Sustainable finance heads to the mainstream

In the traditional market, we often see companies borrowing from their banks and then doing a bond. What I think we will see develop is issuers doing a sustainability-linked loan (SLL) and then refinancing via a GSS bond. Borrowers can get a bespoke loan that suits their profile and industry, and which they could structure to meet the targets required.

I don't see further market development being about issuers either doing SLLs or GSS bonds. I think it will be both.

Semi-governments have all talked publicly about the states' major infrastructure task. Some are even bringing this capex forward and are looking to refinance through the GSS bond market, which is pleasing. A lot of the physical and social infrastructure spending by the states, like public transport and eductation, lends itself well to the green and social categories. We should continue to see large-volume deals.

It's a different story for corporates. There is always interest, but whether this translates into deals is a separate matter. Clients are getting closer, though - and there is much interest.

A couple of years ago, the sense was that transaction costs for GSS bonds would be too high and the process too resource intensive. This has changed: now there is a sense that corporates want to be involved and it is a case of looking at how they can.

Cost is no longer the barrier. It is more about internal resources and having sufficient assets for GSS bonds. Also, as we get more sector definitions - beyond renewable energy, buildings and low-carbon transport - there will be more eligible green and social assets. This will open up the market to more potential issuers.

Through the early part of 2019, there was possibly some trepidation from new issuers around coming to the GSS market. But there have now been some good examples of new issuers in the market, including international banks like MUFG [Mitsubishi UFJ Financial Group] and OCBC [Oversea-Chinese Banking Corporation] through its Sydney branch. NextEra Energy has also come to the Australian dollar market in Kangaroo format, as well as National Housing Finance and Investment Corporation (NHFIC) and flexigroup, which brought two green securitisation deals in 2019.

It took a while to establish comfort about the depth of demand in Australia. But the deals done so far have been well supported. It is disappointing that the corporate sector has been slow to issue, but engagement from issuers and investors has increased dramatically – domestically and offshore.

From National Australia Bank (NAB)’s perspective as an issuer of GSS debt, 2018 was a breakout year. We raised more than A$2.5 billion across four green bonds we brought to market in a range of currencies and formats. We then followed up with the uBank retail green term deposit, launched in early 2019.

Corporates that are focused on issuance costs in isolation from their broader sustainability strategies will face challenges. We find that things start happening when treasury teams, C-suite and sustainability teams are integrated and working together.

It is morphing, though, more into a greater focus on sustainability. This will propel these markets forward, through the growth of products like SLLs, which we have seen emerge in the Australian market in 2019.

The investor market is becoming more sophisticated. It is no longer just about the transaction and how funds are being used. It is more about what the borrower stands for and how the transaction matches with the company’s overall sustainability strategy.

However, I think sustainable finance could be the trigger for a real secondary loan market in Australia because demand for sustainability-linked loans is not just price-driven. There is a whole different complexion because it is also driven by behaviour and shareholders.

In the more liquid part of the market, 2019 has been a very positive year with a lot of issuance from supranational, sovereign and agency (SSA) issuers and semi-government borrowers. As David Jenkins mentions, there has also been issuance from offshore corporates and financial institutions, which is good for the expansion and liquidity of the market.

Another positive theme on the corporate side is that the domestic market is the option of choice at the moment. This has not always been the case but I don’t see it changing in the immediate future. Then it is a case of whether or not the issuer has the bandwidth to look at a green or sustainability deal.

We want to have as many avenues available for diversification as possible. In this sense, Europe has led the way for issuance in GSS format, as it is accretive to our total universe and expands our investor base.

Australia is very much on the journey towards this being the case, but it is behind Europe. It will probably evolve in time and we will potentially see some bifurcation in demand for GSS products and traditional vanilla bonds.

The benefit of having a strategy and appetite for this type of lending is that, as funders, we can apply this collateral to the issuance function and feed the appetite for GSS product in debt capital markets.

Another benefit of a clear sustainability strategy for organisations relates to the way investors that are allocating capital to us view and score us as an issuer. Having clear and articulated sustainability strategies and providing a demonstration of how we are addressing climate change are becoming increasingly important. This is about issuance not only in GSS formats but across the whole spectrum of products.

