Driving ESG bond markets to new heights

The environmental, social and governance (ESG) debt market had an eventful year in 2020 with the pandemic spurring the growth of social bonds and increased issuance of other types of sustainable debt. BBVA was also the first private institution in Europe to issue a Covid-19 bond, setting the precedent for others to follow. Patricia Cuenllas and Michael Gaynor review the events of 2020 and assess what this means for the year ahead

Environmental Finance: One of the big trends for ESG bonds in 2020 has been the proliferation of social bonds. What has driven this trend and are social bonds here to stay?

Patricia Cuenllas, DCM, green and sustainable bonds, BBVA: Social bond issuance exploded last year. The total amount issued was well above €200 billion ($240 billion) and it now represents around half the total ESG issuance volume. To put this in perspective, the volume has more than tripled in the last year. It shows a rebalancing has taken place in the green, social and sustainability (GSS) bond space.

In the first instance, there was a need to mitigate the effects of the pandemic. But at the same time, the exceptional situation made the market become more aware of the importance of including social aspects in corporate and investment strategies.

While the pandemic put the social bonds in the spotlight, this is just the beginning.

EF: Which geographies and sectors have most potential for increased issuance of social bonds?

PC: We expect to see more social bond issuance in the public sector, mainly by financial institutions in those geographies where there are more opportunities for a positive social impact.

Increasingly during the pandemic, we are also seeing more interest from corporates in this same category. However, it can be difficult for corporates to analyse how to incorporate social categories into their frameworks and transactions. Therefore, I think that instead of standalone social bonds, we can probably expect more issuance of sustainability bonds that incorporate environmental and social categories.

In terms of geographies, we have seen increased interest in Europe, but also and Latin America. In the beginning of the pandemic we saw large transactions from International Finance Corp (World Bank) and Inter-American Development Bank (IDB), as well as the social bond issue of Ecuador. Most recently, also Chile updated its framework to incorporate social categories.

We also anticipate seeing more microfinance related social bonds in Latin America. They have a unique opportunity to focus on the impact they want to have on society.

Without a doubt, we have had more issuers from Latin America contacting us to find out how they can add value to their clients and to see if they are in the position to issue a social bond.

EF: You were the first private institution in Europe to issue a Covid-19 bond last year. What drove your decision making and how did you approach structuring the use of proceeds for it?

PC: At BBVA we have always tried to innovate in the ESG bond market, and we are conscious of the impact such transactions can make.

The decision to issue our own social bond in May was an easy one. On the one hand, our sustainable development goal (SDG) bond framework already included social categories and, on the other hand, BBVA was already providing support and financing to the most affected sectors of the pandemic.

We placed €1 million towards our Covid-19 social bond and it was a very successful execution. We were particularly happy to see that many of the investors that subscribed to the bond had already invested in our green bond transactions before. The demand was closed at €5 billion and it goes without saying, we were pleasantly surprised.

In terms of use of proceeds, we wanted our social bond to contribute to one of the four social categories defined in our SDG bond framework: healthcare, affordable housing, small and medium-sized enterprise (SMEs) financing and education. However, since this was a Covid-19 social bond and as many companies are now struggling, we decided that this bond should primarily focus on SME financing.

EF: What were some of the challenges you experienced in issuing this bond?

PC: Being the first private institution to issue a Covid-19 bond was a challenge. We were sure that we wanted to do it, but at the same time, we needed to make sure that the deal was going to be a success. Our primary concern was linked to the volume. As BBVA had been very active in helping clients during the pandemic, we knew we had enough loans – a total collateral of over 3 billion euros – to justify the exercise. However, we were not sure if we would have the data needed to do the reporting.

We needed to see if we had enough information to provide a value analysis in our reporting, around areas such as employment retainment figures. We are now looking at this and will be publishing our first impact report for the Covid-19 social bond in May or June.

EF: Looking at other innovative structures in the market, such as sustainability-linked bonds (SLBs), why might some issuers and investors favour this structure over a use of proceeds structure?

PC: Before the International Capital Market Association's (ICMA) Sustainability-Linked Bond Principles were announced, some companies were already looking for a way to enter the ESG bond market but adopting a use of proceed format to identify specific green or social projects or initiatives did not fit their strategy.

