Sustainable corporate debt establishes base camp in Australia – and looks to the summit

Like the Australian corporate debt market as a whole, the local sustainable debt space has progressed in leaps and bounds over recent years but still has a mountain to climb. The emergence of sustainability-linked instruments has opened the sustainable-debt door to a new range of borrowers, while investors are increasingly integrating sustainability principles in their credit processes. Participants at a roundtable convened by KangaNews and Westpac Institutional Bank in November discuss their sustainability journeys and how they are preparing for the climb ahead.

PARTICIPANTS
  • Peter Block Head of Corporate and Nonfrequent Borrower Origination WESTPAC INSTITUTIONAL BANK
  • Lilly Cheung Group Treasurer GPT
  • James Dolton Chief Financial Officer NSW LAND REGISTRY SERVICES
  • Shan Kwee Portfolio Manager JANUS HENDERSON
  • Richard Lovell Executive Director and Head of Capital Management CLEAN ENERGY FINANCE CORPORATION
  • Eliza Mathews Head of Sustainable Finance WESTPAC INSTITUTIONAL BANK
  • Sean McGuinness Head of Corporate Finance and Investor Relations ESTIA HEALTH
  • Vivek Prabhu Head of Fixed Income PERPETUAL
  • Marayka Ward Senior Credit and ESG Manager QIC
  • Terry Yuan Senior Credit Analyst PENDAL
MODERATOR
  • Laurence Davison Head of Content KANGANEWS
  • Chris Rich Staff Writer KANGANEWS
THE STORY SO FAR

Davison What are the most significant developments in sustainable finance corporate borrowers and investors should be thinking about at the end of 2021?

MATHEWS There is so much going on across the ESG [environmental, social and governance] sector as a whole and in how this translates into sustainable finance. To start with, we have seen key reports from the International Energy Agency and the Intergovernmental Panel on Climate Change. They are really powerful statements from the science community.

Regulations are also having a major impact in Australia and overseas – specifically reporting on climate-related risks and the formation of bodies such as the International Sustainability Standards Board. Then there is a suite of commitments and standards coming out of COP26, from governments and companies announcing new targets and making existing ones more aggressive.

Issuers and investors increasingly need to think about how they continue to thrive in a net-zero emissions economy – and what their transition strategy is. Sustainable finance can help achieve these goals, and the market continues to develop structures to assist.

YUAN Of late, it seems as though the majority of bonds issued in the primary market are green or sustainability-linked bonds. Issuers are seeing it is worth the effort to do the work to set up a sustainable-bond programme because they get the benefits of increased demand and tighter spreads.

However, we see two major problems in the ESG-aligned bond space at the moment. The first is that it is very hard to compare programmes. The second is that some of the targets in sustainability-linked bonds (SLBs) are too back-ended. We do not see the point of implementing a target one year from maturity, because all this can do is penalise the issuer for just a single year. This does not seem to be in the spirit of ESG and SLBs.

KWEE Investors definitely face challenges on the reporting side, as well as communicating their portfolio’s carbon footprint and their embedded climate-risk positions to their own investor base.

On a slightly different topic, we have seen ESG intent and commitment rising. It is now transitioning into changes in corporate behaviour as well as capex intentions to transition.

Challenges are being solved in a few different ways. We are seeing changes in the business-unit mix for traditional borrowers, for example Woolworths spinning out its Endeavour Group business due to its significant alcohol exposure and AGL trying to split its business to ringfence coal- and gas-fired generation away from its retail and renewables generation business.

The reaction from corporate borrowers to the scrutiny of capital providers – in equity and debt markets – is shifting traditional business models quite rapidly. This is something we are very conscious of from a credit-fundamentals perspective: it means issuers are reacting to the increasing pace of ESG transition and debt holders facing changes in earnings and asset profiles.

“It is still challenging to connect sustainability strategies to finance and to be willing to pay a penalty if goals aren’t achieved. The level of internal approval needed to get this done of itself shows a strong commitment by a company. We should be supporting and celebrating companies coming to market.”

WARD In the client space, we expect to be doing a lot more on the reporting side – things like helping clients modelling sustainability pathways through their investment portfolios.

Another issue we are focused on is nature-related risk. With the Taskforce on Nature-related Financial Disclosures being developed, we are analysing what we are financing, how companies are handling the risk and whether financing opportunities for solutions will emerge. Then there are the product-side opportunities as well. A lot will be reporting and regulatory driven.

