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ESG Focus: Premium Hunters Eye Additionality

ESG Focus | Apr 22 2021

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future:

ESG Focus: Premium Hunters Eye Additionality

Not all green investments are created equal and, as predators line up for the ESG ball, investors seeking a sustainability premium are sticking to the rule of additionality.

-Expect an explosion in sustainable finance in 2021
-Beware working capital funding disguised as green investments
-Who to trust?
-Uneven playing field in indices

By Sarah Mills

Following President Biden's announced green stimulus plans on World Earth Day (yesterday), it is timely to take a quick look at the green bond and sustainability linked bond market.

This year, 2021, will be the year of green and sustainable financing.

Green bond issuance hit US$269.5bn in 2020 (US$1trn total market according to Bloomberg) – representing an average annual growth rate of 60% since 2015.

Issuance is set to rise another US$1trn this year based on German issuance alone. Biden’s announcement will clarify how many more trillions will also be issued in 2021.

Green bonds now represent 47% of the ESG bond market; the combined issuance of green, social and sustainability-linked loans and bonds topping US$2trn last year.

And this year is particularly likely to see the rise of the sustainability-linked bonds – bonds with less binding terms than use-of-proceeds bonds.

ANZ Bank’s Director Sustainable Finance, Tessa Dann notes that the market has grown exponentially from US$4bn in 2017 to US$140bn in 2020 and she expects the market will rocket in the second half of 2021.

A cautionary tale

A recent article in IEEFA, picked up from Responsible Investor, stands as a cautionary tale to investors to beware of greenwashing, in what is shaping up as whirlwind of investment activity.

It points to an example of working capital funding being provided through green finance, simultaneously “credentialing” the debt-laden recipient as an appropriate destination for green funds in future.

The article is an excellent case study in the application (or lack thereof) of the rule of "additionality" (which we will discuss in the second article in this series) to green investments, not to mention a timely reminder that often the authorities investors rely on for guidance may have their own agendas.

Trillions of dollars are flowing into the green transition and predators have bought advance tickets to the ball.

The securitisation fraud of the noughties remains fresh in the memory for many, and a reminder that credit rating agencies were party to this fraud, assigning triple-A ratings to junk securities.

Investors no longer blindly accept the advice of financial advisers and ratings agencies, and according to IEEFA, the World Bank and affiliated organisations should be no exception. 

Working capital funding disguised as green investment

As the IEEFA article states:

“Sometime bankers can be too clever for their own good. This is especially true when the market is distracted by misleading statements about sustainable development impact and investors fail to read the fine print.”

The topic of the IEEFA article is the recent US$550m sustainable loan from a consortium of global banks including Citibank, DBS, JPMorgan, Standard Chartered, and SMBC, to one of their customers, Indonesia’s state-owned, debt-laden power company PT Perusahaan Listrik Negara.

Its purpose was to fund short-term working capital expenses for renewable projects. Most investors understand the risks associated with working capital shortages.

The loan was guaranteed by the World Bank Group’s Multilateral Investment Guarantee Agency (MIGA) 

“On the face of it, this was a tailored loan that looked like a welcome solution to PLN’s urgent cash needs,” says the article.

“The loan was also pitched as a good way for PLN to begin establishing credentials with the green and sustainable finance market.” 

In other words: the same green markets in which you and Australia’s super fund industry might be seeking credentialed investments, and who might be seeking an imprimatur from the likes of MIGA.

The article goes on to note that PLN has been under serious financial pressures to address their situation and so it understandable that they were on the hunt for affordable funding.

Running close to the edge of self dealing

“What’s more puzzling is MIGA’s cynicism,” says the article.

An analysis of this green loan makes it hard to shake the impression that this was an opportunistic green-box ticking exercise.

“That’s because the indirect beneficiaries of the proceeds are the six sponsors of operating renewable projects that have already been funded, in part, by the World Bank and two fellow development finance institutions, the Asian Development Bank (ADB) and the Japan Bank for International Cooperation (JBIC).”

“MIGA’s documentation for their board states that this guarantee is “consistent with MIGA’s US$6bn COVID-19 response package” which is intended to “assist member countries in addressing the global pandemic and its impacts” … and support “sustainable energy and universal access in Indonesia”.

“This is nothing more or less than a credit-enhanced working capital facility designed to cover PLN’s “operational expenses” related to six projects that have already been fully funded,” says the article

“In other words, the funding will cover tariff and power purchase agreements for renewables projects that have already been completed and are presumably already part of PLN’s operating budget. 

“That means that the loan fails the test of additionality. The funding does nothing to provide new incentives to PLN to accelerate energy transition – or to address any of its existing operational challenges. 

“It merely means that PLN will benefit from an injection of cheap working capital to stay current with its IPP payments—the clean and the dirty. … It merely plugs a cash hole.”

The article notes that the project comes uncomfortably close to self-dealing on behalf of MIGA and its parent (the World Bank) and other DFI institutions, given the proceeds will fund projects already funded in part by its parent the World Bank. 

