ESG - what lies ahead for emerging market bonds?

In our previous articles, we focused on the importance of ESG (environmental, social and governance) factors in emerging market debt. This included a detailed look at our ESGP framework. In this article, we look to the future – specifically, the opportunities we are seeing in emerging market sustainable bonds.

Funding the future

Emerging market countries’ sustainable development needs are immense. Currently, their internally generated resources are not enough to meet these needs. Multilateral support in the form of concessional loans will continue to provide some help. However, ultimately emerging markets will need to find ways of accessing the huge global pool of private capital to plug the gap. This is where the nascent but fast-growing sustainable bond market can play an important role.

Sustainable bonds – key background

Sustainable bonds, broadly comprising of green bonds, social bonds and sustainability bonds, share many of the characteristics of traditional bonds. The key difference is that sustainable bonds have specified ‘use of proceeds’, which codify how borrowers must spend the money.

Green bonds – issued to finance new and existing projects designed to have a positive environmental impact. Examples include projects connected to renewable energy, clean transport, energy efficiency, water/waste management and green buildings.

Social bonds – for projects designed to have a positive social impact. Examples include affordable housing, affordable infrastructure and community development.

Sustainability bonds – a combination of positive environmental and social impacts. Examples include upgrading/modernisation of education and health facilities.

Aside from these three categories, there are sustainability-linked bonds. These have more generic sustainable goals, with ‘step-up coupons’, meaning the issuer pays a higher coupon if they fail to meet their sustainability objectives.

Compelling growth potential

The overall market is growing fast. In 2019, Green bond issuance of USD258 billion (bn) was 51% higher than the previous year and accounted for the bulk (around 75%) of the total sustainable bond issuance of USD341bn in the year. As shown below, as of end June 2020, the total size of the sustainable bond market (green, social and sustainability bonds) was USD1,239bn, with 70% in green bonds 1. However, while this is encouraging, we need some context. First, the total size of the global bond market (government and corporate bonds) is comparatively vast at around USD1.28 trillion (trn)2. Sustainable bonds account for less than 1% of this. Furthermore, sustainable bonds issued by emerging markets are presently only a fraction of the total figure.

Global Sustainable Bond market share (as of end-June 2020), USDbn

Source: Climate Bonds Initiative - Sustainable Debt - Global State of the Market H1 2020

Despite this, we believe the future growth potential for emerging market sustainable bonds is good from both a supply- and demand-side perspective.

The supply-side perspective

A defining feature of emerging markets is their relative underdevelopment. Issues range from poverty and poor education, to insufficient healthcare and crumbling infrastructure. It will require huge outlays to address such challenges. According to the UN, spending in low and lower-middle income countries needs to amount to at least USD1.4 trillion per year in order to meet its Sustainable Development Goals (SDG) targets by 2030. Given the gaping inadequacy of internal resources, sustainable bond issuance could contribute meaningfully in this regard.

The demand-side perspective

On the demand side, the explosion of investor interest in sustainable investing is arguably the most important industry trend of the past few years. According to the research firm Opimas, the value of global assets applying ESG consideration almost doubled over four years, and more than tripled over eight years, to USD40.5 trillion in 2020. While equity investing has certainly led on this front, fixed-income adoption of sustainable investing approaches has been catching up fast. This makes sense. Interest in more responsible investing is ultimately driven by clients and the typically long-term nature of bond investing is also well aligned to such approaches. In the case of emerging markets in particular, we think the very high (positive) impact potential will increasingly be understood by responsible-minded investors.

The coronavirus pandemic – a ‘force multiplier’ for sustainable bond investing

The coronavirus pandemic has led to great human cost and severe economic disruption. However, a silver lining has been its supportive impact from both the supply and demand side for sustainable bonds. From the supply side, the huge unplanned expenditures of the pandemic have dramatically increased financing needs. From the demand side, the pandemic has spurred bond investor interest in contributing positively to the biggest and most pressing health and social challenge of the day. According to Refinitiv data, this resulted in a remarkable eight-fold increase in social bond issuance this year so far3. Emerging market issuance has been a major contributor to this. For example in March 2020, the African Development Bank launched the USD3bn ‘Fight COVID-19’ social bond. According to the Institute of International Finance, this was the world's largest dollar-denominated social bond transaction at the time.

Recent landmark sustainable bond issuances

This year has seen some landmark emerging market sustainable bond issuances, which we think are likely to pave the way for others in the future. On the sovereign side, in September 2020, Mexico issued USD890m worth of SDG bonds. These were the world’s first-ever bonds structured specifically with a view to achieving the UN Development Programme’s SDG goals. Similarly on the corporate front, in September 2020, the Brazilian paper and pulp company Suzano became the first emerging market company to issue carbon emissions-linked bonds. The USD750m issuance commits the company to cutting its greenhouse gas emissions by 15% over 10 years. Should Suzano fail to be on track to reach the target by 2026, it will have to pay an additional 25 basis points per annum on its coupon.

Barriers to growth

While there are many positives, there are some important limiting or break factors that could slow the progress of sustainable bonds.

Lack of universally agreed standards – this applies particularly to social bonds because, unlike their green bond counterparts, their impact is harder to measure. This is due to comparative lack of easily quantifiable metrics (such as the reduction in greenhouse gas emissions or energy use). In turn, this increases the risk of ‘social-washing’ where issuers might misuse the ‘social’ label by overstating the true social benefits of a transaction.

Transparency/corruption – typically, lower transparency and higher scope for corruption mean that many issuers face a sizeable credibility gap with international investors. This is an important limiting factor for sustainable bond development, particularly on the sovereign side. Another challenge, also on the government side, can be getting sufficient engagement from policymakers. In particular, instead of focusing on the longer-term financing issues, elected politicians can be influenced by near-term election cycles.

In general, there is also a lack of institutional/technical capacity to conduct the necessary background work for sustainable bond issuance. For example, in the case of green bonds, the size of technical capacity requirements are evidenced by World Bank estimates that the total project life cycle for issuing such bonds is generally between nine months to two years.4

Final thoughts…

The increasingly strong alignment of demand- and supply-side factors suggests great growth potential for emerging market sustainable bond issuance. The coronavirus pandemic has given this further impetus, as evidenced by the remarkable eight-fold surge in social bond issuance in 2020 year-to-date. As we have seen, there are some limiting factors that could slow the progress of sustainable bonds. However, we think these will ease as the market grows and matures. We are therefore optimistic on the outlook for this important and fast-growing asset class.

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