New Pictet-IIF report says inconsistent disclosures are limiting growth, with ‘climate-aligned’ bonds meeting the supply shortfall.
Global issuance of ESG-labelled bonds could reach USD 4.5 trillion per year by 2025, according to new research by Pictet Asset Management and the Institute of International Finance (IIF).
The research, titled ‘Bonds That Build Back Better’, predicted a “silent revolution” in the fixed income markets over the next 5-10 years as bond investors increasingly direct capital to the transition to a low carbon economy. According to the International Energy Agency, USD 4 trillion of clean energy investment will be needed annually by 2030.
ESG bond issuance reached USD 1 trillion in 2021 for the first time according to Refinitiv.
An expanding universe
A key factor in meeting demand for climate-positive investment could be the growth of climate-aligned bonds. These do not carry an ESG label or follow common principles, but are issued by firms that contribute directly to the clean energy transition, and as such may “add further heft and variety to the market”, said the report.
The market for climate-aligned bonds has developed in response to a shortage of ESG-labelled debt, with investors seeking instead to identify the debt securities of firms deriving the vast majority of their revenues from climate-aligned activities. The Climate Bonds Initiative estimated the size of the non-ESG labelled climate-aligned bond market at more than USD 900 billion in 2020.
“If the transition in global bond markets keeps pace with energy consumption patterns, the climate scenarios set out by the Network for Greening the Financial System [NGFS] imply that the size of the climate bond universe – ESG-labelled climate bonds and climate-aligned bonds – should reach USD 25 trillion by 2025 and over USD 32 trillion in 2030, even under current climate policies,” said the report.
Achieving net zero by 2050 could require the climate bond universe to reach USD 36 trillion by 2025 and over USD 60 trillion by 2030, it added.
The ESG-labelled bond markets are typically considered to include green, social, sustainability, sustainability-linked and transition bonds. While the proceeds of green, social, and sustainability bonds are ringfenced for projects with specific sustainability-related objectives, sustainability-linked bonds can be used for a wider range of purposes to support the issuing entity’s sustainability performance targets; transition bonds are a hybrid.
Refinitiv’s 2021 Sustainable Finance Review reported that total sustainable bond issuance exceeded USD 1 trillion last year for the first time. Issuance volume rose 45% over 2020, with sustainable bonds accounting for 10% of overall debt capital market activity. Q4 2021 was the fourth consecutive quarter to surpass USD 200 billion and over 400 issues.
Green bonds accounted for around half of all issuance (USD 488.8 billion), having almost doubled 2020 volumes. Social bond issues totalled USD 192.9 billion, representing a 17% increase on 2020, while sustainability bond issuance volumes soared to USD 186 billion, an annual rise of almost 49%. The number of sustainability bond issues doubled versus 2020.
According to the Climate Bonds Initiative, cumulative issuance under the Climate Bonds Standard, which requires science-based alignment to the goals of the Paris Agreement, passed USD 210 billion last year, covering certified bonds and other debt instruments issued by 200 entities from 40 countries.
The research highlighted several challenges to the future growth of ESG-labelled bond markets, primarily around disclosure standards. It also noted the cost burdens of scrutinising more complex instruments effectively and incorporating them into existing portfolio construction frameworks.
Inconsistencies between jurisdictions on labelling and certification and the mixed success of efforts to harmonise disclosure requirements were cited as major barriers to expansion.
The International Capital Markets Association (ICMA), which updated its voluntary principles for issuers last year, provides guidance on data disclosure and transparency. A growing number of jurisdictions have also introduced voluntary and mandatory frameworks, which typically cause fragmentation by including market-specific requirements.
The European Commission issued proposals for an EU Green Bond Standard last year to create a common framework for issuers using the ‘European green bond’ designation for use of proceeds bonds that pursue sustainability objectives under the EU Taxonomy Regulation.
The European Central Bank (ECB) has called for the European standard to be mandatory, but the Association for Financial Markets in Europe (AFME), which represents banks and other financial market participants, recently said the standard should be voluntary to enable the market to evolve quickly in response to market demand
“A mandatory standard thus risks slowing down the flow of capital to support the decarbonisation objectives of the real economy,” it said.
In light of differences between markets, the Pictet/IIF report called for further international cooperation to support consistency and transparency to investors. “Global efforts to standardise product labelling and certification for green/sustainable financial products would support cross-border alignment, which in turn would boost the growth and the liquidity of ESG fixed income markets.”
It added that the difficulties for investors caused by varying levels of information from issuers are further complicated by inconsistent ratings. “The agencies that assign ESG ratings to both bonds and their issuers use different methodologies that often conflict with one another and are not wholly transparent,” the report said.
Although green bonds are “the most dynamic segments of global bond markets”, they still represent just less than 1% of the total amount of fixed income securities outstanding, and are “insufficiently diversified across industry sectors”, the report said.
It also warned that the secondary market for the most established ESG debt market – green bonds – is less liquid than conventional bonds due to their strong appeal to long-term buy-and-hold institutions, such as pension funds, insurance firms and sovereign wealth funds.
“The secondary market is not mature enough to absorb large buy or sell orders without precipitating significant shifts in price,” it said.
Nevertheless, the report suggested ESG-labelled bonds will be a growing presence in emerging markets debt, with issuance increasing from some USD 50 billion per year in 2020 to USD 360 billion by 2023.
It added that “a fully-fledged sustainable debt market” would go a long way to filling the “SDG financing gap” – the difference between what emerging nations need to achieve the UN Sustainable Development Goals (SGDs) by 2030 and current investment levels – estimated at USD 2.5 trillion per year.
“By 2025, there will be few global investors who don’t have a significant allocation to ESG and green investments,” said Sonja Gibbs, Head of Sustainable Finance at IIF, predicting a greening of the global bond markets as governments and companies seek to deliver on net-zero commitments.