ESG issuance steadily grows despite politicization, labeling concerns

From an investor perspective, there is demand for ESG bonds, but it is mostly concentrated in select funds.

Barclays PLC noted in an April report said “most U.S. municipal bond investors, do not allocate their portfolios specifically to ESG bonds.”

Watch The Bond Buyer’s California Public Finance Conference investor panel on ESG here.

Still, they noted that ESG funds “tend to have overweight positions in labeled securities, particularly green and sustainability bonds, versus traditional funds.”

Most traditional municipal funds also invest in ESG bonds, “but their decision to put money to work is determined mostly by valuations, rather than any other considerations,” Barclays said.

Where’s the pricing benefit?
Some hesitation to issuing labeled bonds, “even where the use of proceeds has a clear environmental or social benefit, has to do with an issuer’s traditional cost-benefit analysis,” Ducret said.

At this point, she noted, there is a “lack of discernable price benefit to issuing a labeled bond in the muni market.”

Labeling bonds as ESG has not been something that is materially and explicitly tied to improving issuers’ cost of borrowing, at least not yet in the muni market, Chapman said.

“Maybe you can squeak out a couple of extra basis points, but I don’t know if that’s even a trend; those are more anecdotes,” he said.

“As much as I would like to believe that a lot of investors care about ESG bonds, they pick the one that makes the most sense to invest in,” Cheng said. “So meaning higher yielding, higher returns, are more attractive.”

This is not lost on issuers.

“I’m frustrated that we were not seeing that [pricing] differential” for ESG bonds, said Nikolai J. Sklaroff, capital finance director for the San Francisco Public Utilities Commission, at The Bond Buyer’s California Public Finance conference. He noted he’s fearful if the market will ever see the differential.

“We are a small part of a global investing universe, and this effort with ESG began in the taxable market and began internationally,” he said.

Watch The Bond Buyer’s California Public Finance Conference panel: The ESG Evolution – A Look at Industry Sentiments, with SF PUC’s Nickolai Skarloff

The United States’ counterparts in Europe are typically thought to be several years ahead of the U.S., Sklaroff said.

“In this regard, what is important to understand about how that whole universe got started was that people who wanted to affect change went to investors and said, ‘You can do this without giving up yield,'” he said.

That’s the premise that he said has been promised to the investing side.

“If only we grow this marketplace, if only we build the demand, we’ll eventually have a pricing difference,” he said.

Barclays noted in its April report that part of the challenge is the dearth of supply.

With the lower issuance overall, Barclays strategists noted “it is not surprising … that municipal ESG bonds mostly trade with a very small green premium (if any), unlike their corporate counterparts, at least on the Euro side.”

Consequently, they said a “muni greenium will likely remain very small for the foreseeable future, at least until municipal investors become more interested or are incentivized to dedicate more funds to ESG bonds.”

The costs of designating
The designation of ESG-labeled bonds hasn’t historically mattered in a “meaningful way” to the issuer, said Matt Fabian, a partner at Municipal Market Analytics.

“It matters a little bit more to the buyer if it fits a portfolio need or an investing strategy or a marketing narrative,” he said.

ESG bonds help “sort bonds slightly differently between investors, but the net impact to the issuer is minimal or nonexistent,” he said.

“Issuers are generally disposed to seek a green or ESG label when it’s appropriate,” said Pat Luby, a CreditSights strategist, noting there is also the cost and time commitment of seeking out an ESG designation.

The cost can range from $10,000 to upwards of $25,000, according to Chapman, which is expensive for cost-conscious issuers.

Furthermore, Chapman said, “whether you pursue a second party opinion, whether you just choose to self-label and commit yourself to presale reporting and disclosure, potentially ongoing post sale, disclosure, that’s a time commitment, that’s a potential financial commitment.”

Therefore, Luby said, it makes more sense for larger issuers who frequently come to market but less so for smaller ones who access the market every year or two.

The politicization of ESG
There are also political contentious to content with related to ESG-label bonds and investing in ESG.

ESG, according to some politicians and other government representatives, is a part of the financial markets’ “woke” agenda, from the states all the way up to federal level.

