Bringing sustainability transition finance into the debt-market mainstream
Green, social and sustainability (GSS) bonds opened the door to a more active sustainable debt market in Australia. But they are only the first step. In a roundtable hosted by ANZ and KangaNews in September, credit-market participants looked at the full scope of potential growth in the sustainable-debt universe, including the role of new products in the loan and bond space, and the end goals of this type of financing.
Craig Can we start with a sense of how sustainable finance is evolving in Australia. What are ANZ and corporate borrowers trying to achieve?
Some interesting trends have developed over the last 12 months. There has been the advent of transition bonds and more recently an ESG [environmental, social and governance]-linked bond for Italian power company ENEL.
The sustainable-finance markets in Australia and New Zealand are moving in line with the trend to focus on transition. We have seen Contact Energy and Investa Property Group develop holistic green-debt programmes. Meanwhile, Housing New Zealand set a benchmark by issuing New Zealand’s first social bond, followed up by the incorporation of all its outstanding lines into wellbeing bonds which are aligned with the New Zealand government’s living-standards framework in its innovative wellbeing budget.
In loan format, we have seen green loans for real-estate companies Fraser’s Property and Brookfield Asset Management. In sustainability-linked-loan (SLL) format we have seen transactions for Adelaide Airport and Sydney Airport. Just this week in New Zealand, dairy producer Synlait announced the country’s first SLL.
The transition to a low-carbon economy is closely aligned with ANZ’s purpose and its increasing focus on issues associated with the environment. We are committed to lowering the direct environmental impact of our activities. Our operations have been net-zero carbon since 2010. ANZ has also recently announced it will be joining the RE100 which will mean its entire operations will be 100 per cent renewable by 2025.
ANZ is a key participant, alongside insurers and investors, in the Australian Sustainable Finance Initiative (ASFI), which is designed to come up with a roadmap for what it will take to deploy more capital into sustainable finance as we move forward.
There is a lot more to do and forums such as these help galvanise awareness and conversations on how we can continue to grow the market.
We have a range of ESG goals around indigenous workforce, gender equity and others that are more specific to our business such as food and general waste, animal welfare, sustainable sourcing of food, packaging and greenhouse gases.
Sustainable finance further embeds sustainability-performance improvements into our everyday activities. In our case this is by directly linking sustainability performance to our funding costs, incentivising and driving further engagement across our business.
The goals that pertain to the pillars include targets for reducing greenhouse gases and water use, improving the representation of women in the workforce and leadership, and building reputational currency through better food safety and transparency standards.
We look at this through the lens of decarbonisation but also of ensuring energy supply continues to be reliable and affordable. It is a ‘trilemma’ that we need to manage – we are walking a tightrope between sustainability, energy security and affordability.
This focus is why we shifted to an integrated reporting format this year. Our sustainability team also sits within the capital markets team, which reflects our view that the team needs to be immersed in the goals and outcomes of AGL’s sustainability measures in order to have meaningful conversations with our debt and equity investors.
Zaunmayr To what extent do issuers’ goals need to tie in with debt funding? In this context, what is the potential scale of financing based on holistic scoring of sustainability performance, such as SLLs versus the use-of-proceeds funding we see in, for instance, the green-bond market?
We did not require the funding to achieve our sustainability goals for our recent ESG risk-weighted loan. Rather, the loan is an appropriate size and links to our purpose statement and who we are as a company as well as the measures we are taking to improve our ESG reporting.
Renewable energy is a good example of this. We have a 20 per cent equity stake in an Australian renewables fund set up with QIC and The Future Fund. It is a decision point for every project whether we have it on balance sheet, sell it into the fund or do an entirely different form of financing altogether. Given the nature of the company, for on-balance-sheet funding it is important that we are proactive in linking funding to ESG performance.
While this is nice to do today, it isn’t necessary. The hope is that, in future, banks will require the type of thinking from all borrowers and customers that makes them comfortable that where their money is going respects the challenges coming and is prudent in managing and mitigating climate-change risks.
This very much seems to be the case for many other issuers that have reached out to us following our SLL transaction. Aside from the flexibility of holistic scoring, it is worth noting that products such as SLLs offer other unique benefits such as the potential for a direct and transparent pricing discount or penalty.
We will, however, continue to investigate ways in which we can issue use-of-proceeds-based sustainable funding, especially in the context of our balance sheet being primarily comprised of long-dated bonds. Interestingly, more than one in five of the questions asked on our most recent bond investor update through Europe were related to ESG or ESG funding. It is a clear area of increasing interest among our investor base.
When our treasury team is on a debt-investor roadshow, we now find there are questions around what we are using funding for to shift the nature of our balance sheet. There is a push from the investor base; there is a pull from the client base as well. The connectivity between the funding we raise in capital markets, with an ESG overlay, and how we deliver to our client base is very important.
