Review of the Year 2018 and Outlook 2019

These are unnerving times for all involved in global capital markets. We haven’t quite gone to the financial equivalent of Def Con 1, but as 2018 draws to a close, the warning signals are flashing red.

Some — Brexit, an unpredictable and volatile US president, slower growth expectations reflected in an increasingly flat yield curve, the end of quantitative easing in Europe, Italy’s arguments with the European Union over its budget — are beyond the control of issuers, bankers and investors.

Others are market-specific concerns, in particular fears over when exactly the credit cycle will finally end, real estate bubbles and a white-hot leveraged finance market that has been driven, in part, by energetic CLO issuance.

Anyone who was working in the markets 10 years ago when the global financial crisis struck could be forgiven for a sudden attack of déjà vu. It is tempting to think little has changed since 2008.

But look a little closer and capital markets are very different. Banks are much better capitalised (even though there is no still universal standard of what capital should consist of); there is a lot more non-bank finance, giving companies more choice and flexibility; regulators are more practised at coping with critical moments and have more oversight of banking systems; large swathes of the derivative markets have been moved to a centrally cleared model and even Libor is being replaced (although again, there is a lack of standard).

But there is another way markets have changed. When capital markets people get together nowadays, talk is no longer just about coupons, yield curves and cocktails. You are as likely to hear about the Sustainable Development Goals or gender lens investing.

The attention being paid to sustainability in capital markets would astonish someone who had time-travelled out of the Lehman Brothers office in Canary Wharf on September 15, 2008 and into the Euromoney Global Borrowers’ and Investors’ Forum in Mayfair on June 26, 2018.

Some talk of a new type of finance emerging — purposeful finance or inclusive capitalism. Ten years ago, such phrases might have been scoffed at. Now, they are taken seriously.

“The modern funding model can be characterised as finance with purpose,” says Phil Jenkins, chief executive of Centrus, a corporate finance advisory business in the UK that focuses on what it calls essential service industries. “This it illustrated by pension funds and insurance companies generating stable and reliable returns by directly financing renewable energy, transport, power and water infrastructure or new affordable housing.”

One of those insurance companies is Legal & General. Its chief executive, Nigel Wilson, is a keen advocate of this new type of finance, having this year pushed the concept of inclusive capitalism through various media channels.

“Environmental, social and governance interventions by investors are here to stay. Diversity, solar and wind power are happening, as is decarbonisation and a reduction in plastic consumption,” he wrote in an article in September. “Inclusive capitalism works as a way to finance economic growth in cities governed by people of all political colours... Manchester, Newcastle, Cardiff and other UK cities, and the same is true in Austin, Denver and Seattle.”

Planting seeds

For many in the primary capital markets, this new age has its roots in the years just before and during the global financial crisis.

The International Finance Facility for Immunisation’s $1bn five year bond in November 2006, the European Investment Bank’s first Climate Awareness Bond in 2007 and the World Bank’s first green bond in November 2008 were the pioneering deals that launched this new era for the global bond new issue markets. Ten years on, these deals have generated the $500bn+ labelled bond market.

On November 16 this year, the 10th anniversary of its first green bond, the World Bank hosted an event, From Evolution to Revolution: 10 Years of Green Bonds, at the George Washington University.

Participants included representatives of the firms that worked on the original deal, such as lead manager SEB, syndicate bank Credit Suisse, investor AP2 and second opinion provider Cicero.

A theme of the event was how much capital markets have changed over the last 10 years, from a market where investors knew — and cared — little about what their investments were supporting, to one where purpose matters.

Green bonds have played a key role, according to Heike Reichelt, head of investor relations and new product development at the World Bank and one of the architects of the original deal. “Green bonds have sparked a revolution in thinking about sustainability, purpose and potential for liquid bond investments to achieve a positive impact. Investors understand their power to support initiatives their stakeholders care about, and that they do not have to give up returns to do so. Investors also increasingly see the links between environmental, social and governance factors and risk and opportunities in their investments. An issuer with good sustainability practices will generally be a better investment. Importantly, investors want data that shows how their investment is creating social value — and issuers are responding. They are engaging with investors to show how their bonds present opportunities to achieve both financial and social returns.”

