Ronald Van Steenweghen on how the ESG debt market is becoming mainstream

Ronald Van Steenweghen, Fund Manager Fixed Income at DPAM, talks to Climate Action about the recent developments of ESG or sustainable debt market structure and how it will look like in the next five years. He also approaches the impacts of the ongoing conflict in Ukraine ESG debt markets rank versus standard fixed income markets.

Can you briefly explain the main financial instruments we can find today in the ESG debt market?

The ESG debt or sustainable bond market has been one of the fastest growing segments in the fixed income market landscape. While the market lacks uniform definitions, we tend to distinguish between activity-based/use-of-proceeds bonds and behaviour-based instruments.

In its most essential form, activity-based instruments finance or refinance new/existing projects with environmental benefits (green bonds), with positive social outcomes (social bonds) or a mixture between both (sustainability bonds). The direct link between the net proceeds of the issuance and the type of projects that are outlined by the issuer within a documented framework are the distinct feature of this segment. A non-exhaustive list of eligible green project categories is clean transportation, renewable energy generation and green buildings, while social bonds typically target a part of the population such as people that are unable to access affordable housing. Both government and corporate issuers and are active in this market segment. Sustainable investors should therefore ensure that the project categories in the bonds’ frameworks are correctly delineated to ensure that all the bond’s proceeds are redirected towards sustainable projects. As pointed out in the IPCC WG III report, markets for green bonds, ESG (environmental, social and governance) and sustainable finance products have expanded significantly, however “challenges remain, in particular around integrity and additionality, as well as the limited applicability of these markets to many developing countries.“

Behaviour-based instruments are a more recent phenomenon and typically tie the issuer’s achievement of a predefined set of sustainability objectives to the structural/financial parameters of the bond. There is usually a coupon step-up if targets are not met during the lifetime of the bond, but many variants are possible. In this pool we find the so-called sustainability-linked bonds (SLBs) and their proceeds are not ring-fenced, therefore they provide more flexibility for the issuer. Greater flexibility for companies must go hand in hand with greater scrutiny by investors. Among the elements to check are the choice of KPI’s and targets on which the coupon might change and the fit of these targets with the issuer’s overall strategy. SLBs are quickly becoming the favourite financing vehicle for aligning a company’s sustainability goals and commitments with their financial profile. It is also frequently used by issuers form hard to abate sectors and companies that have balance sheet capacity constraints with respect to multi-billion EUR use-of-proceeds programs. While the space was dominated by corporates so far, Chili has issued in March an inaugural USD 2 billion sovereign SLB with a focus on reducing annual greenhouse gas emissions and the generation of renewable energy.

The total size of the ESG debt market is hovering around the USD 3 trillion mark with a dominant share of green bonds. This only represents a single digit percentage when looking at total outstanding amount of debt, but since the start of the year almost 40% of all EUR denominated corporate debt issuance is under an ESG-labelled format.

What are your predictions for ESG debt markets in the next five years?

While it is clearly tricky to look that far into the future, we expect the ESG debt market will flourish over the next five years and our baseline calls for an average growth rate of 40% per annum leading to a total market size topping USD15 billion.

This growth will come from multiples drivers, especially a broadening of the green bond market at the geographical level driven by the development of local taxonomies. We also anticipate more issuer diversification in certain sectors such as insurance, basic industries, and transportation. The focus will also broaden towards less frequently used green categories such as sustainable water, circular economy, biodiversity, and climate change adaptation. The biggest growth driver is likely to come from SLBs where climate pledges and net zero commitments make up a fertile ground for a financing and investment boom into the transition to a low carbon economy.

Next to its comment on integrity and additionality, the IPCC WG III report also stressed the striking fact that financial flows reaching the fossil fuel sector still exceeded the ones towards climate adaptation and mitigation.

What is the impact of the ongoing war in Ukraine on ESG debt markets? How does the performance of ESG debt markets rank versus standard fixed income markets?

Beyond the incredible human tragedy, there are multiple impacts from the Ukraine war on ESG debt markets.

There is a macro effect given the acceleration in hawkishness by global central banks on the back of the additional inflationary impulse of the conflict. Bond markets continued repricing lower, and green bonds at the index level were penalized due to their long duration bias compared to standard fixed income indices.

At the sectorial level, we have also seen an outperformance of energy and commodity related companies that typically are less present or even excluded from ESG-focussed indices. In a like-for-like comparison however, we have witnessed that at the individual bond level the so-called “greenium” has increased only by a few basis points in both sovereign and credit markets indicating a very mild underperformance.

Beyond the short-term financial impact, the true decisive impact will come from the policy choices that (European) governments will make with respect to the future energy mix. It is a challenging task in the short term to balance energy security with energy affordability and a shift towards a low carbon economy. However, if the REPowerEU plan is a template for the future, we will witness an additional push to renewables and investments into low carbon technologies. This will benefit both the planet and the companies that are taking decisive action to lead and enable this immense transformation.