20 February 2023

The sustainable bond market against the background of a new geopolitical reality

2022: The year in which everything turned out differently than expected. Marcus Pratsch looks at the dynamics shaping sustainable bonds

The sustainable bond market has become accustomed to setting spectacular record-breaking annual issuance totals in recent years. Nonetheless, even in that context the eagerly anticipated $1 trillion milestone for green, social, sustainability and sustainability-linked (GSSS) bond issuance achieved in 2021 was a special one.

Marcus PratschIn recent years, the sustainable bond market has only gone in one direction. "Forward always, backward never", was the undisputed trend. Even at the height of the Covid-19 pandemic in 2020, in which social and sustainability bonds soared, the green bond segment, which had initially slumped in a tremendous way, fought its way back to new heights.

Hence, at the beginning of the year, no one doubted that the success story of labelled bonds would continue in 2022.

However, in 2022, for the first time in more than a decade, the sustainable bond market saw a decline in new issuance volume by 23%, affecting every single segment. The new geopolitical reality led to tough fixed income market conditions which these labelled bonds have never faced before: rising energy and commodity prices, a global inflation surge, and the end of a decade of ultra-low interest rates.

While the mature green bond segment proved relatively resilient with a decline of only around 13%, new issuance volumes of sustainability bonds (-21%), target-linked and transition bonds (-37%), and social bonds (-44%) were less immune to the rough market conditions. With a share of 60% of new issuance volume in the sustainable bond market, the green bond segment hence proved to be a solid anchor in turbulent times.

The negative surprise of the year was without a doubt the fall in target-linked (also known as sustainability-linked) bond issuance – both in volume and market share. The 2021 darlings have had a tough time, especially in the second half of 2022, as fears increasingly emerged that such a structure could expose issuers to potential legal risks. In addition, the critical voices among investors and banks grew louder, flagging greenwashing concerns about target-linked debt.

Despite a tough and volatile market environment, there were also bright spots in the sustainable bond market. The new issuance volume of sustainable bonds in 2022 declined less sharply than that of traditional bonds. The share of new sustainable bonds issues in the overall debt capital market, therefore, continued to rise to around 18% in 2022 (2021:15.8%). Furthermore, sustainable bond issuance from financial institutions surprisingly increased by approximately 21% to around $187.5 billion. Thanks to its resilience, the green bond segment hit the $2 trillion milestone (cumulative issuance since the kick-off of the segment in 2008) at the end of the third quarter.

Lessons learned from 2022

2022 has once again shown that the sustainable bond market is not immune to external shocks. However, 2022 has also been a demonstration of the importance of further accelerating the financing of the global sustainability agenda through capital markets and hence continuing to drive the sustainable bond market forward in the coming years.

The war in Ukraine had a massive impact on all four dimensions of sustainability: economic, environmental, social, and governance. Its direct and indirect effects widen the sustainability financing gap, making it even more important to mobilise private capital and allocate it through the capital market to sustainable projects with positive impact. Even before the Russian invasion, the world was not on track to achieve most of the United Nations' Sustainable Development Goals. Unfortunately, many targets will be set back by the new geopolitical situation and, so, even more capital will be required in the future.

Moreover, it is already clear that rebuilding Ukraine will be tied to sustainability. In the "dream of a new Ukraine, not only free, democratic and European but also fair, green and prosperous" recently quoted by the president of the European Commission Ursula von der Leyen, the sustainable bond market is sure to play an important role regarding funding.

2022 has also been a test for sustainable and responsible investment strategies of fixed income investors. It had inevitably led to a reassessment of ESG investment approaches and sustainable fixed income portfolios as it has not only revealed Europe's high energy dependence on Russia and how vulnerable the global food system is but also has raised the question of geopolitical sustainability.

The disruption of the global energy markets has caused sustainable and responsible fixed income investors to rethink energy strategies. Does the pace of fossil fuel phase-out need to be adjusted until renewables, hydrogen, and storage technologies can fill the gap reliably and affordably? Will nuclear energy and natural gas gain importance as bridging technologies?

Without a doubt, this new thinking should focus on renewable energy sources, energy infrastructure, and sustainable technologies to support the transition away from traditional energy sources. Given the "weaponisation of gas", the war is a wake-up call to expedite the global transition to a more secure and cleaner energy future.

The new geopolitical reality has also renewed questions about the sustainability and safety of capital invested in countries with autocratic governments. In theory, an investment in government bonds and an investment in a company based in or conducting business with authoritarian countries should be considered separately. But the boundaries are often not clear. Corporates operating in authoritarian states are typically more exposed to sustainability risks than others operating only in democracies. Examples include human rights, corruption, and reputational risks. Irrespective of a moral evaluation, such ESG risks have a negative impact on a company's performance.