Market flourishes

From $349m issued in 2008, issuance of green bonds has swelled and is expected to hit $150bn this year.

Would these volumes have been achieved without the World Bank’s inaugural deal? IFFiM and the EIB had proved the socially responsible investment drums were already beginning to beat in primary bond markets in the two years leading up to the green bond. Consciousness of climate change and its political and economic impacts was growing, given extra clarity by the Intergovernmental Panel for Climate Change’s report in 2007.

“To some extent I think there would have been a development towards a sustainable bond market anyway,” says Ole Petter Langeland, head of macro, exposure, fixed income, FX and trading at AP2, and one of the investors on the deal 10 years ago. “The trend in the financial markets towards sustainable investing is of course not isolated to the fixed income market but plays a role in most asset classes. The growing awareness of the issue of sustainability and sustainable investments is more a reflection of the development in the overall society. The financial sector is good in generating investment vehicles where they see opportunities. Green and other purposeful finance bonds are perhaps the cleanest way to express that as a fixed income investor.

“That said, I do not think we would have come as far as we have if the market had not started with issuers like the World Bank. I still think the growing focus and attention that green bonds draw to sustainable investing is one of their greatest achievements.”

Christopher Flensborg,head of climate and sustainable financial solutions at SEB in Stockholm, who put the Swedish investors together with the World Bank 10 years ago, agrees. “The time the World Bank invested in interacting with investors to allow them to understand the value proposition and how to integrate the investments has provided the platform for most of the early movers inside mainstream investment,” he says. “It is unlikely that we would have found the way without their clear leadership. However, initiatives like the Principles for Responsible Investment [the UN-supported network of investors founded in 2005 to help develop a more sustainable global financial system] have been very important as well.”

The correct answer to who or what was responsible for the establishment and development of the sustainable bond market is therefore that, in all likelihood, it was lots of different people and lots of different influences — although the World Bank’s deal caught the zeitgeist and helped advance the cause.

“One should not forget that this also was driven by investors like ourselves, that wanted to deploy capital directed towards sustainability but needed an issuer that we were confident could deliver,” Langeland says. “One of the big advantages the World Bank has is their size and the broad array of projects in their books that enables them to be a regular issuer in the market, utilising different currencies and maturities that meet the demand of investors.”

A different definition

But beyond the who and what is the why — in particular why so many people have worked so hard and passionately to promote this market when almost everything it has financed could just as easily (and cheaply) have been financed by the same organisations with other, unlabelled, debt. It is a question that does not sit easily with many people because it touches on a raw nerve — additionality.

It is easy to understand why so many people are so devoted to the sector: they see issuing, arranging or investing in green or social bonds as helping to make the economy sustainable. Green bonds are a very public signal that money is being deployed in a green way. “To provide tangible, quantifiable additionality you need people to act,” says Flensborg. “The green bond market provides the basis for acting. We are currently seeing the early results of this activation with new strategies and products being launched.”

But as optimistic as Flensborg is, is the sustainable bond movement really creating the extra financial resources needed to make a real difference to, for example, climate change? Is it financing projects or results that would have not been achieved otherwise? In most cases, the answer is a simple no.

But, like Flensborg, proponents of the market have faith in the product, and believe it will become such a big and powerful asset class that investors will eventually seek out bonds from riskier issuers that might not otherwise have been able to fund in the bond market. Or that green bonds will receive subsidies to the benefit of green investment, thereby creating additionality. But this destiny still lies in the future.

In the meantime, participants are keen to promote and celebrate a different definition of additionality: awareness. While little has been financed by labelled bonds that would not otherwise have been with unlabelled bonds, proponents are quick to point out the product’s mobilising effect in getting institutions, such as borrowers, switched on to the concept of sustainability, from C-suite to the shop floor.

“It is quite natural that the first step for an issuer will be to finance already decided projects but most organisations we meet stress the positive internal effect and the focus to continue developing new sustainable projects,” says Langeland. “This also creates a process where the treasury department considers not only pure financial matters but also sustainability issues. Our belief is this change of thinking and consideration of sustainability more broadly in the investment process will have an additionality effect.”