Mathews Picking up on the point about target setting, it is a choice between testing targets toward the back end of the bond or moving the test date earlier on, where decarbonisation will not be as dramatic because there is less time to achieve it? What is the preference?

YUAN We could have both. I would like to see an additional target date that lies within the first half of the tenor of the bond. Currently, many bonds have sustainability target dates only in the last one or two years of their tenor.

The last problem we are seeing in the ESG bond space is that some issuers have emissions targets that are ratios rather than absolute limits. For example, this could be an emissions-intensity ratio where absolute emissions can still grow as the business and its revenue grows. Again, we feel this is not in the spirit of ESG or SLBs because it is not encouraging an absolute reduction in emissions.

PRABHU We do not want to let perfection be the enemy of the good, especially at this early stage in the development of the green-bond and SLB market. It is important to keep this in mind.

As an example, we launched an ethical SRI [socially-responsible investment] credit fund about three-and-a-half years ago, and one of the holdings in this fund is the Ampol hybrid security. It has raised a question from some investors about exposure to fossil fuels.

In this particular case, the fund was set up explicitly to screen out upstream fossil fuels – extraction – whereas Ampol is involved in distribution and retailing. When I say do not let perfection be the enemy of the good, I think we are better off engaging with companies like this to help them make a transition.

Ampol recently announced it is rolling out installation of EV [electric vehicle] charging points at its outlets. This shows that complete lack of engagement from investors will likely result in a worse outcome than if we help companies make the transition.

“Of late, it seems as though the majority of bonds issued in the primary market are green or sustainability-linked bonds. More and more, issuers are seeing it is worth the effort to do the work to set up a sustainable-bond programme because they get the benefits of increased demand and tighter spreads.”

LOVELL The market is making encouraging steps but every investor has particular concerns or challenges with aspects of these structures.

Instruments that look at emissions-productivity metrics instead of outright emissions is one example. We have seen some instances where borrowers are using emissions-productivity metrics when doing so is a materially less ambitious approach. In other instances it is either unavoidable or in fact desirable to focus on these kinds of metrics.

We believe the market is progressing in a rapid and, generally speaking, constructive way. There are risks associated with greenwashing. But it is refreshing to hear that every investor has these concerns front and centre, and there is absolutely a good-faith engagement from virtually all market participants to avoid greenwashing.

In respect of overall market developments, we look at a wide range of emerging technologies – such as hydrogen, soil carbon and even seaweed. This space is flourishing and there is a lot of capital on the hunt for these types of opportunities. In the bond space, we receive a lot of interest from corporates to explore a range of options.  

The taxonomies coming out of COP26 will be important for driving capital flows, and harmonisation of these taxonomies is important because it will help cover the issues to do with ambition. Some degree of complexity is unavoidable but the more that can be standardised the better.

Block How can the market manage the competing desires of not letting the perfect be the enemy of the good and achieving maximum impact?

LOVELL There are some companies for which transition is not going to be possible and it will be painful for investors that have equity in these companies. But there is no point pretending transition will be possible when it is not, or avoiding doing the hard work.

ClimateWorks Australia put out some markers on the requirements for a credible transition. Any analysis will show there are still companies in the ASX300 that have not even begun to take the necessary steps to decarbonise.

KWEE We have reached the point where transition acceleration is upon us. But in speaking to our client base and end investors, there is no consensus as yet on whether to pursue a pure divestment strategy or to provide capital with conditions of a valid transition pathway.

When we analyse companies with an eye to maintaining provision of capital, engagement is crucial to understand whether the appropriate actions are being taken and whether the capex to enable transition is manageable. This is becoming an acute consideration.

MATHEWS I speak to companies across the spectrum, from the very green to the pretty brown. Every entity that is considering some form of sustainable finance is pushing itself. It is still challenging to connect sustainability strategies to finance and to be willing to pay a penalty if goals are not achieved. The level of internal approval needed to get this done of itself shows  strong commitment by a company. We should be supporting and celebrating companies coming to market and making these types of statements.

CHEUNG GPT has a long-standing focus on sustainability and has set itself strong ambitions on this front. We were on the path long before sustainability or ESG was a topic among our investors – equity or debt.  

