More recently, the sector has started to encounter resistance in various areas. Scaling up the adoption of sustainable finance in the debt market means broadening its usage to entities beyond the most obvious contenders. This is perhaps best described as the evolution from using sustainable debt to finance a wind farm to using sustainable debt to finance an energy company’s transition from fossil fuel generation to renewables.

Greater scope and visibility has brought with it enhanced regulatory scrutiny and, as a further consequence, a degree of fear on the part of investors about being accused of inflating or misrepresenting sustainability credentials. This has prompted investors to adopt exclusion policies, which limit capital flows to the companies that arguably have the largest transition funding needs.

At the same time, market participants continue to wrestle with some of the most fundamental questions in sustainable finance and transition – perhaps most prominent among them being: who pays? Sustainable debt has yet to consistently deliver either a cost of funds incentive for issuers in the primary market or the level of incremental demand, liquidity and investor diversity that were among its early selling points. Nevertheless, there are examples where current secondary bond pricing suggests investors are willing to pay a premium for deals with solid environmental, social and governance (ESG) credentials.

In the bond market, the reality of this challenging period in market evolution is that the range of issuers regularly funding via use-of-proceeds green, social and sustainability (GSS) bonds has been fairly consistent. Meanwhile, attempts to deliver a product suitable for transition finance – sustainability-linked instruments – have had more lasting success in the loan space than in the debt capital market.

None of this needs to mean long-term problems for the sector. It is inevitable that there would be growing pains in such a broad and consequential new market, on which so much importance has been placed.

The general tone of market participants has changed from being generally welcoming of best-efforts attempts to introduce new products and borrowers to much tighter oversight of genuine impact and materiality. This is not to suggest that earlier efforts were definitively lacking in some respect, just that expectations of quantifiability have gradually increased over time and baseline standards have risen.

The bottom line is that every market participant wants the sustainable debt sector to succeed but it can only do so with rigour and demonstrable value. This is especially true in an environment of heightened focus on greenwashing – although there is mixed information on exactly how significant investors’ fear factor really is (see box).

The fundamental purpose and value of sustainable finance is still very much in place. Underlying all the recent developments is the ongoing need for capital to support the transition to a low emissions economy. This means borrowers are able to maintain focus on the big picture rather than short-term wins.

“We are observing a shift in issuer objectives toward prioritising access to capital, volume and diversification,” says Jo Lyn Tan, executive director, ESG DCM at Commonwealth Bank of Australia (CBA) in Sydney. “This is likely because we are going through a huge step-change in the capex requirement to fund transition plans – as well as, perhaps, a recognition that investors are reluctant to offer a greenium and hence sacrifice returns. This change in approach makes me confident there is still a significant role for labelled bonds especially over the next five or so years through to 2030.”

The 2024 CBA-KangaNews survey attracted responses from more than 40 Australian fixed-income investors, with the biggest weighting in the institutional funds management sector but representation from across the real-money space (see chart 1).

The survey response comes from a largely mainstream investor universe, with three-quarters of survey respondents saying they have no funds under management in dedicated ESG or impact investment mandates (see chart 2).

This could be due the lack of a framework for ESG labelled funds in Australia – unlike in Europe, where there are guidelines for Article 6, 8 and 9 funds.

Australia’s Commonwealth Treasury sustainability strategy outlines that Treasury intends to develop a sustainable investment labelling regime to provide better information for investors and regulators to support the Australian Securities and Investments Commission’s ability to address greenwashing. This development is expected to begin in early 2025 with 2027 the target for implementation, subject to final policy decisions.

Speaking at a roundtable discussion arranged by CBA and KangaNews to discuss the survey results, CBA’s Sydney-based head of ESG DCM origination, Lauren Holtsbaum, added: “A fund labelling framework could mean more investors establishing ESG labelled funds over time as there will be specific criteria outlining the requirements.”

Investors continue to believe demand from their clients will drive uptake of green, social and sustainability (GSS) bonds and sustainability-linked bonds (SLBs) over the coming years (see chart 3). However, there are clear signs that Australian investors are less convinced than they used to be that labelled bond supply will grow significantly.

Just 5 per cent of survey respondents expect GSS and SLB issuance to be significantly higher in 12 months’ time and only 15 per cent anticipate significant growth in the next three years – down from 12 per cent and 32 per cent in the 2023 survey. The three-year projection is down from a record high of 44 per cent as recently as 2022 (see charts 4 and 5).

At the CBA and KangaNews roundtable discussion in Sydney in September, a group of investors that took part in the survey was offered an opportunity to add colour to the results. Asset managers suggested sustainability credentials in the debt market are no slam dunk with their clients.

