustainability label on these bonds is based on the underlying ESG credentials of the funded projects. Issuers have to provide investors with information about the ESG features of the projects, the selection process and the expected environmental and social impacts.
However, there are no globally accepted standards or disclosures for measuring project sustainability. The ESG data presented in bond disclosures is often selective, inconsistent and lacks transparency. Since the projects are evaluated internally by the issuers, there is heavy reliance on qualitative Claims which are difficult to verify. Quantifiable metrics like greenhouse gas emission reductions are often missing or calculated using the issuer’s own accounting methodologies.
Growth of the Sustainable Bond Market
The sustainable bond market has expanded from just $3 billion in issued bonds in 2012 to over $850 billion by the end of 2021. Green bonds aimed at environmental projects make up the majority, but social and sustainability bonds focused on social projects and a mix of environmental and social projects are growing segments. More issuers have entered the market ranging from development banks to corporate issuers from various sectors.
As the market grows, so does the diversity of bonds and requirements around use of proceeds, reporting, and verifiability. This presents data and transparency challenges for investors to navigate. Access to clear and consistent data is key for investors to understand the sustainable bond market and make informed investment decisions.
Importance of Use of Proceeds
A key component of sustainable bonds is transparency around use of proceeds to fund eligible sustainable projects. Some bonds detail upfront how full proceeds will be allocated to specific assets and projects. However, many provide only general details on project categories and types with funding allocations to be determined. Tracking how proceeds are used can be difficult without detailed reporting from the issuer.
Investors should review bond frameworks that outline eligible project categories and environmental/social objectives. Where possible, investors can engage issuers to provide more granular data on full project allocations and outcomes funded by bonds. Clear use of proceeds data allows investors to better determine bonds’ sustainability characteristics and impact.
Evaluating Reporting Around Impact Metrics
Sustainable bond issuers are encouraged to report regularly on allocation of proceeds and progress on environmental/social projects. However, current standards and requirements around impact reporting metrics and frameworks remain inconsistent and open to interpretation by issuers. This creates gaps and inconsistencies for investors on gauging actual on-the-ground outcomes and impact.
Investors play an important role in holding issuers accountable on reporting against key performance indicators (KPIs) tailored to the use of proceeds projects and assets. Analysis by the Climate Bonds Initiative highlights the need for bonds financing climate-related projects to set forward-looking impact reporting tied to science-based targets and trajectories. Consistent, quantitative environmental and social impact data should be encouraged to bring more accountability and credibility to the sustainable bond market.
The Sustainability Linked Bond Market – New Complexities
A newer but fast-growing segment is sustainability-linked bonds (SLBs), making up over $85 billion in issuances as of Q3 2021. Unlike standard sustainable bonds, SLBs do not finance specific green/social assets. Instead, they incentivize issuers to achieve predefined sustainability/ESG objectives and key performance indicators through coupon adjustments.
However, this dynamic introduces further data complexity for investors to incorporate these performance-based instruments in sustainable portfolios. The key is access to reliable data on the sustainability performance targets defined by issuers and transparency around baselines. Verification of performance against targets by external reviewers adds credibility but is not always required.
Investors should closely evaluate the ambition, benchmarks, and measurability of the predefined ESG-linked targets that trigger coupon adjustments in SLBs rather than make assumptions on their sustainable credentials. Ongoing reporting by issuers on target progress is also critical for investors to track.
The Need for Greater Standardization and Assurances
While sustainable bonds present an opportunity for investors to finance positive impact, they bring growing data and transparency risks to navigate. The diversity of instruments, variability in reporting requirements, and continued lack of standardization makes consistent data analysis challenging. This may allow for “greenwashing” without careful due diligence of bonds’ sustainable features.
Greater regulation and standardization of sustainable bonds is required to uphold accountability. The EU has taken steps with its recently launched European Green Bond Standard requiring alignment of financing with the EU Taxonomy climate targets and mandated verification. Such enforcement of “best practices” makes sustainable credentials and reporting more consistent for investors while allowing the market to still innovate.
Investors also have a critical role to play by conducting thorough analysis on bonds’ sustainability objectives, pushing for detailed impact reporting tailored to the use of proceeds, and rewarding bonds that incorporate ongoing verification. Utilizing consistent disclosures, impact metrics, and external reviews will be key to creating credible, transparent sustainable bond instruments to drive meaningful impact.