Evolution, exclusion & the outlook for green finance
The pace of change in the green, social and sustainability (GSS) bonds market has been rapid and this new is only just getting started. Where is the market heading in the future?
In a roundtable hosted by ANZ and KangaNews, 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.
In this, the second part of a two-part discussion, we began by asking what the market could look like over the next three to five years – and what role transition bonds could play in that change.
BLÁTHNAID BYRNE: In three to five years Europe will be at the tipping point that Gavin 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.
GRAHAM MCNAMARA: It is a challenge in Australia. The bond market here is fickle at best. For many years people have talked about a vanilla corporate bond market but it has never really developed other than for a handful of top-tier corporates.
I’m not sure whether there are enough investors locally that are willing to support the development of a broader bond market, including investing in transition bonds.
Australia has a bank-dominated debt capital market and the banks can drive the transition to a sustainability-linked loan (SLL)-type format.
If banks were to receive beneficial capital treatment for participating in SLLs, it would drive the price lower. This would likely make them less attractive for other, nonbank, investors.
BB: If Australian companies are able to issue transition bonds overseas it would be a source of differentiation and a competitive advantage for those markets.
Australian investors would be at a disadvantage.
HC: Can SLLs go some way to reversing the problem of exclusion by broadening the scope of sustainability investing?
GAVIN CHAPPELL: SLLs demonstrate and promote companies that are engaging in active transition processes. This can only be positive. The Loan Market Association and Asia-Pacific Loan Market Association have come out with strict guidelines on what is required, and the first point is that the company must have a strong ESG strategy.
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.
Around the table
Bláthnaid Byrne, Group Treasurer, AGL Energy
Gavin Chappell, Head of Loan Syndications, Australia ANZ
Nigel Greenwood, Chief Financial Officer, Synlait
Laura Innes, Treasury Manager, Liquidity and Funding, Coles
Graham McNamara, Managing Partner, Metrics Credit Partners
Michael Momdjian, Group Treasurer, Sydney Airport
Katharine Tapley, Head of Sustainable Finance, ANZ
Christina Tonkin, Managing Director, Loans & Specialised Finance, ANZ
Marayka Ward, Senior Credit Manager and ESG Champion, QIC
Helen Craig, Head of Operations, KangaNews
Matt Zaunmayr, Senior Staff Writer, KangaNews
KATHARINE TAPLEY: This is a very important development because it is a way that banks can steward change. Equity investors have been doing this for a long time. Meanwhile, banks have been heavily invested in the specific use-of-proceeds piece.
This is great and will continue to have a place and serve a purpose in catalysing investment. But SLLs offer a way that banks can actively participate with their customers, through their balance sheets, in making change happen.
NIGEL GREENWOOD: It is a fantastic initiative from the banks. They are offering incentivised pricing based on improved risk weighting. This means they are giving away funding cost, even though at this point there is no benefit for them in their capital-adequacy requirements. Right now, it is actually costing them money.
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.
CT: ANZ is a relationship bank. We have an established set of customers with which we have detailed account-planning sessions to work through issues.
Increasingly, the focus around ESG in businesses is becoming essential to these account plans. It is not a tick-the-box compliance exercise, it is central to the strategy of ANZ.
Our head of environmental sustainability sits within group strategy so the role is core to strategic direction.
Like Marayka, 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.
BB: I think the onus is also on borrowers to help the banks help them. We should recognise that banks have their own internal mandates and challenges, in some cases, to justify why they continue to support a borrower.
It is on the borrower to show what steps it is taking towards transitioning or ‘greening’ itself so the bank can make the case internally.
MATT ZAUNMAYR: Does a margin step up or down, based on sustainability performance, mitigate any pricing disadvantage for lenders?
GC: I take a long-term view on the way this market is developing. A key reason the bank is potentially providing this discount is because we want to work with borrowers on improving their sustainability risk and performance.
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.
MICHAEL MOMDJIAN: I agree. In addition, the acknowledgement and possibility of ESG transition will ensure ‘browner’ companies will still have adequate access to capital at a reasonable price over the long term.
KT: On the Synlait transaction in New Zealand, I was asked about the risk of ANZ taking a hit on its pricing. My response was that we do not see this as a risk.
We view it as the right outcome because we want Synlait to continue pushing the boundaries on what is already a strong sustainability agenda.
This is good for farmers, good for consumers and good for the community. It is a much bigger picture than the immediate transaction.
MW: Hopefully, sustainability performance improves borrowers’ profitability and therefore gives them – and us – more of a ratings cushion. If a borrower gets an upgrade it will be better positioned in our portfolio.
KT: We are talking about mainstreaming sustainability. The concept of SLLs will go a long way to pushing this right to the fore. We will also see this in the bond market.
MZ: 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?
BB: It depends how prepared you are and how much you are already doing. It should not be any more onerous to provide reporting on metrics if you have a robust sustainability reporting regime in place.
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.
MM: The fact we have a standalone sustainability function and publish a highly comprehensive sustainability report annually made it much easier to establish our SLL and agree associated targets.
Furthermore, engaging Sustainalytics as an independent third party somewhat outsources assessment and allows us to focus on delivering sustainability-performance improving initiatives over administering our loan.
KT: We receive a lot of investor interest in how we demonstrate the impact of our bond programs in particular. This is a hot topic and is a particular stream within the Australian Sustainable Finance Initiative (ASFI).
MW: We have had MSCI ESG scores in our portfolio for a while now. We have added onto this, though. We calculate carbon emissions across all our portfolios down to the security level. With insurance clients, this is a very real risk they need to consider.
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.
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.
