With sustainable bonds accounting for a growing share of the overall bond market, MSCI's Jakub Malich, Meghna Mehta and Michael Ridley see new applications, growing regulatory tailwinds – and the integration of ESG analysis into the wider bond market.
Environmental Finance: Sustainable bond volumes in 2023 were up slightly on the prior year, but not quite at 2021 levels. What do you see as driving volumes and activity in the market?
Jakub Malich: If we look at what was driving issuance in 2021, a lot of that was related to the Covid 19 pandemic and to financing the relief programmes; this was evidenced by the jump in social bond issuance and in issuance by government-related entities. Since then, of course, the pandemic has ended. Interest rates have also risen, which has had a cooling effect on all debt issuance, because it makes it more expensive. This means that some slowdown in issuance versus 2021 is understandable.
So, rather than look at absolute numbers, it makes more sense to gauge issuance trends by looking at the labelled bond market in relation to the wider bond market. Here, we see that the proportion of labelled bonds within global bond benchmarks has been increasing steadily. In the last year, more than 5% of the bonds included in MSCI corporate bond indexes were labelled bonds, up from just over 4% in 2022.
Michael Ridley: The signalling effect of the labelled bond market is also quite a powerful driver of issuance. Issuing a labelled bond both signals that the bond is funding green projects – helping to bring sellers and buyers of bonds together – as well as showing that the issuing company has a transition story to tell.
Figure: The increasing proportion of labelled bonds in global bond benchmarks
EF: Within this, green bonds are growing as a percentage of the overall labelled market. To what do you attribute that?
JM: Among the four types of labelled bonds – green, social, sustainability and sustainability-linked – green bonds are dominating issuance. We believe the main reason for that is the focus on financing the transition to a low-carbon economy and related regulation.
In terms of regulation, we have the EU Green Bond Standard, the China Green Bond Principles and a number of transition taxonomies emerging, such as the one recently introduced by Singapore. Meanwhile, our use-of-proceeds analysis shows that, among the green bonds that we analyse, most are financing transition-related projects, especially projects related to energy. Here, the energy crisis resulting from the war in Ukraine provided a tailwind to green bond issuance, as many companies started to invest in energy efficiency projects.
EF: Where do you expect to see innovation in the green bond market in 2024?
Meghna Mehta: We are beginning to see a wave of green bonds being issued for hydrogen production, hydrogen transport, hard-to-abate sectors like steel and cement production, and categories like the circular economy.
One of the drivers we are seeing here is the production of taxonomies that can help to clarify definitions and set out what activities within hard-to-abate sectors can qualify as sustainable. These taxonomies are helping to define 'green' and may give issuers more confidence to issue green bonds across different sectors, without risking being accused of greenwashing.
MR: When the International Capital Market Association released its Green Bond Principles in 2014, it purposely didn't define exactly what was green: a lot of leeway in judging the greenness of green bonds was purposefully left to the market, and that worked for a long period of time. But, as we move beyond renewables and the electrification of the economy, we need to look at emission reductions from harder-to-abate sectors. Here, we need taxonomies to provide support and give confidence to issuers in these more complex parts of the economy.
EF: How does this innovation affect your green bond methodology at MSCI?
MM: The MSCI green bond assessment methodology has historically included sectors like alternative energy, green buildings and energy efficient public transport. With the advent of different taxonomies and innovative projects entering the green bond market, we are updating our methodology to broaden it. The aim is not to replicate any one taxonomy, but instead take a global approach to these different sectors that have been covered by the EU Taxonomy and others and define thresholds for them.
In this, we are being led by our clients. They want us to retain a global methodology that reflects both emerging and developed economy constraints. So, as we work to update our methodology, and decide which activities we will be including, we will consult with our clients as to what we will propose.
EF: The EU Green Bond Standard was finalised last October. Do you expect market participants to embrace it?
MM: If you look at labelled bonds being issued in the EU today, a lot of them reference the EU Taxonomy, and talk about how their proceeds are aligned with it and its Do No Significant Harm and minimum safeguards pillars, and with its technical specifications. It is likely that many of these issuers are already prepared to comply with the EU Green Bond Standard when it comes into force, which is likely to be by the end of 2024.