GPT Wholesale Office Fund achieved carbon neutrality on 100 per cent of its operating assets in 2020. At group level, this year we brought forward our target to reach 100 per cent carbon neutrality for our managed assets to 2024 from 2030.

We believe these are very ambitious targets. Beyond carbon neutrality, other areas of focus for the business include a target of water neutrality by 2030, reducing landfill waste through closed-loop recycling recovery and electrifying our buildings where feasible.

This means we have found the SLB path really difficult. It is difficult for us to say we plan on being even more ambitious than an already ambitious target, which is one of the criteria for an SLB.

It would also be nice to see a two-way street on the cost of funds for targets within an SLB. There is a penalty for not meeting targets but we would like to see a reward for meeting them. This is something that can be achieved for sustainability-linked loans (SLLs) but it is not in the bond market at this stage.

We executed a debut green bond for GPT Wholesale Office Fund in October this year. We chose to go down the green use-of-proceeds (UOP) pathway rather than an SLB given all the work we have already done.

YUAN GPT has been focused on ESG for a long time and is a leader in the space. I understand why it would be difficult for it to do a SLB. We are not beating the whip on ESG leaders like GPT – it is others that have come to the market that need to do more on the ESG front.

Issuer timing

Australia’s first use-of-proceeds corporate green bond priced in 2017, but the flow of new issuers coming to market with sustainability-labelled debt financing continues to grow. Some have been waiting for the market to align with their sustainability ambitions, while others have been sparked into action by the arrival of new products.

RICH GPT has been a regular issuer in the domestic bond market and it has obviously been on a sustainability journey for some time. Why did it choose 2021 to issue a debut green bond?

CHEUNG When ESG [environmental, social and governance] financing first arrived there were not a lot of standards or consistency on the principles and requirements. At the same time, we were already doing a lot on the sustainability front and didn’t feel we needed the marketing of green financing to show all our work in sustainability.

Our decision to execute now came from watching the standards develop to the point where there is clarity on the principles and process. It has become more a question of ‘why not’? We have a large pool of eligible green assets and have always disclosed a lot of information on our environmental impact, such as our energy, emissions and waste. We have been providing this environmental data since 2005, and it is also externally assured.

Issuing a green bond does not materially add to our existing reporting process. But we see the benefit in increased investor diversification and demand. The green bond also provides more stickiness in our investor base.

LILLY CHEUNG

Our decision to execute now came from watching the standards develop to the point where there is clarity on the principles and process. It has become more a question of ‘why not’? Issuing a green bond does not materially add to our existing reporting process but we see the benefit in increased investor diversification and demand.

LILLY CHEUNG GPT GROUP

Prabhu One of the challenges for fixed-income investors is that we are not owners of the businesses we are investing in. An equity holder can make demands or suggestions with regard to ESG initiatives. How do issuers view fixed-income investors compared with equity investors?

CHEUNG We see both debt and equity investors as important capital partners to our group. Equity investors provide capital for us to continue to fund and grow our business, but so do our debt investors. We are always open to engaging with our debt investors to listen to their feedback.

As a business, we are very passionate about the sustainability journey. It is embedded within the organisational culture and the way we operate, and we have been driving sustainability through the business and then communicating to investors. However, we also get feedback that we do not promote all our sustainability initiatives to the extent we should. The findings and experience of our journey are something we need to learn to communicate more to investors.

ALIGNING PRODUCT AND AMBITION

Kwee We were hopeful when the UOP market started, but it was unclear whether the extra commitments of auditing and ringfencing green assets would change behaviour. Do issuers believe sustainability-linked borrowing has aligned behaviour and incentivised future action at senior management and shareholder level? As a capital provider with a footprint in the impact market, this is the kind of impact we are trying to generate.

DOLTON We have a three-, five- and seven-year facility, and there was some debate internally about to which tranche we should link the ESG piece – precisely because of the point about target ambition.

Our company goals are certainly more aligned to the three-year target because we have a really good understanding of what we want to achieve over the next three years. But in discussions with our shareholders and the sustainability coordinators of the transaction, we chose to go with the five-year tranche. It forced a number of conversations with senior management and the board to ensure they were comfortable with the targets, which were beyond our near-term strategy. It certainly broadened our ambition.

This is one of the components that adds to the complexity of issuing in this space. It forces borrowers to think in a longer-term timeframe. This adds time to the process because we then need to collect additional approvals from stakeholders in relation to the stretch targets.

