The 2020s - The decade of Sustainable Bonds

Channels: Green Bonds

Companies: DZ Bank

People: Marcus Pratsch

Welcome to a new decade of finance

Marius Pratsch, Head of Sustainable Bonds & Finance, DZ BankOur blue marble faces long-term environmental and social challenges that are far more pressing than most economic topics discussed in the daily press. And time is running out. The point of no return is approaching.

Climate change is not fake news. It is very real. In the last twelve months, climate change and the destruction of nature have become impossible to ignore. The latest climate science tells us that the window to halt the dramatic changes that threaten our civilisation is shorter than we had hoped. Climate change is happening faster than the world's leading scientists ever predicted. And it's going to be expensive: If climate change continues unabated, its impact will cost humanity around 7% of global per capita income by 2100.

In addition, many of the Sustainable Development Goals are currently lagging far behind in their implementation since they were adopted back in 2015. The world is off-track to meet most of the targets linked to hunger, food security and nutrition for example.

Overcoming these challenges, which will mean trillions in investment, knows no borders. It's a global challenge. According to our calculations, we need at least 500 billion US-Dollar per year to close the climate financing gap in the next ten years. Considering the costs of inaction, it might even increase in the coming years. The United Nations estimate the gap in financing to achieve the Sustainable Development Goals at 2-3 trillion US-Dollar per year in developing countries alone. Hence, it is not enough to sail across the Atlantic alone. The capital market must be on board.

The road towards a sustainable economy is unthinkable without the participation of the capital markets. Public money will not be enough. Fortunately, investors have started to recognize the sign of times realising that finance was one of the missing links on the sustainability agenda.

We are entering a new decade of finance. We are in a sustainability investment race; to attract the trillions in private capital needed for the sustainable transformation.

The role of capital markets

The global fixed income market plays a key role in this transformation process. With an estimated volume of more than 100 trillion US-Dollar, it bears huge potential for facilitating the transition to a sustainable future.

From our point of view, one of the most promising investment vehicles helping to close the sustainable financing gap are Sustainable Bonds as they facilitate re-allocation of capital flows towards sustainable projects, and hence allow investors to attach purpose to their investments, reconnecting finance with hard assets in the economy.

Sustainable Bonds: Market Forecast 2020. Source: DZ Bank (2020)

Sustainable Bond market: the diversification continues

In 2007, the European Investment Bank (EIB) pioneered the Green Bond market by issuing the world's first Climate Awareness Bond (CAB). Thirteen years later, everyone is talking about Green Bonds. Initially regarded by many as a marketing tool, they have developed from niche to serious mainstream.

2019 marked another record year for Green Bonds. According to statistics of the Climate Bond Initiative (CBI) global annual Green Bond issuance increased by 49% from 171.1 billion to 254.9 billion US-Dollar. For the first time in the history of the Green Bond market, the new issue volume already broke through the 100 billion US-Dollar mark in the first half of the year. In September, new issue volume surpassed previous year volume and in October, it exceeded the 200 billion US-Dollar mark.

In addition, the trend "Green goes rainbow" which we have highlighted in last year's edition of Environmental Finance Sustainable Bonds Insight continued. More and more issuers are going beyond the pure environmental perspective when issuing sustainable bonds. While the Social Bond segment took a slight breather in 2019, new issuance of ESG, Sustainability and SDG Bonds continued to support the growth of the overall Sustainable Bond market.

2019 was also the year of new labels like Sustainability- linked Bonds and Transition Bonds (Transformation Bonds), allowing investors to make more bespoke choices. Considering the ongoing diversification, the overall Sustainable Bond market (according to DZ BANK definition) grew by around 50% from 230 billion US-Dollar in 2018 to 345 billion US-Dollar in 2019.

Green bond market. Source: DZ Bank (2020)

Billions are not enough to address the sustainability challenges

Although the Sustainable Bond market has shown impressive growth in recent year, we have to admit that a 350 billion US-Dollar market is by far not enough to address the global sustainability challenges and provide the capital at scale urgently needed for the necessary transformation. Compared to 100 trillion US-Dollar global fixed income market the sustainability bond market is still a small but shiny light.

Approaching the first trillion in annual issuance is now critical. Hence, we need more investors making their sustainable investment demand visible to encourage potential issuers to come to market with more deals.

The growth in the number of dedicated Green Bond funds as well the emergence of more and more Social Bond and SDG Bond funds demonstrates the increasing demand for sustainable fixed income products, which should encourage issuance. Especially in the non-financial corporate world, there is quite a large number of potential issuers sitting on a pool of eligible sustainable assets without knowing it.

The race for the trillions is supported by regulation and numerous sustainable finance initiatives, which are luckily now happening at a higher level than ever before opening new pathways to achieve the critical sustainable investment goals. The EU, which has a very important asset – the single market, which will incentivize investors to scale up their sustainable investments across the union and outside - is currently working on the metric system of the 21st century. The so-called EU Taxonomy represents one of the single largest steps yet in reorienting basic economic activity towards sustainability.