A new generation

If the World Bank and other supranationals started the movement that created the sustainable bond market, what — excuse the pun — is going to sustain it and drive it forward?

Many public sector issuers and fund managers have told GlobalCapital how much interest students and other millennials have begun to show in their activities since they embarked on their SRI journeys. The topic can pack out lecture halls and ensure spikes in job applications.

This is heartening and all very well. But it does not alter the fact that — despite all the excitement about how the younger generation has a natural affinity with all things social and environmental and it is they that will drive real change in investment markets — the sustainable bond market is still being driven from the top down, by the issuers and fund managers, rather than from the bottom up, by end investors such as pension funds and, of course, millennials.

A recent fund dedicated to social assets launched by a UK fund manager is a case in point. When GlobalCapital asked the manager what had driven the creation of the new fund, in particular whether it had come about from an upsurge of interest from the millennial end investor, he rather sheepishly replied that it was in fact all the fund manager’s idea and there had been no initial reverse enquiry.

Of course, one reason why millennials have yet to make a big impact in investment is simply that they are still far away from retiring and have not saved much yet. So far their influence has mostly been felt on consumption trends, particularly in the digital economy, artisan coffee shops, beard conditioners and the smashed avocado market.

But given that they are widely touted as having more interest in sustainable consumption than other segments of the population it is surely only a matter of time before they make their mark in capital markets.

In late November, First State Investments published a piece of research entitled Millennials & Responsible Investment that found an overwhelming majority, 81%, in a survey were interested in socially responsible investing — and that they thought friends and colleagues of their age were more easily convinced than previous generations of the importance of responsible investments.

More than a quarter (28%) highlighted impact investment — the ability to have a positive social or environmental impact alongside financial return — as one of the themes of most interest to them, while 57% thought the application of ESG could boost long term returns and only 8.5% believed it would shrink returns.

First State concluded: “As this generational cohort goes through their working lives and becomes the savers and investors of tomorrow, responsible investment looks likely to be a significant feature of their thinking and choices.”

Yet of those surveyed, only one in nine currently invests in a fund focused on sustainability issues. That proves there are barriers to such investing — and that there is a large potential for it to grow. Four fifths of the respondents thought more education was needed and 40% wanted more information about performance.

Into the mainstream

The green bond market has contributed to a change in ethos, so that sustainability has become a strategic concern for most organisations today. It has gone from something that is good to do to something that is necessary to consider and the only way of doing business. Sustainability has — to coin a phrase — reached its own tipping point.

In the second half of 2018 barely a day has gone by without a new initiative or announcement by a government, bank, company or investor from every corner of the globe about sustainability in one form or another.

In September, California’s governor Jerry Brown signed an executive order declaring that the state would seek total, economy-wide carbon neutrality by 2045. A month earlier, its treasurer John Chiang had signed the Green Bond Pledge, making it the first state in the US to promise to use green financing to combat climate change.

In October the Seychelles issued the first blue bond of its kind to support sustainable marine and fisheries projects, while in the same month, KfW, the EIB and Agence Française de Développement launched a €2bn Clean Oceans Initiative to finance projects aimed at reducing marine litter and tipping untreated sewage into the sea.

In November Ma Jun, a member of the People’s Bank of China’s monetary policy committee, called for altering bank capital rules in China to give lower risk weights for green assets.

And in December UBI Banca set out on a roadshow to promote a new sustainable bond framework — despite Italian banks having been largely absent from the bond market all year. The framework included financing not only for small and medium-sized enterprises and charities but also religious entities. It’s taken 10 years, but we can finally say that sustainable bonds are on a mission from God.

The next 10

But what about the next 10 years? “The challenge now is to build on the momentum,” says Reichelt. “The Sustainable Development Goals are a collection of 17 global goals agreed by 193 countries in 2015 that range from education to health and sustainable cities. They are a helpful framework for investors and issuers to focus on areas beyond climate and highlight how they are connected.”

There is great interest in the Sustainable Development Goals in the financial world, with umpteen banks, investment firms and companies using them as a framework to help them structure their efforts to further a healthier and more sustainable economy, through their ordinary business activities.

