June 30, 2020
June 30, 2020
All Green Bonds Are Not Created Equal
June 30, 2020
The universe of “sustainable bonds”—labelled debt instruments where the issuer has committed to financing certain environmental and/or social objectives—spans a broad set of categories (Display 1), creating a confusing mosaic for investors to decipher.
The market for sustainable bonds has grown dramatically over recent years, with total all-time issuance now well in excess of $1 trillion1 across a broad swathe of issuer sectors and geographies. This rapid growth has not been without its critics, who question the integrity of some of the issuance that has come to market, taking aim with accusations of “greenwashing” at sub-standard transactions.
As an active fund manager, the Morgan Stanley Investment Management Fixed Income team (MSIM FI) looks through the labelling and critically assesses the sustainable bonds that come to market, to ensure our evaluation of their sustainability characteristics is integrated into the investment process, for the benefit of our clients.
Note: Categorisation based on the main labels of bonds issued to date, including those recognised by the International Capital Market Association (ICMA).
We also believe we have a duty to encourage issuers and underwriters to strive to implement best practices to achieve meaningful positive sustainability outcomes through the issuance of robust sustainable bonds, and we engage with them and participate in industry initiatives to help achieve this.
In order to formalise our approach to this evolving space, MSIM FI has developed an analytical process to evaluate sustainable bonds in a transparent, systematic and objective way, which can be applied in a consistent and comparable fashion across the full spectrum of issuers, themes and asset classes. This quantitative and qualitative analysis is conducted by MSIM FI’s Sustainable Investing team, examining the key characteristics of a sustainable bond through the lens of our proprietary Sustainable Bond Evaluation Model.
Our Sustainable Bond Evaluation Model
The Global Fixed Income Sustainable Investing team has developed a model for assessing the quality and impact of sustainable bond issuances, and monitoring them over time as reporting is made available.
The model—which is fully integrated across all of our sustainable and mainstream portfolios—is aimed at informing portfolio managers and research analysts and is an integral component of the investment decision process for these instruments.
The assessment covers a multiplicity of factors related to the bond issuance, which we group into four main components, as summarised in Display 2 and presented below.
1. ISSUER’S ESG PROFILE AND FIT OF THE BOND WITHIN ITS SUSTAINABILITY STRATEGY
The investment team relies on proprietary Environmental, Social and Governance (ESG) scores, integrating them with the Fixed Income Sustainable Investing team’s qualitative analysis, to determine whether the bond fits within the issuer’s broader strategy and can contribute towards its environmental and/or social goals and targets. While issuers with higher ESG scores would start with an advantage, we acknowledge that these scores are not real-time, and that labelled bonds can also be a way for an issuer to signal a new or enhanced commitment to invest in sustainable projects. We thus retain the flexibility to adjust the profile assessment if we believe such commitment is credible and the issuance supports its progress.
2. STRUCTURE OF THE BOND, CHARACTERISTICS OF THE PROJECTS OR TARGETS, AND ALIGNMENT WITH MARKET FRAMEWORKS
We evaluate the level of ambition, additionality and innovativeness of a bond’s use of proceeds or Key Performance Indicators (KPIs), and the alignment of its process and structure with market frameworks. We consider the International Capital Market Association’s (ICMA) Green and Social Bond Principles, Sustainability Bond Guidelines, and the recently published Sustainability-linked Bond Principles,2 as well as the Climate Bonds Initiative’s (CBI) standards,3 to represent best practice in terms of completeness and transparency of information. We also take into account, where relevant, issuers’ early and voluntary alignment with the EU Taxonomy criteria, and we will be monitoring developments with respect to the EU Green Bond Standard as well as to the Green Bond Guidelines in China.4 For transition bonds, where market guidelines are evolving, we welcome alignment with the pillars of the Green Bond Principles in terms of the framework structure, while we assess the use of proceeds based on their contribution to the low carbon transition, relying, for example, on the IPCC’s analysis of how to reach the Paris Agreement’s goals as a reference.5 We also look positively at the mapping of projects or targets to a set of UN Sustainable Development Goals (SDGs) towards which the bond issuance can be reasonably expected to contribute.