New laws in several states, including Alabama, Texas, Florida, Oklahoma, Louisiana, Indiana, Missouri and others, ban companies — such as commercial and investment banks — from doing business in the state if said companies are perceived as boycotting or otherwise discriminating against certain industries or other companies, mostly firearms and fossil fuels companies. Some states seek to ban issuers from using ESG labels and putting public investment funds in ESG-related holdings. Florida has a law that effectively bans all state and local issuers from issuing ESG-labeled bonds.

In August of this year, the Securities Industry and Financial Markets Association, a trade association representing financial services firms, sued Missouri to try to halt its ESG-related rule that would require advisors and broker-dealers to obtain written consent from customers to buy or sell an investment produced based on social or other non-financial objectives.

The state is expected to respond with its motion to dismiss by Monday.

Wells Fargo and RBC Capital Markets were recently dropped from two separate Texas deals since state Attorney General Ken Paxton’s began examining several banks’ climate change practices.

“A lot of times issuers are trying to tiptoe around these political issues,” Cheng said.

“The political climate does matter in so much as in some states, labeled bonds are viewed negatively by politicians or in the case of Florida, they are not permitted,” Ducret said. “But in states like California where labeled debt is encouraged, lack of resources and price discovery are more influential.”

This is why ESG-labeled supply comes from blue states, especially from California and New York, which together represent the bulk of the ESG universe, Barclays strategists noted.

Additionally, some other blue states, such as Massachusetts and Washington, have “more ESG bonds outstanding than some of the more active issuers of traditional municipal bonds such as Texas and Florida.”

Some issuers, aware of the contentious nature surrounding ESG bonds, may try to market the bonds differently, Cheng said.

This could lead to bonds that have an ESG bent being called something else, she noted.

Cheng recounted an anecdote about a school bond deal with renewable energy component had to be renamed so it appeared it had nothing to do with renewable energy.

The non-ESG-labeled bonds were still issued and had good traction, but at the end of the day, she said, the organization recognized the purpose of the deal and why it was important but was unable to “name it anything remotely related to ESG.”

Due to this, she said it’s possible that there may not be as much of a slowdown in ESG as the numbers indicate due to issuers choosing to not label ESG bonds as such.

Potential for growth
Despite the slowing of overall issuance, market participants still expect that ESG may lead to growth for the industry.

One in three respondents to The Bond Buyer’s ESG survey said they believed ESG is highly important to the industry, while a majority said it is at least somewhat important, and nearly half of respondents said they expected ESG to have a positive impact on industry growth over the next five years. Twenty-four percent said it would be a limiting factor.

Ducret believes there will “continue to be an increase in the percentage of labeled municipal bonds in the market.”

The muni market “continues to fund projects that serve the public good with both environmental and social benefits and therefore lends itself nicely to the issuance of labeled debt,” she said.

Additionally, Ducret noted there is “the potential that as market technicals shift, we could start to see a price differential between labeled and non-labeled debt which would drive more issuance.”

“A recognized price differential for labeled debt vs. traditional non-labeled debt would drive more issuance in the municipal market as well as a de-escalation of the politicization of the label,” she continued.

Listen to Breckinridge’s Ruth Ducret lay out climate change challenges for state and local governments in this podcast with The Bond Buyer’s Lynne Funk.

Outside of a general decline in issuance, Ducret does not expect a “proportionate decline in labeled bonds compared to the overall market.”

If this decline happened, she said “it would largely be driven by either political reasons or a lack of resources available to issuers to produce the disclosure associated with this debt.”

With the adaptation of more ESG labeling and disclosure regulations, Cheng hopes 2024 will be a better environment for investors who are looking for less greenwashing and putting more bond proceeds to their intended use.

“What you want in a bond sale is the broadest possible base of investors, and in a market like this one, in particular, this is when you really want to be appealing to as many people as possible,” said Kim Nakahara, a senior research analyst and portfolio manager at Allspring Global Investments, at the California Public Finance conference.

While labeling bonds as ESG is a challenge, she said “it’s also the reality of where our market is going.”