The future of sustainability linked instruments and financing opportunities for change
The views and opinions expressed in this article are those of the thought leader as an individual, and are not attributed to CeFPro or any particular organization.
Clinton van der Spuy, former Head of Risk Management Financial Markets Americas, Rabobank
What are some of the best practice methods for driving innovation in sustainable finance in a market-friendly environment?
Deregulation is often touted as a tool for encouraging innovation. History, however, has demonstrated that unfettered innovation may not be good for all stakeholders (looking at you, residential mortgage market). Regulation that levels the playing field and that ensures the efficient and effective transmission of information and pricing signals serves all parties. And this sometimes comes in the form of requirements, like the proposed SEC disclosure regulations.
Again, data is key. Issuers and structurers must be clear about the objectives of the financing, be able to measure progress and ensure that it is aligned with the broader sustainability objectives of the issuer. Encouraging innovation for both issuers and investors requires transparency, trust and credibility – basically the same things that will support Sustainable Finance in general. In support of this, innovation does not have to equal complexity, and innovation is likely to be more successful if the risks and benefits are clear. One way to create value could be by aggregating or de-aggregating risk factors or sustainability factors.
An example of innovation through de-aggregation might be the vaccine bonds issued by The International Finance Facility for Immunization (IFFIm). The objective was to deliver funds for global vaccinations programs in the short term by leveraging international donor commitments over the long term. The case for doing so was clear (getting vaccinations done now is better than doing them later) and the financial structuring was sufficiently robust and transparent to achieve AA ratings for the bonds.
The C-PACE market (Commercial – Property Assessed Clean Energy) is another small, but fast growing, sector that is focused on funding energy efficiency alongside a robust regulatory framework. The objective is clear – improve energy efficiency to meet legal/regulatory requirements – using a funding mechanism that provides strong credit protection by transforming the funding into a tax assessment.
Innovation should support all stakeholders by making the instruments useful for issuers (by being impactful at a market price), by telegraphing issuers intentions (as being sustainability aware and credible) and by bringing value to investors (by providing market returns while meeting other investment guidelines) – all requiring transparency and credibility. As with other financing instruments, market, credit, and liquidity risks must be visible to investors – and that’s another reason to limit complexity. Participants on either side of the trade must be comfortable that the stated objectives can be met in a measurable way and that the risks and returns are appropriate for these objectives.
How do you imagine future sustainability-linked instruments will evolve?
This is still very much an emerging sector. There will still be greenwashing. Honest mistakes and errors will also happen (making it all the more important to vet data suppliers carefully). But the market will continue to grow. It will be driven on the one hand by regulation and legislation – compliance products – and by market demand and innovation, on the other.
From a compliance perspective, for example, SEC disclosure requirements and reporting on Net Zero commitments provides the opportunity for issuers to raise project or objective-specific funding directly connected to the underlying sustainability strategy of the firm – and that is supported by regulatory reporting. Recent, more rigorous enforcement of sustainability-related disclosures by the SEC and German regulators signal a change of tone at the regulators – which, while increasing the reporting burden, also creates opportunities for further development of the sustainable finance market.
From a market demand perspective, market data show that year-to-date (June 9), companies with better ESG risk scores have outperformed those with worse ESG risk scores within both the S&P 500 and S&P Europe 350 indexes. Of course, data can say whatever you want it to – so there will certainly be dissenting voices – but some investors are certainly of the view that there is alpha to be had in the sector. But again, credibility of the issuer and instrument remain paramount. This points to investors continuing to press on matters of data quality, transparency and comparability, and new instruments and issuance should reflect these demands.
Another interesting issue will be treatment of assets that are considered broadly non-sustainable like fossil fuels, for example. Here, there are – and will be – opportunities to engage in potentially high impact activities at these firms. Defining the instruments as green or sustainable will be controversial – but if the objectives and results are clear and measurable – they should meet (some) sustainability investment criteria. On the other hand, where the market begins to steer clear of certain assets (coal for example), there are opportunities for hedge funds and other investors that seek to maximize the return from assets that are increasingly at risk of becoming stranded.
