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Picking up the pieces Ten trends in sustainable debt for 2023
A mere 12 months ago, sustainable finance
was the name of the game. The year 2021
had seen a record of more than $1 trillion
of sustainable bonds (which include green,
social, sustainability, and sustainability-
linked bonds) being issued, according to
S&P Global. Market observers confidently
predicted that global issuance volumes of
such labelled bonds would surpass $1.5
trillion in 2022.
And then Russia invaded Ukraine.
Soaring energy prices and rising inflation prompted central banks across the world to put an end to a decade of low-interest rates. All of a sudden, issuers that had been able to tap the bond markets at prices close to zero found themselves struggling with heightened volatility and widening bond spreads.
As a result, global bond issuances fell across the board in 2022, and the sustainable bond market registered its first year-on-year decline, coming in at approximately $863 billion, according to Bloomberg. While sustainable bond volumes outperformed the wider bond market, that's really just a nice way of saying that labelled bonds didn't decline as much as conventional bonds.
So where does sustainable debt go from here?
In this blog post, we look back at what happened in 2022 and identify the ten trends
1. Green bonds remain the cornerstone of the market
Green bonds are the most mature of the sustainable debt products, having been around for more than a decade. Here, issuers commit to using the proceeds of the bonds to fund eligible green assets or projects. While their share of the sustainable bond market has gone down in the last
three years as other types of instruments (such as social bonds, sustainability bonds or sustainability-linked bonds) became popular, they still represent by far the biggest asset class in the market.
Overall issuance volumes declined in 2022, particularly in Europe, which has traditionally been the largest market. But issuance volumes held up well in Asia-Pacific, particularly in China, which published its own Green Bond Principles in the summer. And while market conditions made it more difficult to issue new green debt, more issuers took the opportunity to ask bondholders to convert their entire existing bond portfolios into green bonds (see our blog post here).
Despite investor concerns over quality (see below), green bonds are expected to be the main driver of growth in sustainable debt this year as corporates and sovereigns will need to meet increasing capital needs to succeed in the energy transition.
Recurring issuers, particularly those with green bond programmes, are at an advantage here as they already have the necessary issuance infrastructure in place, such as green bond frameworks and second party opinions. In times of high volatility, being able to go to market quickly will prove to be a strategic advantage.
Over the last two years, the green bond market has also expanded from senior bonds to a variety of other green instruments, such as green hybrid bonds, green Schuldscheine or green convertibles. Particularly the latter could play a more prominent role in 2023 for green issuers as convertible bonds are slated for a revival as higher interest rates mean corporates will seek cheaper sources of financing.
2. SLBs are facing headwinds
They were heralded as the most exciting thing in sustainable finance, but after their issuance volume grew almost tenfold in 2021, sustainability-linked bonds (SLBs) didn't continue their meteoric rise last year.
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Unlike "use of proceeds" instruments, such as green, social or sustainability bonds, SLBs allow issuers to access the sustainable financing market without having to commit to use the proceeds for specific ESG projects or assets. Instead, under SLBs, the issuer has full flexibility to use the proceeds for general corporate purposes but the overall cost of the SLB is linked to the achievement of one or more specific sustainability performance targets (SPTs), such as a reduction in carbon emissions.
There are two main reasons why SLBs struggled in 2022, in addition to the broader market pressures:
Firstly, SLB issuance was hit particularly hard by the steep decline in the high yield bond market, which decreased by 80%. In 2021, almost four in ten SLBs were issued by high yield (or sub-investment grade) issuers, according to Dealogic. Given the elevated exposure to high yield, it is not surprising that the crisis in the high yield market had a disproportionate effect on SLBs.
Secondly, not least due to their newly-found prominence in the market, SLBs came under heavy scrutiny in 2022 (see below). Issuers were criticised for a lack of ambition and credibility in choosing their sustainability targets, particularly those that were set against business baselines rather than science-based pathways. This meant that structuring an SLB became more difficult as financial advisers and external verifiers demanded more robust targets to avoid accusations of greenwashing.
2022 also saw the first SLB issuer missing its target and incurring a financial penalty and market participants are closely watching a number of other SLB issuers to see whether they will be able meet their SPTs when they come up for testing this year. Any such failure to meet targets will provide an interesting insight into how the market reacts: Will this lend credibility to SLBs because they will be seen to be working exactly how they are meant to be? And will the market price be affected? Investors would get a slightly higher coupon, which could raise demand for the bond. On the other hand, green or sustainable funds might be forced to sell the bond, which would depress the price. Or perhaps the price doesn't move (after all, such interest rate penalties tend to be small) but the issuer would suffer from adverse publicity, which may affect its reputation among sustainable investors going forward.
