2023 ended with a cautiously positive turnaround for sustainable bond markets. A promising start to 2024 suggests new heights could soon be reached, says Marcus Pratsch
For a long time, it looked as if 2023 would be the second consecutive year in which the sustainable bond market would see a decline in new issuance volume. Ongoing geopolitical uncertainties, macroeconomic headwinds, increased cost of capital, a volatile overall market, and challenges about sustainable finance regulation are just some of the factors that have led to the postponement - or even cancellation of sustainable projects, a slowdown in sustainable lending by financial institutions as well as a slowdown in sustainable funding activities.
However, the year ended on a conciliatory note, with the new issuance volume growing by around 14% to just under $866 billion. The sustainable bonds' share of total market new issuance increased from 18.5% in 2022 to 19.8% in 2023.
With a share of 59%, green bonds reasserted their position as the dominant sustainable bond label in terms of issuance. Target-linked structures faced another challenging year as many investors continue to criticise the lack of materiality of the selected KPIs and the level of ambition of the underlying sustainability targets. With a share of 40%, supranational, sovereigns and agencies (SSAs) remained the biggest contributor (by volume) and hence a solid anchor and guarantor for quality in the sustainable bond market. With an increase of 25%, issuance by financial institutions has continued its uninterrupted growth over the past 10 years.
Without doubt, 2023 was a record year for sovereign sustainable bonds issuance. The new issuance volume increased by around 49% to $156 billion (2022: $105 billion), hence surpassing the previous record volume of $117 billion in 2021. At the end of 2023, 52 sovereigns had issued sustainable bonds with a cumulative volume of more than $450 billion.
Lessons learned from COP28
COP28 has brought back into focus the need to accelerate the climate transition. It concluded with a strong agreement to transition away from fossil fuels, triple renewable energy capacity by 2030, double energy efficiency improvements by 2030, and increase climate finance for the most vulnerable.
COP28 showed that the interplay between climate change and other environmental and social challenges is moving up the agenda of policymakers and financial market participants. It was the first summit to consider health issues in depth, with a meeting of global health ministers to highlight the consequences of the climate crisis for wellbeing. For the first time ever, the conference featured a whole day devoted to food and agriculture and saw a food systems roadmap laid out by the UN's Food and Agriculture Organization.
Nature-based solutions were also recognised in the Global Stocktake, recognising that nature and biodiversity are key to mitigating a heating planet and protecting vulnerable communities from the impacts of a changing climate.
This is where the market for sustainable debt instruments comes into play and could benefit. COP28 has shown that there is still a large climate finance gap, an even larger overall environmental finance gap, and a huge UN Sustainable Development Goals (SDG) finance gap. To close these gaps, we need to mobilise much more private capital, much faster, through the capital market and allocate it to projects, products, and processes that have a positive impact on the sustainability agenda. And sustainable bonds are one of the instruments we can use for this purpose that does not require us to reinvent the wheel.
As a result of the final COP28 document, and with only a few years left until 2030, we are confident that the proportion of sustainable bonds in the new issuance volume of the overall market will increase. We assume that the proportion will rise from around 20% today to a quarter within the next two to three years. By 2030, we expect this figure to double to 40% compared to the 2023 level.
Drivers and opportunities in 2024 and beyond
COP28 has shown that the fixed income market is an important piece of the puzzle for financing the global sustainability agenda and therefore has enormous potential for further growth, which is also backed by supportive policies, taxonomies, and regulations around the globe creating a favorable environment for the issuance of sustainable debt.
Investor appetite for sustainable bonds continues unabated. We have seen continuous inflows into sustainable and responsible funds, adding further demand for sustainable bonds. Hence, we expect further diversification by issuers, structures, and themes as we move throughout 2024 and beyond. Diversification in the sustainable bond market provides investors with more bespoke choices. That's important for investors when they're looking to build balanced portfolios.
We expect nature-related risks to move further up on the agenda of sustainable bond issuers in 2024 as environmental sustainability becomes about more than just climate change.
Sustainable bond market at a glance
By bringing SDGs such as "Life on land" (SDG15) and "Life below water" (SDG14) into the focus of sustainable finance, the groundwork will be laid for more transactions focusing on biodiversity, marine economics, and other nature-related issues. Biodiversity "competes" with climate change as the most pressing environmental problem. It has so far only been partially considered in the context of responsible and sustainable investment decision-making. But there are already voices saying that "biodiversity is the new climate change".
And we must remember that we only have a few years left to achieve the 2030 agenda.
With all the other environmental and social challenges that need to be funded, we must not lose sight of climate resilience and adaptation. There is still a huge funding gap. Climate finance needs to be accelerated to triple renewable energy capacity and double energy efficiency improvements by 2030.