Zaunmayr The link between sustainability and long-term shareholder value seems clear. But does the same apply on the debt side? Does it fundamentally matter if the debt market comes along for the ride?
Zaunmayr Europe is clearly leading the way in sustainable finance. But even in Europe there is a sense that the market needs to grow exponentially if it is to have any hope of achieving global goals outlined by the Paris Agreement and the SDGs. Central to this growth will have to be progress beyond use of proceeds as the basis for financing. How clearly does this message resonate with Australian issuers and investors?
Once back in New Zealand we enquired with ANZ about these loans and it began guiding us through the process. ANZ was impressed with our recently announced sustainability goals and thought we would be a good candidate for this type of financing.
I would also like to stress that our loan was not an SLL. It is an ESG risk-weighted loan so it has focus across environmental, social and governance reporting requirements.
SLLs are suitable for any company that has a sustainability agenda, whereas a green loan or a use-of-proceeds type of financing is not necessarily suitable for everyone.
When it comes to capital-investment decisions, the CFO can demonstrate the cost of capital being directly affected by increasing sustainability. This incentive is of benefit to all users of capital within an organisation.
While improvements must be meaningful, they need not be delivered via one or two blockbuster initiatives and need not only focus on any one of ‘E’, ‘S’ or ‘G’. Governance is relevant to all issuers, is critical to corporate sustainability and is a great area to focus on. But this element is at times overlooked, sitting in the shadows of more topical and tangible environmental or social initiatives.
Zaunmayr We should get a view from lenders on the value of offering a sustainability incentive in loan facilities. But first let’s hear about investors’ overall ESG drivers.
ESG is very important at the wholesale end of our investor base. These clients don’t give us targets but they do give us a clear indication of what they like and don’t like. We are required to complete ESG surveys every year for many investors. At this stage their ESG targets are largely broad-based.
We don’t have any explicit exclusions although there are some areas – such as arms, pornography and gaming – that we don’t look at. We have heard from a number of investors that they have restrictions on investing in any carbon-related industries.
As a lender it is very difficult to separate ESG from credit risk. A company or a borrower that has a bad ESG track record will undoubtedly end up being a bad credit risk. This is the way we look at it and it is a big part of our investment process. We have declined a number of transactions because of ESG-related issues with a borrower.
We have had a range of exclusions for a number of years, similar to what Graham McNamara outlined. We also have a range of clients that are at different stages of their ESG journeys. Some clients are very advanced, particularly those in the insurance industry.
The range of exclusions and reporting requirements we are being asked to do is interesting and aligns with a lot of the work we are doing in thinking about risk in portfolios. For instance, some clients won’t fund energy companies that don’t have a transition plan which meets the company’s national Paris Agreement commitments.
We are fixed-income, predominantly vanilla-bond investors so our central interest is in default risk. In other words, we are downside risk managers. If we get some upside that is great, but this is not equity. We look for issues beyond financial metrics that could affect the price of bonds or the ability of an organisation to repay.
Banks will need to become quite clear in what they do and don’t do as well as why they are doing it – and be clear on how they are influencing transition and why.
The role of transition bonds
Corporate balance sheets are more suited to funding based on sustainability scoring than the use-of-proceeds approach taken by green, social and sustainability (GSS) bonds. In theory, there is no reason why financing supported by the principles of sustainability-linked loans (SLLs) could not also be available in bond format.
TAPLEY It has now happened offshore, with a transaction by ENEL. This is an Italian energy distributor with operations across Europe. It issued a bond referencing its emissions-reduction target. If this is not met by 2021, the coupon the company pays to investors steps up by 25 basis points.
ENEL has not been able to get investors to agree on a coupon step down. But I think this will come in time. It is no different from the risk-rating pricing grid we sometimes see in bond transactions.
Craig Can SLLs go some way to reversing the problem of exclusion by broadening the scope of sustainability investing?
The second piece is that SLL goals need to be linked to the company’s ESG strategy. It can’t just be business as usual for the company, either. The targets need to make a meaningful change.
These two factors show that what the market is trying to achieve with SLLs means companies that are focused on improving sustainability can be rewarded. If they are not focused on improving ESG performance an SLL is not the right product.
Banks are telling me that, with capital becoming scarcer, they want to apply their capital to companies they think will be there for the long term and with lower risk. It is a strong, positive signal from the banks that they will reward companies that are focusing on the right things over the long term. It is up to companies now to get on the bus and commit to it.
Like Marayka Ward, I think exclusions were initially set as a blunt object to drive change away. Now, the market is developing towards a nuanced approach which means there is less chance of poor outcomes. We would prefer to work with our long-term customers to assist them to transition, even if they are in a carbon-intensive industry, rather than divest.