The war in Ukraine has also brought a controversial ESG discussion back onto the front pages. How should the issue of security and defence be interpreted in a sustainability context? Is defence ESG-compliant? Is "Security the mother of all sustainability" as the Federation of the German Security and Defense Industries argues? How should SDG 16 (peace, justice, and strong institutions) be interpreted in this context?

It should already be clear today that for most sustainable and responsible investors arms for defence purposes will not be an option for their portfolios in 2023 either. Furthermore, in the target-linked bond market, there is growing pressure on issuers to increase the ambition of the targets and the materiality of the pricing benefits and penalties.

Using the proceeds of target-linked instruments for general purposes appears to be increasingly at odds with investor and regulatory expectations for greater clarity and consistency of allocation of proceeds to dedicated sustainable outcomes.

Addressing these concerns in 2023 will be crucial to restoring confidence in this important funding structure as a suitable instrument for transition financing. Unlike the use-of-proceeds transition bonds structure, target-linked bonds focus on the transformation of the issuer as a whole and are also suitable for less asset-intensive issuers who do not have the necessary volume for a use-of-proceeds transition bond.

Hence, for credible transition financing using target-linked bonds, it is important to choose KPIs [key performance indicators] that are relevant, measurable, comparable, central, and essential to the issuer's transformation process. They should also have a high strategic importance for the issuer's future operations. In addition, the Sustainability Performance Targets (SPTs) should be in line with the issuer's transformation strategy and be ambitious, i.e., go beyond a "business-as-usual scenario".

A look into the future

The overall bond market appears to be in a much more promising position than it was last year. However, the uncertain macroeconomic outlook and persisting geopolitical risks should still be a concern for fixed income investors. Hence, we do not expect new issuance volumes in the sustainable bond market to go through the roof in 2023. It will not be until 2024 before the sustainable bond market sees record heights in growth rates once again.

But, as investor appetite for sustainable bonds remains strong, we expect a gradual return to growth in all segments of sustainable debt in 2023. It will remain a growing portion of overall issuance and we expect sustainable bond issuance to outperform the broader bond market once again in 2023. According to our forecast, global new issuance volume will rise by around 36% to surpass $1 trillion in 2023 (2022: $740 billion; 2021: $957 billion). In contrast to some record years in the past, this regained growth will be qualitatively rather than quantitatively driven. We forecast that the share of new sustainable bond issues in the overall market will rise to around 20%.

Drivers and opportunities: the sustainable bond market is heading in the right direction again

In 2023 and beyond, we expect further diversification in the sustainable bond market both by issuers and themes. Investor interest in sustainable bonds remains high. There is still too much demand chasing too little supply. ESG integration in portfolios is further on the rise. And it goes far beyond climate issues. Investors are also increasingly looking at nature-related issues or social issues in their fixed income engagements.

Improving market conditions ensure that maiden issuers who deferred their sustainable funding in 2022 will regain confidence and come to the market with their inaugural issues in 2023. We also expect to see a further pick-up in issuance from emerging markets.

We forecast a strong pipeline in sovereign sustainable bond issuance. India was the latest addition to the growing cohort of sovereign sustainable bond issuers. A couple of maiden issuers like Brazil are waiting in the wings to come to the market this year. Sovereign issuers already established in the market are looking to expand their sustainable funding activities, such as Indonesia, which is planning to issue a blue bond. Sovereign target-linked bonds are becoming increasingly popular among smaller sovereign issuers. Following the success of Chile and Uruguay, it can be assumed that the instrument will establish itself in the market beyond Latin America and that we will also see issuances from Southeast Asia, for example.

With an estimated share of 62%, the green bond segment will remain a guarantor of growth in 2023. We expect new issuance volume to increase by almost 40% to around $620 billion. The new geopolitical reality revealed that accelerating the energy transition is not only key to tackling climate change but that it is also pivotal to ensuring energy security. Hence, growth in the green bond segment will be supported by the policy push towards low-carbon energy projects in key regions like the EU and the US.

Furthermore, we expect that nature-related risk will move up the agenda of green bond issuers and investors. By putting SDGs like "Life on land" and "Life below water" into the sustainable funding focus, the foundation is laid for more and more biodiversity-focused transactions. Growth of the green bond segment is also backed by supportive policies and regulations around the globe. Further steps by the European Central Bank (ECB) to incorporate climate change into its monetary policy, the launch of China's Green Bond Principles, or the Inflation Reduction Act in the US are only a few examples.

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 SPTs to enhance the quality of target-linked financing via the fixed income market and, thus, its credibility.

Target-linked instruments play a key role in transition finance and the need for it to successfully implement the Paris Agreement is undisputed. We cannot achieve a decarbonised and more sustainable world by focusing exclusively on economic activities, business models, and sectors that are already 'dark green'. We can have a much greater positive impact on the global sustainability agenda by helping to make 'brown' economic activities, business models, and industries 'light brown' or 'light green', rather than painting already 'dark green' activities, models, and sectors one shade greener.

Marcus Pratsch is head of sustainable bonds & finance at DZ BANK AG.

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