“In talking to other issuers, it is clear some are trying to use the lending outcome to generate their sustainability strategy. I have indicated it is a multiple-year piece of work to develop a sustainability strategy that works for a business, and the company has to make this commitment to sustainability, irrespective of its funding, as a first port of call.”

Block How does a board get comfortable? Obviously it would not want to commit to targets unless it is comfortable there is a strong runway to achieve them.

DOLTON We have used various measures to get comfortable with this in aggregate. Part of the risk-management process is sizing the deal. As this is our first sustainability-linked issue, we did A$300 million (US$218.7 million) in the five-year tranche. This is a small piece considering our aggregate debt, and starting small is partly how management and the board gets comfortable.

I expect it would be similar for other issuers. As they get more comfortable and familiar with the track record of achieving SLLs, issue sizes will go up. In the first instance, it is relatively easy for a board to get comfortable with a 3-4 basis points margin adjustment mechanism on a A$300 million piece of debt.

MCGUINNESS As a first-time issuer in the green space, we worked across the organisation – focusing, with the ESG team, across the SLL’s goals, objectives and the measurability components, and of course the stretch nature of the targets.

We found it has created new energy for our next-phase goals and objectives, and greater alignment with the business. A number of stakeholders saw the need for us not just to think about today but about where the strategy is going to be in 3-5 years’ time – and then what could be the next level of our stretch goals.

When it comes to risk, 90 per cent of the board’s focus in this transaction was on the goals and the outcome. It really scrutinised and worked with the parts of operational management that had accountability in the implementation and delivery, and really wanted to understand the downside risk.

The board did not come at the SLL from a financial perspective: it was looking at the reputational aspect, and what energy and effort was required to commit to the goals. Some of these have been turned into KPIs for key members of management. They know the targets are a stretch for the business but they want them to be achieved. And they do not just want to set what is in this SLL as the benchmark – they want it as a new baseline level to grow from in future.

WARD Before I say what I want to say here I should be clear that there is definitely a place for both sustainability-linked and UOP issuance. However, while UOP labelled bonds have their place it is SLB structures that really excite me as an investor – because they seem to have the ability to influence across an entire organisation. They are effectively converting people within businesses.

As debt investors, we are downside-risk managers. Every time we buy a bond we think about what could go wrong – what could destroy the value of that bond. If a borrower is improving the sustainability of its business across the entire organisation, which SLBs seem to be demonstrating the ability to do, and implementing this over a long period of time I think it is pretty positive for the placement of our portfolio.

KWEE I have the same response when borrowers talk about the influence of their SLL targets, measurability and the behaviour they will have to follow to achieve them.

We do not hold equity and traditionally do not have influence rights over corporate strategy, other than at the point of lending. The sustainability-linked structure has elongated the engagement and the influence of debt capital beyond traditional financing, and sets sustainability ambitions that contractually stay in place through future borrower leadership and strategic changes. This is very exciting.

MATHEWS We have had SLLs on our books for a couple of years now and I keep up to date with issuers to hear how sustainability commitments are progressing for them. The comments we are hearing today do not surprise me at all. I get the same affirmation from many borrowers: there is further investment in the team or in sustainability activities as a result of sustainability-linked transactions.

Approval needed to be sought at the top to enter this kind of financing, but this also means there is a constant check-in that really drives change through the organisation on an ongoing basis.

Coming back to the question of how a board gets comfortable, these decisions tend not to get made quickly. James Dolton mentioned 2019 as the time when he first flagged an SLL with his board, ahead of closing a transaction in 2021 – and this is pretty normal. I have spent a couple of years talking to several potential borrowers that are still looking to come to market. It takes time to get used to this new form of financing.

Part of it is that management want to understand what they will be committing to and whether they need to start making decisions now that might help them reach those commitments. With some companies, discussion with the board or management has led to them deciding to make extra investments in certain sustainable activities prior to finalising sustainable finance, because doing so gives them comfort they will be able to hit targets.

These are decisions that would not have been made if we had not been having the conversation. It is an extra expense that would otherwise have been discarded – a sustainability improvement that would not have been agreed to if it were not for the fact it is going to be connected to financing.