Zaunmayr Does a margin step up or down based on sustainability performance mitigate any pricing disadvantage for lenders?
In the long term, as ESG risks become fully integrated into our credit-risk calculations, I can see this changing. It will potentially become the norm for companies to have a pricing penalty if they do not perform. The discount would likely become the standard market price with only the potential for a penalty for poor performance rather than a benefit.
This is good for farmers, good for consumers and good for the community. It is also very good for ANZ when we look at the long-term risks on our balance sheet. It is a much bigger picture than the immediate transaction.
Zaunmayr As the market evolves from use-of-proceeds to borrower-level sustainability scoring, one would have to assume the process of agreeing on performance parameters, and assessing and reporting performance will become more complex. Is this a fair assessment?
It also depends on how a loan is structured. Sustainability metrics can obviously be tailored to the reporting you are already doing. This can be managed and should not be an excuse not to do an SLL.
At the portfolio level, we are also going through every company we have bought bonds in to look at what they are doing through their supply chains and within their businesses.
I sat on the UN Principles for Responsible Investment sovereign working group and we put out a paper in September on how to include sovereign ESG analysis into a bond portfolio.
We now model, through our portfolios, the domiciles of the issuers we provide bond funding to. This could identify country risk relating to water stress or governance issues, for instance. We can then set up our portfolios to account for these risks. Our portfolios are predominantly Australian dollars and under Australian law. But a lot of the issuers operate under the law of a foreign country so we need to consider sovereign risk.
We use a materiality process to map sustainability risks across industries. We do a lot of impact reporting to understand the use of proceeds from GSS bonds and can look at things like specifically how much carbon an investment has saved.
We also align our reporting with the SDGs, looking at what companies are saying they have aligned to. A lot of impact reporting is driving discussion with clients and some of it is a collaboration with clients as well.
In the last 2-3 years we have gone from virtually no-one requiring ESG reporting to the bulk of our institutional investors requiring us to complete regular reporting on our ESG policies and processes. The onus is on us to report and make sure we know what our borrowers are doing to comply with accepted ESG standards.
Zaunmayr Do we need a single framework for determining and measuring sustainability goals and outcomes that borrowers and investors are comfortable with?
This does not mean we need identical thinking. What we need is to put the different parts of the puzzle together. This should help get the market at least heading in the right direction with a weight of views that could also influence political thinking in this country, or at least some of the policy settings around the way regulators are looking at issues. The Australian Prudential Regulation Authority and the Australian Securities and Investments Commission are observers in ASFI, which is quite powerful.
One of the focuses in a working group within ASFI is looking at what we can take from other jurisdictions and how we can apply it in Australia. There is also quite a high degree of trans-Tasman conversation going on. But, again, the Australian and New Zealand economies are quite different in composition.
While frameworks and associated harmonisation are welcome, it is important to acknowledge that sustainability is different from company to company, sector to sector, and region to region.
Craig How useful is the EU taxonomy in Australia?
Next steps in Australian market development
Market participants agree that global sustainable-finance markets need exponential growth if they are to achieve ambitious – but critical – environmental goals. Australia is facing the same race against time.
BYRNE I think so. At that point Europe will be at the tipping point that Gavin Chappell spoke about, where capital allocation costs have changed for lenders in the space because the lower risk of companies taking environmental, social and governance concerns seriously has been proven.
I think there will have been transition bonds in Australia as well, given the transition that needs to occur in Australia and the potential benefit these instruments could bring.
Zaunmayr Would sector-specific frameworks be helpful?
All parts of the economy need to have a broad approach to ESG. But the approach at business level needs to be refined and appropriate for that company.
For a company such as AGL, there are two meaningful triggers which we think are more effective to be measured by: emissions reduction and the renewable-energy mix. It is not the same for all companies. But if you are a company with real impact in certain areas that is where the focus should be.
Having too strict a framework for reporting can become very quantitative. If you become too prescriptive, you move away from what a company is trying to achieve and what is important to it. There is the danger that it takes some investors down the path of just looking at companies within a certain box rather than taking a broader view.
However, if we are not reporting on the exact regime that an investor wants it can be quite difficult because the definitions vary significantly between frameworks.
“In more than 20 years of working in this market there have only been two occasions where borrowers have been this active in approaching us because they want to know how the market is developing. The first was during the events of the financial crisis and the second has been with the advent of SLLs.”
Craig If SLLs are the next step in the evolution of the market, how widespread is the potential application?
This is happening because sustainability is becoming a focus all the way to board level. Finance teams are being asked questions and they need to be properly informed on developments in the space. The interest is significant.
Investors are also becoming more focused. Anyone that lends on a vanilla loan can lend on an SLL basis. Going forward there will likely be more liquidity in this product than there is in vanilla lines.
investing with impact Yearbook 2019
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