3. SCOPE AND QUALITY OF EXTERNAL VERIFICATION
We expect sustainable bond frameworks or KPIs to have been reviewed by an external verifier before issuance, and to have a Second Party Opinion (SPO), (for use of proceeds bonds) if they are inaugural transactions, or an updated one, if several years have passed since the issuer’s last labelled bond, or the scope has changed. While we do not have a specific preference for any SPO provider, we will actively look for any red flags or positive commentaries in the SPOs to inform our scoring.
We also expect issuers to commit to obtaining post-issuance verification, at least of their sustainable bond proceeds allocation, in the form of an assurance report by their general auditor, or a compliance review by an external verifier. We reward with higher scores those issuers that commit to an additional, voluntary external review of their impact reporting. Starting one year after issuance of a sustainable bond, we will check whether the issuer has delivered on its commitment to obtain and publish such reports, and adjust our assessment if needed.
4. QUALITY OF REPORTING
When investing in sustainable bonds, our objective is to finance positive environmental and/or social impacts that contribute to long-lasting outcomes. Transparency from issuers on how proceeds are used, and timely disclosure of the impact achieved, is therefore essential. Higher scores would be assigned to sustainable bond frameworks or related documents that include examples of eligible projects, meaningful impact indicators, and some anticipated allocations. Conversely, an intent to absorb bond reporting into existing sustainability disclosure, without a dedicated focus, is treated negatively. For recurrent issuers, previous reporting will be taken into account. Scores will then be reassessed when the reports are made available, to verify whether the issuer has complied with its commitments. In the case of sustainability-linked bonds, we would expect the issuer to report on how it intends to achieve the stated KPIs (e.g. specific investments) and on its progress towards the targets.
The assessment of each factor across the four components results in a weighted score ranging from 1 to 5. A score of 1 identifies sustainable bonds that lag market best practices, or that we perceive as “greenwashing” attempts, as opposed to a score of 5 for bonds that display leading frameworks, a high degree of transparency, and ambitious, impact-oriented use of proceeds or KPIs. Examples of the output of our model, along with the rationale for the scoring, are presented in Display 3 below.
Individual bond scores are reviewed periodically, whenever there is a new issuance or reporting, by the Fixed Income Sustainable Investing team, to ensure the sustainability characteristics of the investment have not deteriorated. The model is dynamic, accommodating changes in factor weights to reflect any shifts in our focus and/or to add new variables for consideration as frameworks evolve.
This represents how the portfolio management team generally implements its investment process under normal market conditions. The charts are for illustrative purposes and do not reflect the actual factor weights of the model or scores of specific investments. ESG ratings are not intended as a recommendation and are subject to change. Ratings are relative and subjective and are not absolute standards of quality. Ratings apply only to portfolio holdings and do not remove the risk of loss.
Individual funds and client accounts may have specific ESG related goals and restrictions. Please refer to governing documents of individual vehicles to understand their binding ESG criteria.
Conclusion We expect that sustainable bond issuance will continue to increase, and that these instruments are going to play a significant role in mobilising capital in support of decarbonisation and sustainable development objectives. We have seen strong focus from governments, policy makers and regulators on pushing this agenda, with, for example, fiscal stimulus packages and financing plans embedding green and social inclusion features,4 which will further boost issuance. The MSIM FI is focused on ensuring that the evolution of this market is effective and transparent, and that sustainable bonds are intelligible to customers. Our Sustainable Bond Evaluation Model provides us with a framework to deliver this in client portfolios, and strengthens our engagement with issuers to promote best practices in this market. In addition, it enables us to provide ourselves and our clients with clarity on how the sustainable bond holdings in our portfolios are helping to catalyse meaningful positive change.