Kwee From our perspective, providing general corporate purposes lending to a borrower that can use proceeds within its business however it sees fit, but still has a sustainability agenda, provides greater flexibility. But, as we have heard, there is clearly a risk to committing to forward-looking ambitions and targets an issuer may not have a precise handle on how to achieve right now. Is this going to be an impediment for sustainability-linked issuance?

MCGUINNESS Having a sustainability strategy and sustainability embedded in the organisation is key. It has to be the starting point. When we started on the journey of examining an SLL as a refinancing option, about 12 months ago, the fact we had a strategy with targets in it – and this was board endorsed – gave us a starting point.

In talking to other issuers we have been in contact with subsequently, it is clear some are trying to use the lending outcome to generate their sustainability strategy. I have indicated it is a multiyear piece of work to develop a sustainability strategy that works for a business, and the company has to make this commitment to sustainability, irrespective of its funding, as a first port of call. We were fortunate that our investment started many years ago.

Money talks, but price is not the driver

Sustainability-linked structures put an explicit price incentive in place for borrowers to meet environmental, social and governance (ESG) targets – a change from use-of-proceeds structures, where the ‘greenium’ tends to be implied. Issuers still say differential pricing is not the primary motivating factor.

DAVISON Issuers are often at pains to point out pricing is not the main reason for bringing labelled debt to market – but why should it not be? If we believe that – in particular – climate risk is financial risk, why should borrowers not be rewarded for setting out and verifying their plans to deal with environmental risk?

CHEUNG It was a question we received from our board when formulating our ESG-debt framework and looking to issue a green bond. It has always been difficult to demonstrate or quantify greenium, but we pointed out there is increased diversification and demand.

There is also greater engagement from investors – and we have seen examples in the market where there has been greater investor stickiness, which also helps with secondary spreads.

All these factors in theory translate to better demand and should also mean better pricing. It is just not something we can pinpoint or quantify exactly. But we believe there can only be upside – and this is how we sold it to our board.

VIVEK PRABHU

In the short run the motivation to engage in sustainability frameworks is partly to do the right thing, partly reputational and partly having a social licence to operate – which comes with cost. But issuers may get a funding-cost benefit in the long run. It may even be necessary to attract capital.

VIVEK PRABHU PERPETUAL
BORROWER CHALLENGES

Rich The first Australian dollar corporate green bond priced in 2017, the first SLLs closed in 2019 and the first SLBs in 2021. But it is also true that – if we only consider labelled funding – the bulk of corporate debt is still not ESG-aligned. Notwithstanding the comments made about the process of getting the board and management on side, why is more debt not already being done in ESG format – particularly sustainability-linked, which can in theory be applied to any issuer regardless of the assets it owns?

MATHEWS As has been a theme of the discussion today, it remains a big step into the unknown. Connecting financing and sustainability is a challenge that requires more than words. Issuers need to have real actions standing behind these statements. I’m hopeful it will get easier, though.

The second thing that makes this market challenging is the lack of standardisation – particularly in sustainability-linked structures. There are many considerations about what the material sustainability issues for a company are and then whether its targets are ambitious, and there are different ways of measuring ambition.

We do not yet have any clear guidance on materiality or ambition; it is a judgement call. We can call on several methods to land on a decision. These include historical and peer performance, as well as science where possible.

But it is still a judgement call – and mine might be different from somebody else’s. All this makes sustainability-linked debt challenging. It is different in the green-bond market, which is now more mature and established. It has very clear scientific guidance on what is and is not green that we can all fall back on.

One of the ways we try to solve these issues in sustainability-linked debt is by involving third parties. Third parties can look at a transaction and agree the key performance indicators that are material to a business and that they are ambitious – and explain how they have made this determination. It is not just a bank or customer saying it, which means it is an important part of the structure.

“At the moment, we risk punishing good issuers – particularly in SLBs. If an ESG target is set across the entire business theoretically there is no fundamental reason for us buy an SLB over the issuer’s vanilla bonds that are trading cheaper – the issuer is behaving the same either way. We need to eliminate this arbitrage.”

Davison Is the effective requirement of third-party verification assurance a barrier to entry for borrowers? Issuers often report the process is exacting on them – so where is the balance between rigour and making barriers to entry too high?

MATHEWS It is a high hurdle and there is a lot of scrutiny. But I encourage issuers we work with to go down this path – to add credibility to their deals. I want to make sure every company we partner with comes out with a successful transaction that is embraced by the market and seen as driving real change. Part of ensuring this is the case is having an external review. It is not, in itself, a barrier – it is where we set the standard.