That said, missing targets is unlikely to become widespread just yet. This is because issuers tend to set targets that they are certain to achieve and because the bond documentation usually allows issuers to recalculate targets or baselines in certain circumstances both of which are precisely some of the criticisms that have been levelled at SLBs.
Despite the difficulties, we expect SLBs to grow again in 2023, albeit not at the pace seen in 2021. This is not least because SLBs remain the only viable option for issuers to
tap the sustainable bond market where they don't have sufficient green projects or assets to issue green bonds.
3. Social and sustainability bonds are here to stay and transition bonds are not dead yet
The market for social bonds (where proceeds are used for social projects) and sustainability bonds (where proceeds are used for a combination of environmental and social projects) is dominated by sovereign, supranational and agency (SSA) issuers. These bonds took off during the COVID-19 pandemic and, unsurprisingly, overall volumes declined markedly in 2022 as COVID-19-related debt issuances were phased out. However, social bonds grew strongly in Asia, particularly in Korea and Japan, which finalised its Social Bond Guidelines at the end of 2021.
While we expect SSAs to continue to shift their issuance focus more towards green bonds in line with net zero commitments in 2023 (see below), both social and sustainability bonds are now a mature asset class and are here to stay, albeit with a lower share of the wider market. These types of bonds also tend to include some of the more innovative products, raising funds for a range of environmental and social issues (see below).
Transition bonds on the other hand, which have traditionally been the most controversial of the sustainable debt asset classes, made something of a comeback last year. The idea of transition bonds is to help "brown" companies become green. But transition bonds have long been criticised for lacking a clear definition or international standard. The International Capital Markets Association (ICMA), which is the de facto standard setter for the sustainable debt market, confirmed last year that it will not issue specific industry guidance for this asset class and instead pointed market participants to the more general guidelines in its Climate Transition Finance Handbook. What is more, the availability of SLBs means that there is now a more widely accepted product to access the sustainable finance market for "brown" companies that seek funding for their green transition.
Yet reports of the death of transition bonds have been premature. Both China and Japan published guidance for transition bonds last year and almost one in ten sustainable bonds issued in Japan during the first three quarters of 2022 was a transition bond. That said, we expect transition bonds to remain a niche product in 2023 and not a worthwhile option for issuers outside specific local markets.
4. More sovereigns are making their debut in the sustainable debt market
The year 2022 saw a number of countries coming to the sustainable debt market for the first time.
In March, Chile became the world's first sovereign to issue an SLB, setting targets geared toward reducing emissions
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and increasing Chile's use of renewable energy. Uruguay followed suit in October with an SLB linked to emissions reductions and reforestation. While most SLBs issued by corporates include an interest rate step up for missing targets, Uruguay opted for a more unusual two-way structure: If Uruguay were to fail to achieve its targets, the interest rate would go up. However, if Uruguay were to exceed its targets, the interest rate would go down. Despite some resistance from investors about the structure, the bond priced successfully and could set a precedent for other transactions in 2023.
But it is green bonds where most sovereign sustainable debt activity sits. For example, in October 2022, Saudi Arabia issued its first green bonds through its sovereign wealth fund. This included a $500 million tranche with a 100 year-maturity, the world's first dollar-denominated century green bond. And earlier in the year, Austria, Singapore and Denmark also accessed the green bond market for the first time.
The year 2023 has continued in the same vein so far: Israel issued its debut green bond in early January and India followed suit just days later.
We expect more sovereign issuers to make their debut in the sustainable debt market in 2023, particularly in the green bond space. This includes Greece, which had to postpone their green bond debut last year, and Jamaica.
With regard to sovereign SLBs, next in line might be Brazil, where a proposal for an SLB linked to protecting the Amazon rainforest is gaining traction. And in Europe, the Netherlands could become the first European sovereign to issue SLBs after the Dutch State Treasury confirmed in November it was seeking feedback from banks and investors whether SLBs would be a suitable instrument for the country.
5. The ESG backlash from both sides with
energy companies at the centre
Apart from adverse market conditions, the sustainable bond market was also impacted by the general backlash against ESG in 2022.