What is the role of finance in the energy transition, and what challenges may arise within this?
The cost burden of the global energy transition is estimated to be anywhere between $1 trillion and $3.5 trillion of additional spending per year, over the next 30 years – a sum beyond the capacity of public institutions (political will aside). Private finance will play a key role in funding the transition, but it will require steering and support from legislative and regulatory bodies.
The BIS recently published a speech by Claudio Borio, Head of the BIS Monetary and Economic Department et al – emphasizing this point. While there are impact funds or funds/lenders with sustainability portfolio targets, in the absence of adequate policy making in the real economy, this will be insufficient. This is particularly true in the US where the cost of delivering energy from renewables now consistently outperforms oil and coal – and the value of investmenting is clear – but political debate on emissions, supporting coal or undertaking new investments in oil – may slow investment in the transition or will divert capital deployment away from it.
Absent meaningful federal legislation or regulation, local and state-level bodies and private investors will play a much more important role in directing and funding the transition, including deeper electrification of the economy, battery technology and improving the resilience of current infrastructure. The finance sector’s ability to identify value (and risks!) can be leveraged to take advantage of these enormous emerging opportunities.
Can you provide some examples of how we can incentivize sustainability?
Sustainable finance is a tool that can facilitate action on sustainability objectives at the corporate and sovereign level. Tools that incentivize change include legislation – like enforcing carbon taxes, prohibitions or limits on undesirable activities and subsidies for desirable activities – and regulatory demands that impose requirements on public or other regulated companies – like the proposed SEC mandatory climate risk reporting requirements for public companies, or banks being required to undertake stress testing and reporting on climate risk exposures. There is also consumer pressure and public advocacy. Ultimately, incentivization comes down to making the costs of non-sustainable activities visible, while highlighting the opportunities and benefits of addressing sustainability issues.
Data is the messaging tool for incentivizing sustainability because it shows an entity’s positioning regarding ESG principles. From a sustainable finance perspective, regulation requiring credible climate risk reporting and data, transparency and comparability will allow investors to make more informed decisions. It also creates a – hopefully – stable framework that reporting companies can use for their planning. Here, global standards groups like the International Capital Markets Association and International Sustainability Standards Board play a key role in providing the transparency and comparability that the market needs to continue to grow.
Education can bring awareness to corporate executives that sustainable activities can strengthen long-term profitability by strengthening a company’s ecosystem of clients, employees, supply chain and other stakeholders.This can include addressing potential transition and physical climate risks and/or social and reputational risks to the business. There are clear, long-term dollar benefits for pursuing more sustainable practices. Realizing these benefits requires a systems thinking approach that considers business stakeholders, the desired business outcomes and the impact of the broader sustainability issues on a company.
What are the impacts of a market downturn on sustainable finance?
Sustainable finance is at its core, a financing tool that also involves taking documented, ongoing steps towards sustainability linked goals. A retreat of broader market liquidity will impact sustainable finance products in a way similar to more broadly traded products: spreads widen, the credit curve steepens and investors generally become more discerning. For sustainable finance, however, this is where the credibility of sustainable finance instruments, plans and impacts take on greater importance. Complaints of greenwashing have grown in recent months, and discussions around the meaning of ESG ratings have increased (think Tesla being dropped from the S&P 500 ESG Index back in May).
Generally, the market’s calls for transparency, comparability and credibility have only become louder. But showing that this hasn’t slowed interest in pursuing ESG objectives. In June, for instance, UK-based Schroders PLC (which manages a portfolio of around $900bln) was confronted with investor discontent after announcing that it would vote against a shareholder proposal at J Sainsbury (a large UK grocery chain). The proposal called on Sainsbury’s to pay all of its staff a living wage.
Separately, investor returns receive greater scrutiny in a down environment – just like they do with other instruments during a downturn. Sustainability-related products must deliver value to both issuer and investor – not only from an impact perspective – but also from a return perspective, regardless of the status of the market.
Clinton will be presenting at the ESG Congress, this event will be taking place on October 18-19 at Etc Venues Lexington.
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