Ben Squire, Sydney-based executive director and head of credit research, Asia Pacific at UBS Asset Management, said: “Anecdotally, when I talk to friends about investing, as soon as I say ESG and mention that the returns may not be as good, they express concern. This is even if we are talking about a few basis points. It surprises me that there is this response, even if it is a small amount of return sacrificed in the context of a whole investment portfolio.”

The suggestion that end investors are sharpening their pencils on sustainability appears to be widely supported. In fact, Lucie Bishop, Sydney-based portfolio manager at Revolution Asset Management, noted at the roundtable that while Revolution and many other institutional investors in Australia no longer invest in coal, some asset managers continue to be open to exposures to coal for the time being at least – on the basis that it cannot be phased out of the world economy in the near term and in the interim continues to require finance.

“This is actually particularly noticeable in fixed income and credit,” Bishop added. “Loans are typically relatively short tenor, and some investors have decided it’s worth taking the risk that we come up with a solution to partly replace coal in, say, 2030. This is because they are picking up an extra 200-300 basis points today for lending that will have matured by then – during which time substantial reliance on coal will likely continue.”

This may go some way to explaining why survey respondents report a steady decline in the use of positive screening – mandated requirements only to buy high ESG performers or in positive impact sectors. In 2024, just 28 per cent of surveyed asset managers say they use positive screening techniques, down from a peak of 52 per cent in 2020 (see chart 6). Negative screening – excluding certain credits and sectors – remains the most widely-used ESG approach in Australian fixed-income investing.

On the other hand, it may be that the reduction in use of positive screening is not the product of reduced engagement but instead reflects a growing awareness about the importance of transition finance. In other words, that providing capital to entities to improve their performance may have more positive impact than simply divesting from ‘brown’ allocations.

“There has been some degree of pivot to helping with the transition as opposed to exclusion,” Squire revealed. “This means assisting the ‘dirty’ companies that have a strong commitment and a clear pathway. The advantages here are that investors are not just pushing the problem onto someone else, and there is also still potential to find a pathway toward net zero without having to give up returns.”

The need to not give up returns by taking a sustainable investment approach has fed through to an Australian market for GSS bonds where there is only a minimal observable greenium for issuers. The CBA-KangaNews survey suggests that, if anything, the buy side is moving further away from any expectation that issuers should be rewarded with preferential pricing for offering labelled securities.

A total of 54 per cent of investors say they are not prepared to pay any premium for use-of-proceeds (UOP) GSS bonds relative to vanilla transactions from the same issuer, while 43 per cent would contemplate offering a premium of 1-5 basis points (see chart 7).

There are also only limited expectations that issuers will be able to extract a greater greenium for labelled issuance over time. In the 2024 survey, no investors anticipate a significantly greater greenium becoming available in the next 2-3 years and only 26 per cent anticipate a marginal one (see chart 8).

Squire explained: “From a fundamental perspective, I don’t think there is any reason why there should be a greenium. It is the same credit risk, after all. Any pricing differential is more likely driven by technical factors, in the sense that green investors can only invest in green bonds – so there is obviously more demand.”

Identifying a greenium is not straightforward, either. Holtsbaum added: “Greeniums can vary from primary to secondary markets, from sector to sector or even within the same sector. They can also vary over time. They are often not transparent as there may be limited vanilla comparables and transaction pricing can be affected by other factors, such as competing supply and market conditions.”

Market dynamics, especially a very positive new-issuance environment, have also likely played a role in supressing overall GSS issuance and any pricing differential. “ESG issuance by corporates should increase when market conditions become less favourable,” argued Gus Medeiros, head of credit strategy at CBA in Sydney. “Issuance by companies with strong ESG programmes or credentials should be a differentiating factor when investors become more selective.”

Tan added: “Offshore, we have seen some evidence of labelled transactions proving to be more resilient when market conditions are challenging, achieving stronger book covers and tighter pricing outcomes.”

Elsewhere in the realm of labelled fixed-income product, investors do not appear to have given up on SLBs. At present, the product provides a perfect example of the type of challenge the sustainable debt market is confronting in late 2024: initially highly touted as a means of martialling capital to support transition, SLB issuance has slumped as questions have grown about the product’s efficacy and the true level of issuers’ ambition.

However, 72 per cent of investors surveyed in 2024 still believe the SLB has a role to play (see chart 9). While the majority of those believe this to be a “marginal” role, only 10 per cent say they once believed SLBs had a role to play but no longer do so.

Marayka Ward, director, fixed income strategy at QIC in Brisbane, commented: “I’ve always viewed the SLB as the product with the most potential for positive impact on portfolio decarbonisation so I have been very disappointed to see it more or less disappear. I think the problem was that investors were expecting more ambitious targets than issuers could commit to. But this is not a local phenomenon – growth in the SLB market offshore has not been strong, either.”