On one end of the spectrum, the market was feeling the heat from politicians. In the U.S., Republican officials from certain states took aim at ESG investing as a concept, targeting asset managers, among others. This increased pressure is expected to continue in 2023 and may have an adverse impact on the demand of sustainable debt going forward in the U.S. However, it remains to be seen whether this might be partly outweighed by the growing need for green financing resulting from the landmark Inflation Reduction Act, which is expected to accelerate private sector investment in renewable energy.
On the other end of the spectrum, criticism of sustainable debt products around greenwashing hurt the reputation of the market more generally (see below).
Energy companies, particularly those with high exposure to oil and gas, were at the centre of both discussions.
The ESG backlash in the U.S. was partly driven by a desire to protect domestic fossil fuel companies, with politicians accusing banks and asset managers of boycotting the oil and gas sector under their ESG investment strategies.
Conversely, in Europe, energy companies were coming under increased pressure to show they are serious about decarbonisation. In the fierce battle around "divestment vs. engagement", a growing number of banks and asset managers seem to have come out on the side of engagement. This means working with companies on their transition strategies rather than withdrawing funding altogether. According to some analysts, this already had an impact on price, with some seeing bond spreads between oil and gas majors with strong renewable investment ambitions to diverge from peers with less robust transition plans. In other words: Energy companies that are further along their transition path might be able to access funding more cheaply than their competitors.
What is more, in October 2022, the ECB announced that it would gradually decarbonise the corporate bond holdings in its monetary policy portfolios. To that end, the ECB developed a scoring system where companies get credit for having more ambitious decarbonisation targets relative to sector peers, among other things. While this could benefit energy companies with the most robust decarbonisation plans, it is unclear how impactful the new policy will be in practice. This is because the ECB has slowed down its bond buying significantly in response to rising inflation and now merely reinvests maturing principal to keep its portfolios at a constant size. The ECB's effective withdrawal from the market as one of the biggest buyers of corporate bonds in Europe will likely outweigh any effect its new decarbonisation policy (positive or negative) will have on issuers.
6. Some issuers look to retail investors to sell
their sustainable bonds
They say in every crisis lies opportunity. With central banks phasing out their asset purchase programmes and issuers having to adapt to a higher interest rate environment, some corporates have already identified the retail market as a new source of funding. During the long stretch of low interest rates, there was little appetite from retail investors for corporate bonds. However, with higher returns on offer from highly-rated issuers, the retail bond market could make a comeback.
Italian energy company Eni launched its first retailtargeted SLB in January. This comes off the back of Singaporean multinational real estate company Frasers Property and New Zealand power company Transpower, which both issued retail green bonds in the autumn of 2022.
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Offering sustainable debt to the public (rather than to institutional investors) could not only help issuers tap a new investor base but also give them the opportunity to market their green credentials or transition strategy to a wider audience.
But issuing bonds to retail comes at a cost.
First, legal requirements for the offer and sale documentation are more stringent. (Although it is worth keeping an eye on regulatory developments in the UK, where the Financial Conduct Authority (FCA) in December launched a consultation on retail disclosure requirements, which might lessen the disclosure burden for retail bonds in the future.) Selling bonds to the general public as opposed to professional fund managers with billions of assets under management also exposes issuers to increased liability risks.
Second, unlike institutional offers, where the price of the bond is determined following a bookbuilding process, the minimum price in retail offers is fixed at the outset. This means that issuers will not be able to take advantage of tightening spreads resulting from investors' bidding wars to secure a chunk of the bonds.
And third, the cost of marketing bonds to the public is higher as issuers will need to drum up interest through wider channels, such as popular websites, radio and TV, rather than Bloomberg screens and investor calls.
Despite being more cumbersome and costly, we expect more sustainable debt being offered to retail investors in 2023. However, it is likely that this market will only be open to household names that have large funding needs and that don't mind the extra cost and scrutiny in exchange for a new investor base and some green publicity.
7. Blue, orange and rhino bonds exotic
sustainable bonds are thriving
The sustainable bond space has always had a penchant for headline-grabbing exotic products and clever bankers continue to come up with novel structures.
One of the first such products was a "blue bond" designed to support sustainable marine and fisheries projects issued by the Republic of Seychelles back in 2018. Since then, blue bonds have become more popular, with the Bahamas issuing a sovereign blue bond in June 2022 to support recovery for companies that rely on ocean health. This was followed by Japanese fishing company Maruha Nichiro, which issued the country's first blue bond in November 2022 to finance a land-based salmon farming business. The "blue bond" market has been buoyed by the announcement at the UN Ocean Conference in June 2022 that ICMA, together with four other organisations, will develop blue bond guidance to standardise blue bonds, including by identifying the types of investments eligible for funding with blue bonds.