Increasingly, investors want a better understanding of what their capital is going towards and whether it fits with their own sustainability principles. It is more important than ever to have a well-formulated and understood policy on sustainability.

We have moved beyond this, though – certainly for bank and semi-government issuers. The Australian market is following what has evolved in Europe, where there are familiar investors that buy GSS debt and manage large pools of capital, either across multiple strategies or in bespoke sustainable funds for customers.

Some familiar names – like Altius, AMP, Pendal, Pimco and UBS Global Asset Management – are arguably dark green because they have dedicated sustainable funds. It is still possible to classify these and many other large investors as both light and dark green – either or both.

If they are managing funds that integrate ESG screens first but don’t run specific sustainability strategies or funds, we consider them light green. Investors that are signatories to the UN Principles for Responsible Investment (PRI) manage funds that need to be deployed in this way but don’t have dedicated standalone green funds would also fit into this light-green category.

Whenever deal statistics come out, the breakdown of dark versus light green is often contentious. Members of the same syndicate often have different categorisations. Unless you tease out specifically which mandate an investment is going to, you are reliant on judgement calls to assess the dark-  and light-green split for each deal. Often there is just categorisation as either green or nongreen. Green being those that are considered light or dark green, are signatories to the PRI, have ESG integration in place and manage funds across either or both standard and sustainable mandates. Nongreen would be those that buy purely for liquidity or because they like the credit, irrespective of the nature of the deal and issuer.

Some European investors have even begun to divest names because of their exposure to carbon-intensive industries. It is front and centre – and not just with dark-green investors.

Regulators have also been vocal and clear on where they believe the financial-services sector needs to be. This sends a clear signal to anyone who borrows or needs insurance. The Task Force on Climate Related Disclosures (TCFD) is another example – it is a tool to enact the Australian Prudential Regulation Authority (APRA)’s messaging, which is that climate-change risk is a financial risk.

The push for increased transparency and disclosure is continuing as a theme. Investors expect it. When we take issuers on GSS deal roadshows, they are expected to disclose what specific impact reporting will be provided for each deal. This is different even from a couple of years ago.

Most large, listed corporates and financial institutions already report under TCFD or are working towards doing so. This reporting is voluntary, but if you are not doing it investors may ask why. It is all part of being more transparent and assessing risks.

In Australia, we have transition risk because of the nature of our energy, industries, resources and manufacturing sectors, which all tend to be emissions intensive. However, detailed transition plans are in place for many companies.

For example, BHP Billiton has a plan to exit fossil fuels and is looking at a range of other transition measures. Transition financing through loans linked to this transition, or use-of-proceeds bonds that fund transition investments, would make sense for a company like this.

This is where we get back to a definitional challenge, though. If a transition bond is structured as a use-of-proceeds transaction, it will be different from some of the structures we see for general corporate proceeds or for sustainability-linked products. Transition is a broadly defined and evolving term.

In much the same way that the GSS market started with simple use-of-proceeds structures and has taken several years to get where it is now, there is considerable development to come in this space.

The market has evolved from sustainability bonds placed within use-of-proceeds transactions to behavioural-based SLLs. But it took a while to get from one point to the other. It will also take time to get to a sustainability-linked bond market with coupons that step up or down. We have had structured instruments linked to ESG outcomes, but not yet with significant scale.

It may kick off in the loan market, and one of the things we have talked about is a green loan linked to asset financing. This could provide a starting point. It would be a light-green loan, for example to a company that collects waste and wants to convert its truck fleet to the use of gas fuel.

The transition story is pertinent to Australia, and other markets such as New Zealand and Canada, where there are large, emissions-intensive industries. Definitions relating to transition are being debated at the moment but nothing has been set or agreed upon. There will be a lot of discussion on this over the next 24 months, which I think is needed.

Several airlines, for example, have made commitments to transition to carbon neutrality, which has big implications for their businesses. How they finance this transition is important. AGL Energy (AGL) is another good example. It could earmark some of its renewable assets and issue a green bond or, alternatively, the company could do a corporate-level transition bond linked to its sustainability ambitions, including alignment with the Paris Agreement goals.

Ultimately, there is appetite that stems from the top of the business and then there is the economics, which is the transmission mechanism through things like capital benefits and charges to incentivise growth. This could really propel things forward on a sharper trajectory. What form this takes and under what timeframe remain unclear.