Hence, they remain top priorities on the sustainable bond agenda as the scale of the investment needed is vast.
We forecast a further increase in sustainable debt issuance from emerging markets as general market conditions continue to improve and these markets are actively seeking ways to bridge the sustainable financing gap (both from an environmental and social perspective). More efforts are needed to provide access to funding where it's needed the most, which is in the developing world. Hence, scaling up of sustainable finance through the fixed income market by means of strategic partnerships is a must and will help to promote sustainable bond issuance in emerging markets.
As governments start to prepare their next round of Nationally Determined Contributions (NDCs) this year, sovereign issuance of sustainable bonds will be one of the key triggers to accelerate market development in 2024 and subsequent years, and demand will increase. As both first-time issuers are in the starting blocks and established issuers expand their sustainable finance activities, we expect a new issuance volume in the range of around $180 billion in 2024.
Around 70% of that volume is forecast to originate from developed markets countries with the remainder coming from emerging markets countries. The latter are increasingly actively seeking ways to bridge the funding gap associated with climate change, biodiversity loss and social issues through the fixed income market.
Looking at the numbers, the sovereign sustainable bond market offers enormous potential here. About 170 countries are issuing sovereign debt. Hence, there are plenty which have not come to the market yet. This includes two sovereign issuers with the largest outstanding volume (the US and China) as well as many issuers from developing countries.
Following the success of Chile and Uruguay, it is likely that sustainability-linked bonds (SLBs) will attract issuers from beyond Latin America and that we will see issuance from Southeast Asia or Africa, for example. SLBs are expected to become increasingly popular among sovereign issuers from emerging markets as the flexibility in how the borrower uses the money raised makes this type of debt attractive to smaller issuers that may not have an extensive pipeline of green or social projects that would qualify for green or social bond proceeds.
COP28 closed with an agreement that signals the "beginning of the end" of the fossil fuel era by laying the ground for a swift, just, and equitable transition, underpinned by deep emissions cuts and scaled-up finance.
Against this background, no one should be excluded from sustainable funding. This applies in particular to the so-called hard-to-abate industries. This is a major growth opportunity for the sustainable bond market as the conversation in the fixed income market has matured from talking about investing in climate to also investing in transition.
One advantage of using the fixed income market to finance a just transition is that a wider range of actors can issue bonds compared to those who can issue equity. And the good news is that we don't have to reinvent the wheel to finance the transition with the help of sustainable bonds. As transition is a process, it is too broad to reduce it to a label. Hence, it can be financed both through the use-of-proceeds structure and through target-linked instruments.
With a growing number of companies globally committing to a net-zero pathway, we also expect corporate sustainable bond issuance to accelerate. More and more corporates will venture into sustainable funding, particularly due to their transition needs. Against the backdrop of a broader investor and societal push for the financial sector to become more sustainable in the wake of COP28, it is also expected that sustainable loan books will experience better growth dynamics than less sustainable loan portfolios.
This is supported by new investor behaviour. In the past, many sustainable and responsible investors focused on strategies such as exclusions or best-in-class approaches. Those who did not fit into the grid were sold. Today, investors look more at the transition potential of the real economy. The identification of "sustainable companies of tomorrow" is becoming increasingly important. Hence, they live the new credo "transform instead of divest". The investors are entering an active dialogue with the management of the companies to be transformed. The possibility of divestments always remains – but only as ultima ratio if the company leaves the promised, credible transition path.
As target-linked instruments play a key role in transition finance and the need for it to successfully implement the Paris Agreement, we expect market participants to rediscover their interest in target-linked structures. We are confident that issuers and arrangers can address the growing concerns of this instrument by focusing on material KPIs and ambitious Sustainability Performance Targets (SPTs) to enhance the quality of target-linked financing via the fixed income market and, thus, its credibility.
A look into the crystal ball: a promising start in 2024 whets the appetite for more
If the promising start to 2024 continues, the market would be poised to surpass the $1 trillion mark, to warm up for new records in 2025 and the following years.
We are confident that the upward trend will persist in 2024 and forecast that the new issuance volume in the sustainable bond market will increase by 20% to around $1.04 trillion. We expect market growth in all segments of the market.
We forecast accelerated, sustained growth from 2025 onwards. As central banks are expected to begin to cut interest rates and existing sustainable debt matures, issuance will pick up. Growth could be even stronger if fiscal obstacles can be overcome, especially in Europe. The share of sustainable bonds in total issuance is expected to rise to around 22% in 2024 and will be more than a quarter in a few years.
Green bonds are expected to continue to dominate the sustainable bond market in 2024. Among other things, we expect green bond issuance by the EU, one of the largest green bond issuers, to accelerate in 2024 as well as a strong contribution from other sovereigns.
Marcus Pratsch is head of sustainable bonds & finance at DZ BANK