The Australian dollar market has a strong view on the need for verification compared with other global markets. Offshore, it is not as common to have an external review for sustainability-linked structures, and we saw this same preference play out for green bonds.

Davison Did SLL borrowers always assume they would engage third-party verification, and how challenging was the process?

MCGUINNESS The board’s view on the process, particularly in the context of the perception of greenwashing, was that it wanted to ensure there was independent validation to ensure integrity. It was very important from a risk-management perspective.

The Westpac Institutional Bank team put us through our paces before we sat down with the third party, so we were prepared for a lot of the questions we were asked. Independent validators want the transaction to go forward, but of course they have to preserve their reputations.

DOLTON I echo these comments. I did not see the third-party process as a barrier to entry. The additional assurance process is extra work, for sure – but we did not feel it was particularly burdensome.

As for why there is not more issuance, in my view it is down to lack of track record. Issuers have to earn the right to place larger sustainability-linked instruments. Having done one will hopefully give us permission with our stakeholders to upsize in a future transactions – and for it to be a lot easier the second time around.

“The reaction from corporate borrowers to the scrutiny of capital providers is shifting traditional business models quite rapidly. This is something we are very conscious of from a credit-fundamentals perspective: it means issuers are reacting to the increasing pace of ESG transition and debt holders face changes in earnings and asset profiles.”

WARD I would like to see a day where we do not have UOP or SLB issuance but where sustainability targets become covenants in vanilla bonds. At the moment, we risk punishing good issuers – particularly in SLBs. There is pricing arbitrage, in the sense that if an ESG target is set across the entire business theoretically there is no fundamental reason for us to buy an SLB over the issuer’s vanilla bonds that are trading cheaper – the issuer is behaving the same either way. We need to eliminate this arbitrage.

Getting back to third-party verification, particularly in the corporate space, I do not understand the offshore experience of accepting bonds without independent assurance. We would not touch a deal if it did not have a second-party opinion and covenanted reporting.

As analysts, we are very good at understanding industries, interrogating balance sheets and understanding capital structures. Some industries are changing rapidly at the moment and we are keeping up with this change. But some of the projects coming out of these structures are quite idiosyncratic or technical, for instance with an engineering or chemical element to them.

As bond investors, this is just not our area of expertise. This is why a second-party opinion gives us some comfort. It is quite interesting to hear Eliza Mathews and the issuers say it is not just a tick-the-box exercise – that they are put through their paces.

To investors reading this, I would say pick up the phone to the opinion providers – that is what issuers are paying for. They are happy to talk to investors.

YUAN It is also a question of access. Getting put through your paces by a verification provider and a transaction arranger saves an issuer from being put through its paces by 10 investors. It saves borrowers time as well.

LOVELL I am fortunate to be speaking from the extraordinarily luxurious position of being part of an organisation that has been able to analyse deals from a fundamental perspective, because very few of our transactions are the subject of second-party opinions.

However, ultimately if an investor is going to hang its shingle out and make claims to its end constituents or ESG-focused investors, it needs to have some basis for those claims. There has to be a certain entry level for doing the work and we see it as a critical matter for the sector to develop these capabilities. This said, second-party opinion providers can facilitate a functional market, much like the credit-rating agencies do.

CAPITAL EVOLUTION

Rich Picking up on the point about integration of sustainability into vanilla bond issuance – effectively making ESG part of normal terms and conditions rather than a market segment – is this a goal the market is progressing toward at the moment? If so, how long will this transition take and what are the challenges in executing it?

WARD It is a pipe dream at the moment – a lot of demand is going into labelled issuance. I do not have anything against these deals – we like to support transition. I would just like to get to a position where all the companies we invest in are on the same sustainability journey. I would love not to have to think about the sustainability credentials of specific deals. But we are a long way from this.

While we are seeing a massive uptick in interest in the sustainability of investment portfolios, some clients are coming at it only from an exclusionary-based starting point. This is something I hoped we would have moved on from by now so we can focus on transition stories and investing in sustainability solutions.

Rich How helpful would a comparable, rigorous ESG reporting regime be to the process of mainstreaming sustainability integration and transition?