Sustainable bond market. Source: DZ Bank (2020)

The 2020s- The decade of Sustainable Bonds

As 2020 marks the beginning of a decade of urgent climate and sustainability action, we expect strong pick-up in investor demand for Sustainable Bonds.

We forecast that the strong growth momentum in Green Bond issuance will continue in the current year. We expect the Green Bond market to grow in 2020 by around 45% to 370 billion US-Dollar, hence exceeding the 300 billion US-Dollar mark for the first time.

While SSAs in general will remain the guarantors for quality in the Green Bond market, sovereign issuers will be one of the growth drivers. In 2019, Sovereign Green Bonds accounted for around 10% of total issuance for the year. Since Poland has pioneered the market in 2016, twelve nations came to the market. In 2020 countries like Germany, Austria, Italy, Sweden and Spain are expected to debut on the Green Bond market while pioneers like France and 2019 debutants like the Netherlands are expected to return to the market again.

The diversification of the market in terms of both issuers and bond types will continue in 2020 and the following years. New issuance of ESG, Sustainability and SDG Bonds as well as Social Bonds will continue to support the growth of the total Sustainable Bond market. The number of Sustainability-linked Bonds will rise encouraging outcome-focused sustainable finance. Transformation / Transition Bonds have the potential to become an own asset class as an increasing number of non-financial corporates are transitioning to more sustainable business models seeking to use bonds as a tool to finance their transition strategies.

Hence, we forecast new issuance in the overall global Sustainable Bond market to grow by around 45% in 2020 surpassing the 500 billion US-Dollar mark.

We are expecting to reach the critical 1 trillion US-Dollar mark in the overall Sustainable Bond market by the end of 2022. The Green Bond market will most likely see the first trillion in annual issuance by the end 2023.

Sustainability-linked Bonds: boon or bane for the Sustainable Bond market?

The emergence of new labels in the sustainable fixed income world sparked controversies among investors in 2019. One of the labels that stood in the crossfire were Sustainability-linked Bonds, which allow for more outcome- focused sustainable finance. While proceeds from Sustainable Bonds (Green Bonds, Social Bonds and Sustainability Bonds) are earmarked for sustainable projects, Sustainability-linked Bonds are non-earmarked standard bonds whose financing cost may be increased in the event of failure to achieve a sustainable performance objective.

The criticism from many investors focuses on the fact that the issuer will be free to spend proceeds. However, Sustainability- linked Bonds open sustainable funding opportunities for issuers that so far have been unable to issue Green, Social or Sustainability Bonds because they cannot identify sufficient eligible assets / expenditures connected to sustainability. This especially holds through for a large number of small- and medium-sized corporates. Issuing target-link structures allows them to contribute to the global sustainable finance agenda by focusing on a broader transformation rather than focusing on specific projects. Finally yet importantly, Sustainability-linked Bonds offer sustainability-oriented investors a wider range of investment opportunities.

The rationale behind Transformation Bonds

The shift to a low-carbon economy which requires significant investments is currently a much and controversially discussed topic.

Honestly speaking, we have to admit that a decarbonized world won´t be reached by solely focusing on companies which are already 100 percent "green". Furthermore, many sustainable companies still depend on energy and resource intensive materials and processes.

In order not to stray from the sustainable path, we must not exclude anyone from sustainable funding. Hence, providing finance to processes, sectors and companies, which are "brown" today, but have the ambition to transform to more sustainability in the future is critical to achieving the Paris goals.

In our view, bonds are a suitable financing vehicle to support those transformation strategies. A transformation funding market will allow carbon-intensive companies and industries to finance their gradual shift away from fossil fuels for example. Proceeds could be also used to finance transformation technologies, such as less carbon-intensive alternatives, allowing for a shift to a more sustainable business model. It will encourage "dirty issuers" to transform their business model in line with the Paris Climate Agreement.

Hence, transformation bonds have the potential to become an own asset class. A clear distinction between Green Bonds and transformation bonds is very much welcomed as it would help to prevent greenwashing. Moreover, let us not forget that there is also a social transformation. Like Sustainability-linked Bonds, transformation bonds open up broader investment opportunities for sustainability-oriented investors.

The 2020s: A crucial decade for Sustainable Finance

The current decade will be a crucial period for sustainable finance. The role of the financial sector in transforming our economy toward sustainability had been overlooked for too long.

Fortunately, capital markets have taken the right path to support the sustainable transformation of our economy. Some years ago, sustainable finance used to be a small niche. But today it is becoming a transformational force. This is where the opportunity lies for the financial sector: in channeling private sector capital towards the "right" sustainable projects.

However, there is the need for speed!