Any concerns we might have are around the state of development of the EU Taxonomy. It has only defined technical screening criteria for limited sectors so far. However, the EU Green Bond Standard has taken that into account, in that up to 15% of a bond's proceeds can be directed to activities that do not have technical screening criteria defined by the EU Taxonomy.
EF: What bearing is the Sustainable Finance Disclosure Regulation (SFDR) having on MSCI's green bond index methodologies?
MM: We had a consultation in late 2022 with clients of the Bloomberg MSCI Green Bond indexes about how we should incorporate elements of Article 9 of the SFDR, which sets out which funds can label themselves as sustainable investments. That consultation found that clients wanted to place some issuer-level constraints on index constituents. So, for example, issuers with more than 15% of their revenue from thermal coal, or any exposure to controversial weapons, are not eligible for the indexes, nor are issuers with any red-flagged environmental controversies as categorised by the MSCI ESG Controversies and Global Norms Methodology.
MR: Traditionally, companies haven't needed to be in green sectors to issue in the green bond market; so long as the bond wholly funded green projects, that was fine. That ethos has been slightly modified in response to SFDR, to the extent that there are now some issuer-level constraints, too.
EF: What about wider fixed income portfolios, outside the ESG-labelled debt market? How are investors thinking about climate risks there?
MR: Bond investors want to know three things regarding climate risk. What climate-related transition risks are their bonds exposed to? What climate-related physical risks are they facing? And what positive or negative impact are their bonds having? Of course, these concerns extend beyond the labelled bond market, and we have developed a number of different metrics and tools to help investors answer these questions.
MSCI's Climate VaR model estimates the percentage hit to the economic value of a company that is likely to result from climate-related volatility. Climate VaR represents the sum of climate transition risk and climate physical risk. We have also developed an implied temperature rise (ITR) calculation for companies. It is a calculation of what the average global temperature rise would be if the whole world were to follow the same emissions trajectory as the company in question. That allows investors to see an estimate of the impact that the issuing entity is having on the climate.
"Traditionally, companies haven't needed to be in green sectors to issue in the green bond market; so long as the bond wholly funded green projects"
Investors can use it a number of ways: impact investors might decide to sell bonds from a company with an ITR greater than the 1.5°C goal of the Paris Agreement. Other investors might decide they are at risk if they hold that company's bonds, because others may start selling them. Or investors might take the view that, because the company's ITR is high, it is risky because it will need to dedicate additional capex to decarbonisation.
Finally, we have developed a Total Portfolio Footprinting metric, which provides a measure of financed emissions at the bond level. That provides a measure of tons of carbon dioxide for every million dollars of bond principal that is outstanding. It allows investors to estimate the entire amount of carbon emissions associated with a particular bond or portfolio.
EF: MSCI recently published research looking into the links between sustainable bond issuance and wider corporate decarbonisation. What did the research find?
JM: As we noted earlier, the labelled bond market is growing as a proportion of the overall bond market, but we wanted to find out what this growth means in terms of results. Are we seeing any changes in the behaviour or profile of the companies which issue these bonds, and any impact for the investors buying them? To answer this question, we conducted a study that examined the relationship between sustainable bond issuance and companies' climate targets and their decarbonisation.
We looked at all the companies we identified as having issued labelled bonds, and we used the MSCI climate targets and commitments methodology to assess the 'quality' of their climate targets against three main criteria: ambition, comprehensiveness and feasibility. This gave us a view of the rigour of their climate targets and transition paths.
We drew two main conclusions. First, we found that the companies which issued these bonds seem to be on a more credible decarbonisation path as measured by these criteria. That applied to pretty much all the sectors and regions that we looked at. It seems there is a correlation between issuing these instruments and companies actually embarking on the transition journey.
The second main finding is less positive, in that only a minority of these companies actually passed all of the three criteria. So, in terms of meeting global transition and climate targets, that is not such good news. There is a great deal of room for improvement.
Jakub Malich is a vice president in fixed income ESG and climate research at MSCI in Hong Kong, Meghna Mehta is a vice president in ESG research at MSCI in Mumbai, and Michael Ridley is executive director and head of fixed income ESG and climate research at MSCI in London.
For more information, see: Green Bonds and Climate — Towards a Quantitative Method
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