Complex ESG Debt Products Prove Too Risky for Some Investors

Scandinavia’s biggest arranger of sustainable debt says investors will probably continue to favor green bonds over other more complex ESG fixed-income products for years to come.

E. Derry Hubbard, global head of debt capital markets for Danske Bank A/S, says investors generally prefer products that explicitly finance sustainable projects, which green bonds do. Sustainability-linked bonds, or SLBs, are growing fast as a debt class, but are still perceived as less transparent and therefore riskier, he said.

Ultimately, the goals that SLB issuers commit to are “not as defined as-use-of proceeds,” which is a feature of green bonds but not of sustainability-linked debt, Hubbard said. “That type of simplicity is still appreciated by investors,” he said.

Danske helped sell more green bonds this year than any other Nordic bank, and is among the top 10 arrangers in the world, according to data compiled by Bloomberg. Meanwhile the Nordic region, where Danske is based, is ahead of the rest of the world in its embrace of sustainable debt, with a much larger portion of total bonds sold going toward green goals than in the rest of western Europe or the U.S.

Investor demand for financial instruments that target environmental, social and governance targets is reshaping capital markets. That’s as financing plays a key role in helping Europe meet the goals enshrined in the Paris climate agreement. Under new European rules, asset managers and companies need to start disclosing greenhouse gas emissions, in an effort to name-and-shame climate sinners, and reward climate saviors.

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SLB issuance has grown exponentially since the product arrived on the market just a few years ago. In the first five months of 2021 alone, sales are up more than 7,000%. But SLBs still have a long way to go before they catch up and in May, their issuance was just one quarter that of green bonds.

“You will see more use-of-proceeds framework bonds in the near term than SLBs,” Hubbard said. “The SLB thing will grow, but it will continue to be a slightly more niche product than ESG framework bonds for the next three to five years.”

The new regulatory environment has led to a proliferation of green bonds. But research by the Bank for International Settlements last year found that companies issuing green bonds didn’t necessarily improve their overall carbon footprint. That’s because a company can issue a green bond tied to a specific project in one corner of its organization, and continue to pollute in another.

Sustainability-linked bonds emerged as an alternative, since they require businesses to meet goals that go beyond a single project, or face higher financing costs. But an investor doesn’t have the same assurance that proceeds will only go toward climate-friendly operations.

Meanwhile, issuer ESG data remains incomplete, meaning investors have limited information to go on when deciding where their cash might do the most good. European authorities are now revising the Non-Financial Reporting Directive after finding big holes in the information investors need in order to decide where to invest.

Uncertainty around which ESG assets to invest in comes as the wider market faces a “bumpier” road in the months ahead, according to Hubbard. He says it would be wrong to assume the steady pace of issuance this year will continue, amid the “tug of war” between inflation and loose monetary policy.

“Given the extremity of this imbalance that we’re all seeing right now, I don’t think anyone can take anything for granted,” he said. “At one point, one side of this has to give and it’s anyone’s guess how this will pan out.”

©2021 Bloomberg L.P.

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