The World Benchmarking Alliance, an initiative of Aviva, the Index Initiative and the UN Foundation, is seeking to build a suite of free indices tracking companies’ performance against each of the SDGs, to help investors allocate capital to those most helpful.

For its part, the World Bank is issuing a range of sustainable development bonds, whose proceeds are not allocated to specific projects, but which are designed to “engage investors around specific SDGs”.

“For example, a recent initiative is highlighting the importance of clean water and healthy oceans and the World Bank is engaging with banks and investors around those challenges,” says Reichelt. “Other topics of engagement with investors include gender and health, as well as building sustainable cities and the critical role of building human capital.”

Johanna Köb, head of responsible investment at Zurich Insurance, expects the themed bond market to continue to expand, and also to influence the wider capital markets. “We have entered the decade in which the green bond market, like any teenager, will have decided what they want to be when they grow up. I’m personally still very excited about the market and think that on its 20th birthday we will celebrate something that is larger and even more diverse than today. It will have improved in quality and character, and taught us how to think about a company’s sustainability features and measure the impact created. But most importantly, it will have changed the way we see debt capital markets. There will be an entire family of instruments that are green, social and sustainable. And we will have learnt to ask for and assess transparency and ESG features of conventional bonds as well.”

Perhaps most importantly, the idea that finance has a social purpose has moved from a fringe or fluffy notion to the mainstream — and now is even becoming part of the legal architecture of markets. Legislation as part of the European Union’s Sustainable Finance Action Plan will require investors to disclose how they consider environmental, social and governance issues, especially climate change. The European Parliament is pushing for even stronger policies — extending the requirement to banks, and giving investors a duty, not only to avoid ESG risks to their assets, but to avoid causing negative impacts in the world.

Strong policies are desperately needed. Even though the labelled bond market is now into its second decade, with over half a trillion dollars issued, the problems that it was created to help stem are still getting worse. At the end of November, on the eve of COP 24 in Katowice, Poland, the United Nations revealed that CO2 emissions were rising again, the first increase for four years.

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Green light in the darkness

That the World Bank’s first green bond was launched in the teeth of the global financial crisis is intriguing and perhaps easy to forget. It is worth reminding ourselves just how extraordinary this period was. Volatility had been gradually building since April 2007. But by the time the bond was launched in November 2008, capital markets were in utter disarray.

September had seen Lehman Brothers collapse and the US government bail out housing agencies Fannie Mae and Freddie Mac and insurance group AIG. October brought the collapse of Iceland’s banks, the UK government spending £50bn to rescue its banking system and central banks slashing interest rates around the world. These were black days for a debut green bond.

There is no doubt the crisis made planning and execution of the Skr3.35bn deal harder. But, as Langeland at AP2 points out, in a strange way, it also helped train minds on the task in hand. “First of all I think the carnage in the market actually increased focus on longer term sustainability (and also it felt meaningful to work with these kind of issues), away from short term profit-maximising business models.

“That said, of course the increased awareness of risk made the whole process around the bond a bit more cumbersome and time-consuming. Once it had been issued, the attention was amazing and the ball was rolling. The foundation for the sustainable bond market had been constructed.”

The attention Langeland describes has been particularly strong at the investment banks. Many see it as part of their new post-crisis social responsibility and role in providing and arranging purposeful finance. Indeed, for many banks, financing solutions for sustainable infrastructure is now a C-suite concern — a way to promote inclusive capitalism and win back public approval damaged in the financial crisis and its messy aftermath.

In the last 10 years nearly every bookrunner has promoted its commitment to sustainability, with many creating specialist teams. “Banks are good in mirroring the overall trends in society and sustainability is getting more and more attention — nowadays they almost stumble over themselves to declare how deeply they are involved in sustainable issues, so it definitely had an effect,” says Langeland. “Their reputation was not great after the GFC and for sure they needed some positive impetus to look better in society.”

Banks’ enthusiam has undeniably speeded up the development of the market, as they have helped to define standards and diversify the issuer and investment bases. But their growing involvement and the increasing levels of competition pose risks, too, in particular around taking issuers to the market that should not be there. “The risk of green-washing relative to the profits of underwriting is a crucial consideration for the banks,” says Langeland.