Other examples of such exotic sustainable bonds included the world's first "rhino bond" issued by the World Bank in March 2022, which is designed to boost efforts to protect black rhinos in South Africa, and Kazakhstan's second gender bond from February 2022, which aims to provide affordable residential mortgage loans to women borrowers in primarily rural areas of the country. In a similar vein, Impact Investment Exchange (IIX), a Singapore-based company focused on social and impact financing, issued its fifth bond in its Women's Livelihood Bond series in December 2022. This was the first "orange bond" launched under the "Orange Bond Initiative", which is named after the colour of the UN Sustainable Development Goal 5, Gender Equality (SDG 5), and aims to support 300,000 low-income women and girls in Asia and Africa.
We expect such exotic bonds to continue to thrive in 2023, particularly as standardisation and best practices take hold and the concept of "blended finance" (where public and private capital invest together) was a focal point at the UN Climate Conference COP27. Yet, these bonds are usually issued in comparatively small issuance sizes and are only marketable to investors when they come with third-party guarantees or include some sort of "first loss" buffer, usually from international development banks or NGOs. They will therefore remain a niche product in the wider sustainable bond market.
8. The "greenium" debate continues
While the sustainable bond market is still relatively young, the question whether there is such a thing as a "greenium" has been around almost from the start: Can issuers achieve lower costs of funding if they issue sustainable bonds as opposed to conventional bonds? This is called a "greenium" or "green issuance premium".
Scores of academics, bankers and treasurers have since grappled with this question and the debate continued in 2022. Does the greenium really exist? And if it does, where does it come from?
Research by the Climate Bond Initiative found evidence of a greenium in just under four out of ten SLBs it analysed. The European Central Bank concluded that there was a greenium for those green bonds that had the benefit of an external review and an even higher greenium for "green issuers" (such as renewable energy firms). And research by Bank of America put the average greenium for green bonds issued by investment-grade corporates at around 10 basis points at the end of 2022.
But if there is evidence for a greenium in the past, is it still there in 2023? Goldman Sachs doesn't think so, declaring in a research note in January 2023 that there was now no difference in funding costs between conventional debt and bonds linked to ESG efforts, after controlling for factors such as industry, rating and maturity.
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Given the uncertainty around the very concept of the greenium, it is safe to assume that no-one knows where the greenium goes from here. The simplest explanation for a greenium has always been that it is merely a factor of downward pricing pressure caused by increased demand for sustainable debt from asset managers who are trying to fill their green or sustainable fixed income funds.
But the labelling of these funds, which is regulated by the EU's Sustainable Finance Disclosure Regulation (SFDR), has become the subject of some controversy. In 2022, major asset managers decided to reclassify more than $140 billion of so-called "Article 9 funds" the highest ESG fund designation under the SFDR to a less stringent category known as Article 8. The downgrades follow stricter EU guidance stipulating that Article 9 must be reserved for 100% sustainable investments. In the UK, the Financial Conduct Authority (FCA) proposed its own rules for sustainability labels for investment products in October.
Given the increased focus around which products are sufficiently "green" or "sustainable" to merit inclusion in such funds, it may well be that greeniums in 2023 will only be present for issuers with strong sustainability credentials or bonds that align with the strictest standards, such as the EU Green Bond Standard once it comes into force (see below).
Conversely, for some issuers, particularly those with high carbon emissions and that have not quite got their transition journey underway, the challenge in 2023 might be not so much about achieving a greenium but rather to avoid a "brownium", i.e., a higher funding cost for their debt.
9. Market scrutiny is on the rise
Amid concerns around greenwashing, much of the discussion in the sustainable debt market in 2022 centred around quality. In the absence of mandatory regulatory standards, it again fell to the market to apply scrutiny.
For example, research by ESG investment publication Responsible Investor revealed that asset managers rejected on average one in every five green bonds on quality grounds.
But it was SLBs that bore the brunt of the criticism. Bloomberg News analysed more than 100 SLBs issued in Europe and found that the majority were tied to climate targets that were "weak, irrelevant, or even already achieved". To tighten up the key performance indicators (KPIs), which form the basis of the SPTs, ICMA added a KPI registry to its SLB Principles in June 2022, which gives 300 illustrative examples of KPIs covering 22 sectors and a "materiality matrix" to help identify the relevance of key sustainability themes. But research by data and ratings provider Sustainable Fitch found that only about half of the SLBs it analysed included a KPI that
was considered "core" to the issuer's business under the ICMA registry.