Because sustainability is business-as-usual, the need to create specific incentives to create specific types of deals does not really exist – it is just how we operate. Frankly, customer demand is so great that if as a bank you are facing a customer and do not have the capability or willingness to engage in the sustainability conversation, customers will go next door. This is incentive enough.

We have similar conversations with issuers. What TCorp is doing internally regarding sustainability is helping shape what the broader market is doing. At NAB, the sustainable-finance team plays a key role in informing and shaping strategy, which is extremely interlinked with what we are doing across the broader bank.

We are increasing our commitments to deploy capital towards environmental-  and sustainability-themed financing. We have recently announced our coal-financing strategy, with targets in place to get there.

However, we don’t just leave these customers behind: we support their transition. For customers looking to transition, sustainable financing is the perfect opportunity. Customer discussions are now more around what can we do and how can we do it rather than just describing sustainable finance.

Much of what we do is education. We bring customers along for the journey. We have had the benefit of being at the front line for a while now, facing investors’ expectations and being at the forefront of market development. We often hear from issuers that have done roadshows offshore that they have been asked ESG-related questions for which they were unprepared. It is a collaborative approach whereby we can show our clients how we are approaching ESG and sustainability as an issuer, as a corporate and as a bank financier – and why it is important to us.

We have met with Natixis and also started conversations internally around what we could be doing to assess the risk in our balance sheet beyond what we do on a qualitative basis as part of our usual credit assessment of customers. This is about taking it to quantitative from qualitative.

The best thing is that Natixis is happy to share its experience. There is intellectual property involved but collaboration is at the forefront. We each have bespoke systems and challenges around technology as well as resource constraints. We would love to be able to push this to the front of the priority queue but other challenges also demand financial and technology resources.

We are looking internally at potentially putting in place a similar mechanism. It would not be as detailed as what Natixis has done, as this would be difficult for an Australian bank.

Our strategy would involve adjusting the internal capital charge for deals that meet certain criteria, to encourage more of it. This could be done formally through internal structures or informally through pricing matrices.

The big question is whether governments will come to the party with capital relief. We understand there have been discussions with the Chinese regulator and there have certainly been conversations with the European regulator. It would be a game changer if major economies had this kind of regulatory capital adjustment for green lending. But we are not waiting for it.

The conversation is changing. For example, a few years ago, when asset-backed securities featuring solar photovoltaic technology were a new asset class, the focus may have been track record for the asset class. This is still relatively pioneering but there are now data sets that show outperformance of entities that have good ESG ratings.

Now, the scale of development in renewable energy is helping the Australian government meet its targets.

Global investors now generally expect us not just to have a programme for issuing in GSS format but a top-down, overarching strategy, over the whole bank, to get investors engaged with NAB rather than just with specific products. It is becoming more about integrated assessment.

We will also see securitisation in different formats, given the scale of issuance. There will also be finance linked to sustainability and transition in a range of formats and catering to different customer segments.

We said at this discussion at the end of 2018 that SLLs were the main expectation for development in 2019 and we have been proved right. I think there will be exponential growth in this product over the next 12 months.

Earlier in this discussion we also touched on the transition issue. I think this will come to the fore over the next 12 months. I don’t think we will land on a set of agreed-upon definitions as yet, but Australia is in the driver’s seat for what transition looks like.

It is also not just loans and bonds. I think we will continue to see sustainability raised in other areas, like asset finance. This expansion will make sustainability much more mainstream than just having loans and bonds. The SLL area is the logical place for borrowers to start but it is not necessarily what we are targeting.

For Westpac, I would like to see the whole product suite develop so it becomes mainstream and borrowers think about financing in a sustainable way.

If you think about corporate structures, treasury teams look at loans and bonds, someone else looks at trade finance and someone else does asset finance. Mainstreaming sustainable finance means different people in our client set start to think about their requirements from financiers in a way that broadens the sustainability financing platform.

We would like to raise more green deposits. We need to look at what is the better outcome for our customers and the community.

They have been bringing their bilateral facilities together into a sustainability-linked format, which is then taken to the syndicated market. This is interesting from a structural perspective.

There will also be opportunity for the banks to recycle some of the lending they do internally as it gets to scale. There could be bonds or asset-backed transactions linked to this lending.