Squire acknowledged that there “are clearly some flaws in the SLB structure as it has been used to date” – for instance with coupons, step-ups and test dates. But he is hopeful that a solution can be found. For instance, he suggested that some sort of enforcement on missed emissions targets beyond a small coupon step-up – for instance buying a carbon credit – might produce better alignment with what the product and the market are trying to achieve.

Taking a step back from debt products, investors continue to believe that too few issuers – outside the government sector – have suitable transition plans in place. No surveyed investors believe all Australian credit issuers have such plans and just 5 per cent say most do (see chart 10). Even the proportion of investors that say they do not know how many issuers have plans in place – 41 per cent – speaks to a market where flow of information is still imperfect.

“We have come a long way when it comes to assessing ESG performance but there is still too much inconsistency in the data, and we don’t have the same kind of frameworks and information as we do in financial metrics,” Tan suggested. “It is still hard, overall, to pinpoint the ESG component of credit risk and how to price it in.” However, investors at the roundtable suggested the situation is improving and is likely to improve further in the near future – specifically, when Australia’s mandatory climate risk reporting regime comes into effect, starting next year.

“There has been an increase in provision of quantitative data rather than just qualitative stories,” Ward insisted. “The latter are nice, but our clients are asking us to report data points through to them. The situation has improved, as it has in the case of reporting frameworks. Leaders on the issuer side are providing their peers with really good guide posts on what quantitative data investors are seeking.”

Further evolution is expected. Ward continued: “Better information will come in time and it will be helped by the environmental component of climate risk regulation. It will be interesting to see how the market evolves when everyone has access to the same, better-quality data.”

Charles Davis, managing director, sustainable finance at CBA in Sydney, agrees that mandatory reporting should be beneficial for the ongoing evolution of the sustainable finance market.

“Largely, I view reporting as a positive as it will increase transparency, facilitating benchmarking and the development of metrics by providing baseline data,” he commented. “There is going to be some pain in implementation given the significant uplift required in a relatively short space of time. But, by and large, once this has been dealt with it should be a positive addition.”

Better reporting should facilitate wider and deeper analysis. For instance, Davis said there is already increased focus on value chain analysis. This means investors wanting to go beyond exclusions in sectors like resources – most commonly coal – and extend their analysis to other associated areas such as transportation of these commodities.

Ward also noted the growth of revenue-based screening requirements – for instance, screening out credits that derive a certain percentage of their revenue from coal. “Exclusions are growing, and they are becoming further reaching than just a sector basis within the global industry classification,” she said.

One explanation of recent developments in sustainable debt – including the emerging challenges – may be that the market is attempting to deliver a genuinely complex solution: the genuine, accurate pricing in of a range of risks that were historically ignored. This is the much discussed idea of valuing issuers’ ESG performance beyond what they may or may not bring to market in the form of labelled debt. Nearly half the investors surveyed in 2024 believe poor ESG performers are already paying a premium for their capital (see chart 11).

Squire said: “Looking back perhaps 3-5 years, it really didn’t feel that the market was differentiating at all on the basis of ESG profiles. This has changed, and it is certainly a holistic focus on ESG that is most important. Companies are being penalised for poor ESG performance, and this is much more effective as a motivator than a few basis points of greenium for issuing a green bond.”

To some extent, the idea that measurement of ESG performance should take place at issuer level rather than being focused on securities – labelled or otherwise – is not a new development in the debt market.

For instance, Pauline Chrystal, portfolio and ESG manager at Kapstream Capital in Sydney, said at the roundtable: “Our approach has always been to integrate as opposed to just looking at bond labels. Just because there is a label on the bond doesn’t mean the issuer’s whole strategy makes sense. A power generator could issue a green bond to build a wind farm, for example, but if 80 per cent of its capacity is still coal-fired and it doesn’t have a strategy to transition this component, the green portion doesn’t really help.”

At the same time, Tan argued that even if investors further sharpen their focus on whole-of-issuer performance and strategy, this does not necessarily preclude a valuable role being played by labelled securities in future. This is because securities can provide a useful medium for delivery of data and impact reporting. “Even for an issuer that has great ESG credentials and a robust transition plan, it is difficult for debt investors to assess the execution and implementation of the plan if it only issues vanilla bonds,” she suggested. “One key benefit of labelled issuance is that there is accountability and assurance on the actual allocation of proceeds toward specific projects.”

Medeiros added: “A holistic, issuer-level view on ESG should suit some issuers, especially those with strong transition prospects. But labelled UOP deals should continue to suit other issuers. The former may lead to less labelled issuance but the development of a transition bond market would be a very positive outcome for the market and emission reduction efforts.”