And in what might be a sign of things to come, Mighty Earth, a Washington-based NGO, filed a whistleblower complaint to the SEC in January 2023 calling it to investigate a Brazilian SLB issuer for securities fraud. The complaint alleges that the issuer's overall communication with investors about its sustainability performance was misleading, partly because it did not disclose its Scope 3 emissions (which are those emissions that occur in the issuer's supply chain and make up the majority of its total emissions).
We expect this heightened market scrutiny around sustainable bonds to continue in 2023, particularly as regulators are finally catching up (see below). Industry guidance will also continue to evolve, particularly in the SLB space, where more guidance around best practice for calibrating SPTs prior to issuance and updating SPTs post-issuance might be forthcoming, among other things.
10. Regulators are finally catching up
Since its inception, the sustainable bond market has developed without specific rules from regulators. Instead, market participants relied on standards and principles from industry bodies and organisations, such as ICMA, the Climate Bonds Initiative or the ASEAN Capital Markets Forum. While alignment with the relevant standards and principles (certified by second party opinion providers) became the market standard, they remained voluntary. As the sustainable bond market grew, so did concerns over greenwashing and calls for binding regulation.
2022 made it clear that regulators are beginning to catch up. The European Financial Reporting Advisory Group (EFRAG), the U.S. Securities and Exchange Commission (SEC) and the newly formed International Sustainability Standards Board (ISSB) drafted various proposals for disclosure standards relating to sustainability and/or climate-related issues, which are due to be finalised in 2023. Once adopted, they will require major companies to regularly report things like carbon emissions. The most far-reaching regulation in the space is the Corporate Sustainability Reporting Directive (CSRD), which came into force in early 2023 (see our blog post on the CSRD here).
For the sustainable debt market, this means that investors will have a much better idea of the overall sustainability picture of an issuer. This should enable them to compare the sustainability credentials of that issuer versus its peers and to analyse the appropriateness of green projects and sustainability targets in sustainable bonds in the wider context of the issuer's overall sustainability performance.
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More specifically for sustainable bonds themselves, the European Union advanced work on its EU Green Bond Standard (EUGBS) in 2022, although talks between the EU Parliament and member states collapsed in December. While the standard itself would be a voluntary label, market participants have expressed concerns about the current proposals, which would impose a mandatory regime for all issuances of sustainable instruments in the EU, including SLBs. Under these proposals, only those companies that have transition plans in line with the EU's own 2050 net-zero targets could issue sustainable bonds. In addition, the European Parliament has called for civil liability provisions to apply to issuers if they fail to use the proceeds of green bonds for projects that are aligned with the EU Taxonomy.
Negotiations on the EUGBS are due to continue early this year and it is currently unclear where the EU will ultimately land: While a robust regulation might make EUGBS-aligned bonds more attractive (hello, greenium?), it may lead some issuers to turn their back on the European market altogether or, worse still, lead them to issue conventional bonds to avoid potential liability and costs.
Elsewhere, ESG ratings, which are an important tool that some investors use for their capital allocation, are set to be next in line for more stringent rules after providers have been criticised for the differing objectives and methodologies used in their ratings. The European Commission is considering regulating the market and published responses to its consultation in August 2022, while the UK's Financial Conduct Authority (FCA) set up a focus group to create a code of conduct for ESG data and rating providers in November. European securities market regulator ESMA along with the EU's banking and insurance watchdogs also launched a consultation to gauge the scale of exaggerated ESG investing statements and to agree on a definition of "greenwashing".
While complex, tighter standards and regulatory oversight should boost investor confidence in the sustainable debt market, it will likely drive up issuers' costs for structuring, disclosure and ongoing reporting.
General outlook
Early signs in January 2023 are that the global debt market is slowly recovering. Investors are betting that central banks will move more slowly this year in their efforts to tame inflation and that we may reach "peak interest rates" later this year. There is also hope that bonds will regain their traditional role as a safe haven from recessionary conditions where investors turn to from riskier equity investments.
While the sustainable debt market is going through a rough patch at the moment, it is worth bearing in mind that vast investments will be needed for the world to reach net zero by 2050. Reports from Swiss Re and McKinsey put that figure at between $270 trillion and $275 trillion. It is probably a safe bet to assume that a significant part of that financing need will flow through the sustainable debt market.
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