20 February 2024

Looking at the market through a sustainability lens

Sustainable Fitch believes that examining the impact of sustainable debt offers greater insight than its alignment with ESG metrics. Nneka Chike-Obi and Gianluca Spinetti share their thoughts on the evolution of the market.

Environmental Finance: Use-of-proceeds bonds continue to dominate the sustainable bonds market, in terms of issuance. What do you focus on when assigning ESG ratings to this type of sustainable bond?

Gianluca SpinettiGianluca Spinetti: When we analyse use-of-proceeds bonds, the first thing we focus on is alignment with the International Capital Market Association (ICMA) principles: those are our guiding principles, so to speak. In addition to the use-of-proceeds analysis, we look at the management of proceeds, project selection, reporting by the issuer and all the traditional nomenclature around the bond.

That said, with use-of-proceeds bonds, the bulk of the analysis focuses on the proceeds themselves, so we're looking at where the money goes. We look at every single use of proceeds, and we score them from a green, social or sustainability perspective. To do that, we are informed by the ICMA principles, but we also complement that with a taxonomy of reference (which is widely recognised and science-based). If there isn't a taxonomy covering the specific activity or industry, we supplement that with our own internal views on the sector.

We can apply this analysis to all types of bonds, from all types of issuer, including structured financings, such as securitisations and project finance. We also cover loans and commercial paper.

EF: Are there any particular uses of proceeds that are more problematic to assess than others?

GS: In contrast to many other firms, we don't have any sector exclusions. Instead, we prefer to take our time and carefully explain our reasons behind a rating for a more environmentally or socially sensitive sector, and educate the reader on the nuances that are involved in the analysis.

Sustainable Fitch-rated green bonds use of proceeds (excluding structured finance instruments)

Source: Sustainable Fitch

EF: What is your analysis showing about the environmental and social integrity of the use-of-proceeds part of the market? What could issuers do better?

Nneka Chike-ObiNneka Chike-Obi: We've been using our ESG ratings data to get an understanding of trends here. Something we identified that's coming out in our ratings is that issuers could do a better job in two areas. The first is the split between new and existing projects to which proceeds are being allocated. We favour projects that are additional – financing something that is going to create a new environmental or social impact.

A similar topic is the length of lookback periods. Our view is that up to three years is acceptable for financing assets that have already been invested in and are starting to be built. These two areas contribute to some rated bonds performing below where the issuer might have intended.

As far as the specific uses of proceeds, there is considerable concentration in terms of what is being financed. Among green use-of-proceeds bonds, four use-types account for 80% of all financings, namely renewable energy, energy efficiency, clean transport and green buildings. In the social bond market, three uses of proceeds account for more than 85% – these are affordable housing, socioeconomic advancement and affordable basic infrastructure. What that means is that there are a significant number of ICMA categories of projects in both the green and social bond spaces that are being significantly underfunded through the bond market.

EF: Which categories would you say are under-represented, and why?

NCO: Climate change adaptation is one: this might be because it is more challenging for corporate or private sector entities to direct financing towards it, and it may be more appropriate for a sovereign issuer or a public entity.

In other cases, it's just that they're not getting enough financing attention and these are actually areas that are material to a number of issuers. For example, ecoefficiency and the circular economy accounted for only 3% of green bond proceeds. It's an area where lots of companies have a direct relationship between production and recycling and reuse. The sustainable management of natural resources is another. The work of the Taskforce on Nature-related Financial Disclosures might see this area grow. In the social bond space, food security-related use-of-proceeds bonds only accounted for 1% of bonds: this came up at COP28 and, given the effects climate change is having on food production and productivity, it's an area that could see some more attention.

EF: You recently published research into the sustainability-linked debt market. What did that research find?

NCO: The main thing we found in our research and in our ratings on sustainability-linked debt was concern around ambition and materiality. This is aligned with what ICMA found in a report it published at the end of last year. Research we produced in 2022 and updated last November found that a significant number of sustainability-linked bonds did not have KPIs that were considered either primarily or secondarily material to the issuer's main business.

We also found that there is still an issue with the placement of the trigger dates in some of these loans and bonds: they are either too close to the bond's maturity or to the end of the loan. What that means is that any financial penalty for missing those KPIs is very limited, because the company may only face a step-up payment for a small part of the life of the financing. This is obviously not very material.

We've also found that around 10% of sustainability-linked transactions we've rated do not align with ICMA because the issuer has created a sustainability-linked framework with observation dates, target dates and the timing of triggers that are not aligned with some of their loans or bonds.

Sustainable Fitch-rated social bonds use of proceeds (excluding structured finance instruments)

Source: Sustainable Fitch

EF: The SLB market has faced criticism for unambitious target setting and poor disclosure. Are there any signs these are improving?

NCO: There was a significant drop in SLB issuance in 2023, driven by the wider slowdown in corporate bond issuance, so it's hard to say whether things are improving. Certainly, the recent ICMA report specifically warned about greenwashing risk and issues around ambition and target setting.

