Q. What are your views on how institutional investors digest green risk? How does that feed back into the performance of these deals?
A. One of the key things that we have seen as part of this discussion around risk and price is that a number of institutional investors, particularly those advancing the sustainable and green investment segment (because of the scale and seriousness of their approach) believe that if a company strongly aligns itself with ESG principles, whether on the environmental, social, or governance side, those companies will be a better risk prospect in the medium to long term. This feeds back into their perspective on credit risk. The reason why we are seeing such a strong focus on ESG from European institutional investors, for instance, is that they fundamentally believe they will get a better return and see better performance from their portfolio, because companies that do align themselves with ESG objectives will also perform better.
In terms of the performance, a distinction must be made between what issuers and investors get out of a deal. It is, for instance, difficult to prove tighter pricing in the primary markets for a green bond, compared to an equivalent conventional bond, but we do see stronger performance in the secondary markets, to the benefit of investors. Crucially, although it hasn’t necessarily been proven yet, we believe that these instruments will outperform conventional bonds in times of stress because investment in this space will prove to be stickier. Green portfolios have been established with long term horizons in mind, which suggests they are somewhat more insulated from the typical short-term liquidity and positioning-induced churn that you see on conventional instruments, especially in emerging markets – where hot money is both a blessing and a curse. We haven’t seen a significant downturn since the sustainable finance market has taken off, but we do expect these instruments to perform with less turbulence.
Q. Let’s get to the elephant in the room. What are the price benefits, if any, of issuing a green bond over a conventional instrument? Should there be a pricing mechanism directly correlated with a borrower’s ESG score?
A. It is difficult to prove outright that pricing is tighter for green bonds at issuance, but for an established issuer, with an established framework, the ability for them to access private placements with an ESG angle through medium term notes and tap into new investor pools may well benefit them on the pricing front in the future. We feel this will be particularly the case with issuers that already have an established, well-performing, green benchmark curve to act as a pricing reference.
As it stands, it is difficult to see pricing being strongly linked to ESG, either in the bond market or loan market – but for different reasons. In the bond market, prices are determined largely by the underlying credit quality and demand from global investors. In the loan market, the underlying credit quality and a bank’s cost of capital are the biggest drivers of pricing. We have looked at linking ESG scores with loan pricing – and understand the potential benefits and drivers for doing this – but the problem for us as lenders is that we don’t get any breaks on the cost of capital from regulators when we lend to an entity with a higher ESG score through balance sheet lending. Certainly, it would benefit the development of the sustainable finance market if there was a system of regulatory capital breaks, given on the basis of regulatorily mandated sets of ESG thresholds, for lenders willing to put their balance sheet to work in ESG-centric areas. This could incentivise the sustainable finance market by allowing lenders to pass on these savings directly to borrowers through balance sheet lending. This would also have a positive influence on credit curves, creating stronger linkages between the sustainable bond and loan markets.
Q. Apart from the sustainability or environmental reporting component, is there anything structurally unique about green bonds? When it comes to structuring these kinds of instruments, where do challenges tend to crop up?
A. A key component of green bonds is the use of proceeds, which needs to conform to the Green Bond Principles, and which requires the proceeds to go towards green or sustainable initiatives. This is where some challenges tend to crop up for a number of potential issuers. A benchmark-sized bond creates its own internal challenges for medium and smaller sized corporates that may not have the same scale of green investment needs over an 18 or 24-month period as some of their larger peers, which makes it difficult to issue notes of that size dedicated to green initiatives. Hence, a key challenge involves identifying qualifiable use of proceeds for the whole of a bond.
Another challenge that has cropped up in some instances, particularly where an entity may have been a leader in its field and invested in green or sustainable assets a number of years ago, is that these entities can’t issue green bonds to refinance those assets. This is largely because investors are looking to help fund projects that create additional benefit. For a company that is already fairly green and has been operating qualifiable assets for maybe a decade or so – otherwise a perfect candidate for these instruments – this can be particularly frustrating.
Q. What else are you hearing from issuers when it comes to the pain points they face in bringing these transactions to the market?
A. Reporting is a potential challenge for some issuers. They need to understand what they are committing themselves to, in terms of reporting on the performance of underlying assets for at least the tenor of the bond. For a large listed corporate that might already provide regular ESG reporting to shareholders or the public, this isn’t a particularly acute problem, but if you are a smaller or medium-sized corporate, reporting obligations can be a pain point and may influence the decision on whether or not to proceed with a green bond.
The cost is also a pain point. Issuers are well aware that investors have a significant amount of funds to invest in this space, but issuers are the ones who bear the initial financial and internal resource costs associated with auditing, second opinion certification, and so forth. It may not be a huge cost, but it’s a cost nonetheless. Some issuers believe that investors should, in some way, share the costs, and the way they could do that is via tighter pricing.