When a company opts for a SLB format, they are making a forward-looking statement about their strategy, and this broadens the scope of the issuer. For instance, cement companies are aware of their environmental impact and have worked on their targets for CO2 reduction. These targets have been validated by the science-based target initiative (SBTi) and are aligned with the Paris Agreement. These companies are now making a strong statement about their future and can tap the market for investors to finance these strategies. This pushes the sustainable debt capital market toward financing transition.

Michael Gaynor, senior credit research analyst, BBVA: From the investor perspectives, if we compare SLBs with the use of proceeds model, there is a degree of separation between the issuer and the capital with the use of proceeds format. It is the green capital that has traditionally been judged on the ESG criteria, not necessarily the company or the top-level corporate strategy.

As such, there are some investors who are concerned about 'greenwashing' as there might be ringfencing of capital going to fund green projects from the bond being issued, but there is no explicit commitment at the corporate level to greening up the rest of the balance sheet or business operations.

The key point is that investors want to understand the decarbonisation or socialisation story of companies' balance sheet in a much more holistic manner and, as such, SLBs can benefit both issuers and investors.

EF: How do the valuations of the different types of GSS bond and KPI-linked instruments structures compare?

MG: This is something that investors are keen to know. Despite the growth of social bonds this year, we still see that green-labelled instruments have the strongest pricing dynamics and largest investor interest.

This is partly because they have been around longest, and we now have the EU regulation that supports them. For the time being, it is difficult for investors to quantify what is a meaningful social impact. Even if the data is there, the materiality and the meaning of what it means can be missing.

In the green bond space, however, there is more supporting information for investors to make a materiality-based decision on these instruments and this feeds through to the pricing.

We expect this to change when investors become more comfortable with different instruments as they become more mainstream. Then we would also expect to see preferential pricing dynamics emerge and more sustained outperformance in the medium- to long-term.

EF: Are KPI-linked structures easier for investors to track and measure impact?

MG: It depends. With KPI-linked instruments there is a coupon step up or down that is likely to be linked to an already existing, and relatively transparent, corporate target, hence allowing the investors to benchmark these targets versus the sector. With the use of proceeds bonds, investors need to do more digging into the allocation and tracking of the capital. For those investors engaged at the corporate level and looking at decarbonisation transition strategies, it is possibly easier to track the impact of SLBs than use of proceeds.

Another issue is the scalability. Some of these instruments have multiple metrics and targets linked to multiple coupons. As we start to see the number of these issuances grow over time, modelling the optionality of these products in a portfolio will not be an easy task, especially for smaller assets managers. This is an important consideration to address for the scalability and marketability of these products.

There have also been some controversial transactions due to the strengths of their targets. It requires a lot of resource intensive analysis from investors to assess what is material or not, in terms of targets and measurable KPIs.

In summary, this market is incredibly nascent, and investors are still learning exactly how they can incorporate such instruments into their portfolios. The idea behind these instruments and why they need to exist is undeniable; the outstanding issue is how we build these nitty gritty technicalities into the portfolios and how to scale them up moving forwards.

EF: You mentioned the importance of regulation for supporting the markets. How are such regulatory developments framing the market?

MG: In 2020, with the EU Sustainable Finance Action Plan, the Taxonomy, and the Green Bond Standard (GBS) that the European Commission was developing, it appeared they were being incredibly supportive of the development of the green bond market – and of a possible social taxonomy in the future as well.

Then in November 2020 we received a draft from the European Commission which had some meaningful deviations from what the Technical Expert Group (TEG) had originally suggested. Whilst most of the defined activities were fine, there were some questions around some specific details, including natural gas related activities and activities related to real estate.

The future success of the taxonomy is now very much in the balance. The key question is, how willing are the European Commission going to be to change their position when addressing some of the feedback and putting forward a new draft of the Delegated Act?

One of the key barriers for issuers is identifying an eligible asset pool on their balance sheet. A taxonomy allows them to identify those assets. Ultimately for investors, the EU regulations remain a significant step up in terms of the disclosures at a corporate and product-level. This will be massively supportive, not just for the green market, but also for ESG investing. Despite the uncertainty around the taxonomy, the GBS is already being applied by issuers, showing an awareness and enthusiasm from issuers to align themselves to this regulation.

In summary, regulatory frameworks are helping the issuers understand what they can issue and the scope of what is possible under green taxonomy. It is also helping investors understand what is materially green and what can contribute to their targets. Materiality is the most important factor that is really going to drive this market to new heights.