On disclosure, the main concern investors have is where the SLB framework is not clearly integrated with the corporate sustainability strategy. For example, the company may have set a target for the SLB, but it's not clear how that feeds into its day-to-day operations. Because SLBs are financing general corporate activity, it's important for investors in those bonds to have a holistic view of the entity itself.

EF: How do you anticipate that efforts to standardise ESG reporting will affect the wider sustainable bonds market?

NCO: These will, I hope, make that relationship between labelled bonds and the company's overall strategy a lot clearer. It should also reduce the 'pain point' for investors, in terms of them having to do extra homework, on top of reviewing the bond documentation, to really understand how the two fit together.

Investors want to understand how pivotal a particular bond issuance is to the company's overall business and their sustainability journey, and the social or environmental impact it is creating. These are the types of questions that investors are struggling to answer. Standardisation of reporting is hopefully going to make life easier for them.

I'm based in Hong Kong, so looking at Asia, the Hong Kong Stock Exchange, the Singapore Exchange and the Tokyo Stock Exchange are all introducing disclosure requirements for listed companies that will mean they will have to be much clearer on the relationship between sustainability strategy and overall corporate strategy.

EF: Where are you seeing the best disclosure, and what are the reasons for that?

NCO: Europe-based entities generally have better disclosure ratings, performing either excellent or good on average. That's because there's just a longer history of sustainability reporting there. Meanwhile, places that have some kind of disclosure requirements are performing slightly better: in Asia, for example, Hong Kong and Singapore perform slightly better than other parts of Asia that do not have mandatory reporting requirements. Japan has introduced a number of mandatory disclosures related to gender and diversity metrics, so that's going to change the quality of Japanese sustainability reporting. Disclosure is very related to regulation and compliance requirements at the moment.

EF: Many of the insights above stem from Sustainable Fitch's ESG Ratings. Can you explain what the ratings examine, and what differentiates them in the marketplace?

GS: We try to cater to the needs of the fixed income investor. Our sense when we entered this market a couple of years ago was that much of the ESG movement was focused on equity markets; focusing on fixed income makes sense given Fitch's heritage in providing credit ratings, via Fitch Ratings.

Our second differentiation is that we focus on sustainability – on the actual social and environmental impact that the company or its projects are having. I stress this because many other players in this space focus on ESG risk metrics, on how ESG factors could impact a company's financial bottom line.

We also look at the entire financing stack – loans, bonds, convertibles, hybrid debt, etc. Not all debt is created equal, so we don't want to simply apply the same company rating to all the different layers of debt that company might issue. Use-of-proceeds bonds or asset-backed securities are a case in point, as the funding is "connected" to specific projects.

EF: How are clients tending to use your ESG Ratings?

GS: Our clients use our ratings and the underlying data for three reasons. The first is for investment decision-making: (a) to inform investment, engagement and disinvestment decisions with ESG impact data, not just ESG risk; (b) to inform asset allocation using ESG performance data to support entity or security selection and perform peer comparisons; and (c) for portfolio construction using overall ESG ratings or sub-components for negative/positive screening and ESG-optimisation at the entity or instrument level.

The second is for monitoring portfolios. If an event changes an entity or transaction score, then the investor might take action based on that. It may also use the score to identify instruments supporting the transition to sustainable infrastructure and economy, or to screen portfolios for discrepancies at entity level and framework level, thus preventing greenwashing.

The third is for regulatory reporting purposes, particularly in Europe, where regulation is getting tighter, to report to their stakeholders, and to use the scores and raw data to report on impact alignment with the EU Taxonomy and the UN Sustainable Development Goals, for entity-level business activities and instrument-level uses of proceeds or KPIs.

EF: What's next in terms of developing the ESG Ratings product?

GS: Our main focus is to further embed the product with the investor community, particularly among fixed income investors.We also plan to extend our coverage to new regions and other parts of the fixed income markets. For example, we have recently looked at the collateralised loan obligation (CLO) market, which often involves investments in loans made to small- and medium-sized entities: last September, we launched full coverage of the European and North American CLO market.

We have also launched a product for the net zero space, with a methodology aimed at positioning, differentiating and benchmarking companies, particularly in the energy sector, as they transition from carbon intensive to net zero. It is based on the initial work of the Sustainable Market Initiative's Energy Transition Task Force. Given that companies' transition approaches tend to be unique and specific, they are difficult for investors to compare and assess. Our approach aims to provide greater visibility on targets, commitments and actions taken.

Nneka Chike-Obi is the head of APAC ESG ratings and research at Sustainable Fitch and is a member of ICMA's Advisory Council to the Green Bond Principles and Social Bond Principles Executive Committee. Gianluca Spinetti is the global head of ESG analytics at Sustainable Fitch.

For more information, see: www.sustainablefitch.com 

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