The Monetary Authority of Singapore (MAS) provides an interesting example of how to approach this pain point. The MAS recently authorised a grant scheme that would cover issuers’ cost of second-party certification and auditing up to SGD100k, provided certain issuance size, tenor and jurisdiction requirements are met. It is an important recognition of the fact that issuers are bearing a cost, and that it can be a small but nevertheless relevant factor in determining whether an issuer does or does not go green. It is important to encourage initiatives like that, particularly for the benefit of debut issuers.
Q. Coming back to your point about refinancing and use of proceeds for a moment, is there much scope for borrowers that aren’t looking to finance new infrastructure to issue green bonds? What is the ‘limit’ in terms of how proceeds can be used?
A. Investors are looking to encourage the positive future environmental benefits brought about by borrowers, which is why they aren’t typically looking to refinance existing renewable energy assets, for instance. What they are trying to promote is a change in corporate strategy by providing finance that may otherwise not be available on a conventional basis. That said, it does not need to be linked to infrastructure; as long as it is in line with the commitments made at the COP21 meetings, and conforms to the Green Bond Principles framework managed by the International Capital Markets Association (ICMA), that should suffice. Starbucks’ JPY85bn corporate sustainability bond issued in April this year, which saw its proceeds committed to the exclusive purchase of coffee beans that are farmed sustainably, is a good example of this, and allows investors to support the company in its approach to sustainability. The French government’s recent €7bn green bond earmarks proceeds for a wide range of initiatives including sustainable forestry in protected areas and organic farming. It isn’t just a matter of infrastructure, per se – it’s about aligning the best ways to save the planet with the appetites of investors.
As a market, we are still trying to figure out where these ‘red lines’ fall in terms of limits to the use of proceeds. The recent Repsol €500mn green bond transaction, for instance, drew criticism from some because it was an oil company issuing a green bond, and from a use of proceeds perspective, it was not that different from what you might see on a conventional bond issued by this kind of entity. Others would argue that the intention of these instruments is to get companies taking steps – however small – towards investing in environmentally and socially-conscious areas, and that without supporting companies like Respol in these endeavours, one would actually be damaging the development of the sustainable finance market. At the end of the day, and regardless of where one may align oneself in this debate, it catalysed a very important discussion that the industry needs to have.
One could take that example a step further by looking at a market like China, where carbon capture on coal-fired power plants is a permissible use of proceeds under the Chinese government’s green bond framework. Clearly, ‘clean coal’ doesn’t naturally fit into the Green Bond Principles, but the country is actively encouraging a reduction in greenhouse gas emissions by encouraging the use of cleaner and more efficient power production technology. That said, from an ESG perspective, China has a very different starting point to Germany, and I would argue that it wouldn’t necessarily be fair to treat issuers and borrowers from each jurisdiction in the same manner. In any event, I am confident these ‘red lines’ will start to solidify as the market develops.
Q. Speaking of market development, green or sustainability loans are growing in popularity but are often left out of the broader discourse on sustainable finance, in part because there is less transparency in the loan market. How does MUFG approach these instruments? Do these loans have the same verifiability requirements as publicly listed green bonds?
A. At MUFG, we’ve been applying ESG approaches internally in various forms to our portfolios for many years. We apply the EQUATOR principles to our project finance portfolio, a completely different assessment aside from our typical credit work, which imposes a high standard for environmental and social sustainability; if a credit – however strong in a conventional sense – doesn’t meet the EQUATOR principles criteria regarding environmental and social sustainability among other things, we simply won’t lend to that entity.
Banks don’t currently lend on the basis of a borrower’s conformity to the Green Bond Principles – but that may evolve as green securitisation develops. If a bank sets up a vehicle with the intention of buying and structuring loans in a way that allows them to be placed in a bond or securitisation, those loan assets will also need to meet the Green Bond Principles criteria. This bolsters the case for applying many of the same requirements, currently imposed on bond issuers, in the loan space.
Q. That leads us quite nicely into what some are calling the next frontier of sustainable finance instruments – securitisations. What is your view on the appetite for green securitisations?
A. This is a really exciting area of development for this market. I believe smaller sized transactions that can be clubbed together in a way that can be sold to targeted green or sustainable investors as a benchmark sized bond – in other words, anything that enables sub-benchmark sized funding initiatives to be captured or encouraged in this market, or anything that enables smaller or medium-sized entities to seize upon funding opportunities in this space – needs to be encouraged. This is going to be the big next step in the market. Crucially, what the securitisation market is going to do is link the bank loan market with the bond market, which can only be a positive thing for sustainable finance going forward.
