BNP Paribas is the issuer of a bond that embeds a call option on the constituent companies in the ACT index. The bank funds the purchase of shares of index constituents as a hedge against its option exposure. In a forward-looking index, this basket of companies should be environmental outperformers over the life of the bond.

Mike Watanabe, managing director and head of equity derivatives, Australia at BNP Paribas in Sydney, explains: “This means the bond has a dual impact: from the green projects funded by BNP Paribas and additionally from the performance of the companies in the index.”

The provision of equity-index upside reduced the bond’s cost to the issuer. BNP Paribas has not disclosed full pricing details but says the bond coupon is “well below 1 per cent [in order] to purchase participation in upside index performance”. By comparison, UBS Australia Branch issued five-year fixed-rate bonds in the local market in late July with a coupon of 1.2 per cent.

This is not the first time a bond and an equity-index call option have been combined into a single security – indeed, Watanabe says, BNP Paribas has used such a structure several times in Europe and the US. For instance, the bank arranged the inaugural Tera Neva transaction in November 2015. This €500 million (US$588.7 million) deal combined a European Investment Bank (EIB) climate-awareness bond with a payoff at maturity linked to the performance of the Ethical Europe Climate Care Index.

However, the Australian deal marks the first time BNP Paribas has deployed a forward-looking index in this type of structure – and may be the first time ever.

The index associated with the Tera Neva transaction comprises 30 companies selected on present financial and sustainability criteria, reviewed on a quarterly basis. The ACT index is more ambitious. It seeks to project how businesses will perform under five climate-transition scenarios and thus identify companies in three categories that it expects to outperform.

The first category is “enablers”: firms selling products and services needed to support climate transition. Second is the “least affected” companies that will be able to cope with climate change because their existing technologies and services are compatible with the future environment. The third category is “adaptors”, meaning companies that are well-placed to adapt to climate change despite operating in affected sectors.

The ACT index’s universe is firms in the Australian Securities Exchange (ASX) 300 with activities primarily in Australia, with a liquidity filter that left 100 qualified candidates. BNP Paribas applies its own corporate social responsibility filter as an initial negative screen, though Watanabe says this did not disqualify any further companies from index inclusion as of the date of bond issuance.

Companies in the index are assessed according to five climate-transition scenarios, all of which facilitate an outcome of 2 degrees or less of overall climate change (see table). These scenarios take account of the pace of policy, social and technological change to assess not just companies’ current environmental footprint but how it will change as Australia responds to the reality of climate change. They were co-developed by ClimateWorks Australia and CSIRO under the Decarbonization Futures project.

Australian Climate Transition Index climate-transition scenarios

Source: BNP Paribas July 2020

ClimateWorks Australia and ISS ESG have designed a process to score each company under each scenario, every six months. This is converted into a single company score for index calculation, based on relative weighting of the five scenarios. This weighting is initially equal but will be updated annually to reflect the real-world trajectory of Australia’s policy, technology and social response to climate change.

Watanabe tells KangaNews: “In essence we are trying to focus on what the ASX will look like in future – it is, in effect, stock picking based on environmental scenario analysis. The companies that are best at adapting to environmental transition or are least affected by it should outperform in future.”

Developing an investable product with this type of structure requires a deep alignment of purpose. Investors are delegating a stock-picking function to the index methodology. BNP Paribas as the instrument issuer is also relying on the expertise of the index provider for its integrity and performance.

“Climate is a complex, interconnected issue for the investment world and we are seeking to partner with experts that have academic, forward-looking knowledge we do not – this is what attracted us to this project in the first place,” says James Pearson, head of impact and responsible investments at QBE in Sydney.

For a firm like QBE – an asset owner – Pearson compares the process of identifying and using external expertise to the selection of external fund managers for specific asset classes. The company manages fixed income investments in house but conducts investment in equities and other risk assets via exchange-traded funds and third-party fund managers. “Finding managers with expertise in asset classes we are not resourced for is part of our normal process – this is just a different specific area of expertise,” Pearson explains.

The experience was similar even for the deal’s arranger. “The project was only possible thanks to deep collaboration,” Watanabe confirms. “The forward-looking aspect is an area of scientific research, not an investment bank capability. We had to work with two different entities on the scientific and data sides of this issue, while the three initial investors also contributed a lot here and elsewhere.”

Deal participants leaned on established relationships to help navigate what became a two-year process. For instance, Watanabe says BNP Paribas has a longstanding partnership with Monash University’s Centre for Quantitative Finance and Investment Strategies, which acted as advisor to the overall index construction and implementation process, and as academic observer to the index on an ongoing basis. The university also part funds ClimateWorks.

Pearson, meanwhile, says QBE’s own ESG policies were considered in the development process. “We advised BNP Paribas on our ESG processes and exclusions and it built a product based on a comparable level of screening. For instance, we have a comprehensive exclusion of thermal coal and would not have invested in a product that did not pass this type of screen.”

Achieving this degree of alignment between as many parties as a transaction of this nature requires may predicate against its wide-scale deployment in the Australian debt market. For one thing, the combination of a vanilla green bond and an equity-index call option may be disqualifying for many fixed-income mandates.

Engaging with the development of a specialist product was a worthwhile process for QBE as the firm seeks to deploy funds in line with an impact investment agenda it has had in place for around five years. But Pearson acknowledges QBE has some advantages when it comes to aligning a complex, hybrid product with an investment mandate.

“We have a fixed-income portfolio that includes fixed and variable return bond product, and we were able to classify this instrument as the latter,” he reveals. “But it likely helps in this regard that we are investing for QBE, where we have built an impact investment initiative for which we want to be actively seeking opportunities.”

Pearson describes the BNP Paribas product as a positive component of the evolution of impact investment rather than necessarily regarding widespread takeup to be regarded as a success. “Five years ago, finding a product that ticked the right boxes on impact and financial return was sometimes like finding a unicorn. That is much less the case nowadays – the mindset has changed, and we are seeing a proliferation of structures and products that answer the questions we are asking.”

Structures linked to equity indices also have a limited breadth of issuer applicability. Watanabe explains that the issuer has to be able to fund the equity hedge economically over the extended tenor of a bond transaction. This restricts usage to credits with a sufficiently low cost of funds.

BNP Paribas is thinking about deployment on a broader basis. The bank wants to issue at least a few more transactions in this format to demonstrate investor commitment and demand, Watanabe says. But in the longer term it plans to roll out a global equivalent of the ACT index that it may open to licensing agreements. It has committed to disclosing the makeup of the Australian index a year after launch.