KWEE It would help answer the question about longevity of the labelled bond market, once signalling on having a sustainability framework, linking capital and labelling debt becomes standardised.

There used to be a lack of supply of sustainable investment opportunities in Europe, but there are now signals from the pace of issuance we see there that sustainable finance is becoming the market norm. If anything, the greenium is beginning to dissipate.

When the greenium dissipates and ESG reporting is rigorous, the flow of capital will focus on other behaviours. At this point there would no longer be a need for labelled issuance. But it feels, from where we are today in Australia, that this is still a fair way off.

LOVELL The other point is that it is also a function of where we are at in the climate transition in this market. The reality is the very big gains in addressing climate change are going to come from transitioning away from high-emitting fossil fuels and moving into cleaner alternatives.. This has implications for how investors and capital need to signal transition, which changes the equation over time.

I too would love to see a world where we did not need certification. But the logical extension of this is that there would be no capital available for entities that are inconsistent with transition. This is still not the case at the moment.

There is a question about the reconciliation of the physical transition process with the method of allocation of capital, which is an influencing factor. Ultimately, some investors will want to invest not just to avoid downside but specifically to seek ESG outperformance.

“There are some companies for which transition is not going to be possible and it will be painful for investors that have equity in these companies. But there is no point pretending transition will be possible when it is not, or avoiding doing the hard work.”

Davison One of the challenges for sustainable finance has been that we are living in a world of excess liquidity, which means even the poorer ESG performers have not typically struggled to get funded – albeit businesses like thermal coal extraction increasingly have to look outside the mainstream bank and capital-market universe. Is either the liquidity environment or the availability of liquidity to ESG underperformers likely to change materially, and if so how quickly?

MATHEWS Access to liquidity is changing. Banks are making determinations about what they can and cannot finance. The market themes we are discussing will determine how quickly the change happens.

KWEE We have seen a change in the global political rhetoric about certain industries as well. Developed markets such as Scandinavia and Europe have been progressive, and Australia is moving in the same direction – as are the US and Asia. It feels like the net is tightening as the level of scrutiny on capital and finance increases.

LOVELL It is important to remember that what we are talking about is not a binary question of capital availability. It is always at the margin. We are already seeing the equity of large companies that are heavy emitters taking a hit. The market is sending a signal about the relative value it places on higher emitters.

Some debt issuers are already paying a higher premium every time they come to market because they are finding fewer investors. This will affect their cost-effectiveness in the reasonably near term.

BLOCK This is a really important point. We have been involved in a couple of transactions where the phenomenon of fewer investors and greater premium has played out. We are left wondering when the cost of debt will equal the cost of equity – because the day is coming. These companies will not necessarily disappear but the availability of external debt capital may well – or at least it will become a really scarce pool.

WARD There will always be investors that will buy something cheap regardless of its sector. The rating agencies starting to incorporate ESG considerations into their processes, particularly stranded-asset risk, will affect the pricing of bonds.

As fewer investors are willing to fund an issuer, its cost of debt goes up – and no-one wants to be the one holding the bond as its spread widens and it becomes a form of stranded asset. As the rating agencies start to incorporate this higher cost of funding, it will start to affect credit ratings. This is when we perhaps start to see it become more difficult for the issuer to get investors on board.

The road ahead

Five years ago, the Australian corporate bond market had no use-of-proceeds (UOP) green, social and sustainability bonds or loans. It had no sustainability-linked debt as recently as three years ago. Market users do not expect the pace of development to slacken in the years to come.

DAVISON Where do panellists think the sustainable debt market will be in 3-5 years’ time?

KWEE We are just starting to see the mainstreaming of UOP bonds and SLBs [sustainability-linked bonds]. The fact the market is open and is being well received by investors means other borrowers – those that still need to develop sustainability frameworks, and set goals and ambitions – will begin to participate.

We think this is the beginning, even though we have already started talking about the end state of the market. It is an area that still needs to grow and become mainstream. As the market becomes more accustomed to sustainable finance we can think about whether tradable environmental credits become part of debt structures and accepted in investor portfolios and mandates.

PETER BLOCK

SLBs, if they are properly structured, have the ability to change behaviour. This is the way I would like to see things go – a DNA change within companies that allows them the biggest pool of funds, hence allowing the best pricing. Companies that do this will survive best in future.

PETER BLOCK WESTPAC INSTITUTIONAL BANK