GRAHAM MCNAMARA: We are not quite at this level yet – we currently do not do any ESG scoring. We do provide detailed asset reporting to our investors, though.
At this stage we only lend to Australian borrowers, which I think is easier than having to look at the operations of offshore borrowers from an ESG monitoring perspective.
In the last two to three 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.
MW: Sometimes it appears still to be a box-ticking exercise. But even this is a good starting point and we expect quick progress.
Frontier Asset Consultants recently released research, based on a century of climate modelling for superannuation funds, which concludes that climate risk could decrease returns by 25 basis points per year. When the market starts to quantify impact in this way it can also start to target transition in a much better way.
MZ: Do we need a single framework for determining and measuring sustainability goals and outcomes that borrowers and investors are comfortable with?
CT: ASFI has effectively brought together a coalition of the willing across the banking, insurance and investor community as well as notable not-for-profit and industry groups. It is very valuable to have all the key players in the market to provide a common direction.
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.
KT: I think we need to be very careful with definition. There has been very good work going on in the EU and in Canada, but we need an Australian harmonisation of a broad concept of sustainability.
What is sustainable and green in Australia is not necessarily green in a place like Germany, for example.
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.
MM: It is important frameworks serve to guide issuers and set a standard acceptable to lenders. The proliferation of taxonomies and reporting regimes – in addition to any introduction of overly prescriptive frameworks – will likely stifle further growth in sustainable finance, especially among issuers trying to identify a practical way in which they can get involved.
While frameworks and associated harmonisation are welcome, it is important to acknowledge sustainability is different from company to company and region to region.
HC: How useful is the EU taxonomy in Australia?
KT: It is very useful but needs to be made to work in an Australian context. We have to look at our economic context including the resources that make our wealth.
We also need to be aware of the legal and regulatory context we are operating in. We need to understand the whole landscape and figure out what will work best here to enable the transition and mobilisation of capital.
MZ: Would sector-specific frameworks be helpful?
LAURA INNES: I think it would be helpful to have consistency between peers and to have industries working towards common goals. Companies can take different approaches but they should also be comparable by investors.
MM: Sector-specific frameworks may indeed be helpful for issuers and even lenders in encouraging some degree of consistency. But flexibility is key and anything that restricts target setting is counterproductive.
KT: I think it is important, though, for businesses to have sustainability goals that are relevant to their strategies. There needs to be alignment.
For AGL, this would be around carbon emissions reduction and changing the power mix whereas for Coles it is about the supply chain and waste.
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.
LI: I agree that the goals need to be meaningful for the individual business. The focus needs to be on things a business can actually achieve.
If you are being graded on something that is not important to you there is no motivation, whereas if you can display a plan to achieve something that is key to the business strategy there will be much greater support.
BB: For this exact reason, we decided not to link it to a Sustainalytics rating when we looked at doing our SLL. This is a generic rating across ‘E’, ‘S’ and ‘G’ and it ends up producing a diluted impact.
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.
MM: Our SLL incorporated an ESG risk rating despite us having several flagship initiatives, including achieving carbon neutrality by 2025.
The choice of a holistic performance measure opens us up to delivering a diverse range of meaningful sustainability performance improvements, over and above a few predetermined initiatives, across the entire ESG spectrum.
CT: It is about achieving individuality within a common purpose. Every company is different and there needs to be adaptability and flexibility. But the industries and the country in a broader sense need a more focused pathway.
MW: As an investor we like the Task Force on Climate-related Financial Disclosures (TCFD) and we report according to it.
However, we are agnostic on what framework a company chooses to report under, as long as it is producing transparency and data.
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.
BB: It is important for investors not to be too prescriptive because it can be quite onerous for a company to report under five or six different regimes.
For us, TCFD was actually quite welcome because a number of investors in our group look at it. It provides a common denominator.
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.
MW: We have found that ESG ratings do not really tell us much. We still need to go into the detail behind the report and understand what the company is doing, often via direct engagement. No single reporting framework is going to get around this.
GM: Generally what investors want to see is progress against a measure, rather than against a standard target that everyone has. Which measure is used does not matter that much, and obviously one-size-fits-all does not work.
We want to see what is being measured, how it is being measured and what progress is being made.
BB: It is the same when we look at our banking group. We look at our lenders through the same lens of their ESG policies. It is not so much about whether they are compliant or align with our policies, it is more about the deltas and how they have changed over the years.
We will then have a conversation with those that are not changing about why, because there will be alarm bells.
KT: We do similar qualitative exercises when it comes to deciding what transactions we might partner on. We have strong client selection processes around what we do in sustainable finance. Equally we take a very close look at who we are arranging transactions with.
BB: Integrity and authenticity are very important. The feedback we had on our SLL was that authenticity was there due to the fact it is more difficult for AGL to get a margin benefit than to receive a penalty. Lenders had not seen the stick bigger than the carrot before and were quite surprised by our willingness around this.
KT: AGL’s stick went even further than pricing, to incorporate terms as well. This is where I think we need to direct the market, not just in SLLs but also in the green-loan product.
HC: If SLLs are the next step in the evolution of the market, how widespread is the potential application?
GC: Capacity for SLLs is huge: effectively the whole market could comfortably move towards using SLLs if business objectives were appropriate for the product.
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
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.
CT: We are not quite there yet, but I am looking forward to the day when I can change the name of the division from loans and specialised finance to sustainable and conservation finance, with all the categories falling underneath it, to be really focused on a common goal.
You can read part one of the discussion HERE on ANZ Institutional
This story is an edited version of a panel discussion which originally appeared in KangaNews
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