The loan reduces the chances of PLN missing tariff payments.

While impact investment is a thorny area, and some definitions and approaches might consider the PLN deal compliant, this type of investment is unlikely to provide the social or environmental outcomes that will yield the coveted sustainability premium that investors are targeting.

Investors in green bonds and sustainability-linked bonds take note

This example is particularly relevant to investors in the green bond market given green bonds are mostly used for refinancing.

According to Nordea’s head of sustainable bonds Jacob Michaelson advises in an article that investors in green bonds need to examine the fine print and structure.

“The format is critical,” says Michaelson. “… transparency, strategic alignment of the issuer with broader sustainability goals and the impact of the proceeds” all need to be addressed.

“Assuming that, at the time of an investment, the enterprise can productively absorb more capital, the investment has impact if it provides more capital, or capital at lower cost, than the enterprise would get without it.”

Issuers should disclose the use of proceeds, strategic alignment and impact for all public bond market issues. Use of proceeds bonds gives investors some transparency and view into the strategic alignment of corporate investments

This will be of import to investors this year as Biden’s stimulus package drives activity in green issuance and sustainability-linked finance.

As noted above, sustainability-linked bonds are particularly expected to take off this year, and boards of not-for-profits and other investors will need to stay alert.

Unlike green bonds, sustainability-linked bond proceeds are not ring-fenced: to be applied towards green or sustainable purposes. 

The issuer is committed to improvements in the sustainability outcomes of its business within a pre-agreed timeline. They create room for more creative and competitive approaches to sustainability and also greater risk.

The bonds require voluntary commitments and have interim milestones but unlike green bonds, failing to meet these milestones might not be considered a breach of covenant, in the same way as failing to deploy proceeds to a specific use.

However, failure might result in an increase in a coupon. 

The lack of defined repercussions is an added risk for shareholders of companies that issue sustainability-linked bonds, keeping in mind that companies do not have to reveal the terms of loans to the market for commercial reasons.

Sound vague? Sound systemic? Sound fraught?

It has yet to be seen what further financial engineering and packaging may emerge in the issuance markets.

Who to trust – legal suits ballooning

So, if investors can’t trust ratings agencies, MIGA “credentialing”, the World Bank and DFIs, who can they trust?

Certainly not all major banks; and nor it would seem EU Climate Benchmark regulation.

German banking heavyweight DekaBank is being sued for allegedly misleading retail investors over the social and environmental impacts of one of its funds. 

Consumer groups Verbraucherzentral Baden-Württemberg (VBW), a German consumer protection agency has filed a law suit for overstating the positive effects of its impact equity fund.

DekaBank is challenging the lawsuit.

VBW has taken a tack that may be useful to many investors by matching DekaBank’s Deka-Sustainability Impact Aktien fund’s website claims about sustainability criteria against the fine print, which claims:

“That the promised figures for the positive ecological impact are only based on an estimate and that not all companies in the fund were taken into account.”

“Self reports from companies are not a reliable source of information. And statements about the sustainability of an investment should only be advertised by those who can actually prove the effect.”

If the consumer agency wins, it will definitely throw the cat amongst the pigeons, and raise a new standard for those issuing, co-ordinating and trading in green bonds.

Corporate issuance on the rise

And investors certainly cannot blindly trust companies seeking green funds.

Eight brands were called out for greenwashing in 2020, according to

Italian oil company Eni was the first in the country to be prosecuted for greenwashing. 

The company was sued for EUR5m for claiming that its palm oil-based diesel was “green”. 

For those of you who don’t know, palm oil is sourced by razing Indonesian rainforests and replacing them with palm forests.

This not only destroys a carbon sink but bio-diversity, which is soon to become a major investment issue, as FNArena reported in a previous article.

Singapore’s Energy Market Authority also received a media flogging for an advertisement using children to promote natural gas as green.

SC Johnson’s Windex Vinegar Ocean Plastic bottle made from 100% ocean plastic came under fire because it was actually sourced from “oceanbound” plastic from Haiti’s plastic banks, not from ocean plastics. 

Semantics to some perhaps, but those semantics can prove costly.

The company is also being sued for marketing the product as non-toxic, a class action claiming they contain ingredients harmful to people, animals and the environment; pointing to broader liability risks for companies making such statements.

Even Ikea has been hit for being linked with illegal logging in the Ukraine and for greenwashing on a recycling initiative; and building its ‘most sustainable store’ yet in London after demolishing another sustainable store after just 17 years of use.

Eco-fraud proves new frontier for perpetrators chasing the money

Greenwashing litigation “can best be described as eco-fraud litigation”, advises Alston & Bird.

Reflecting this, activists such as Greenpeace have traded in their boats for lawyers; and Greenpeace has shifted its frontier from the oceans to greenwashing litigation.

Corporate misrepresentation has already proved costly to shareholders, and was the basis for a class action brought against Volkswagen in the UK relating to the “dieselgate” scandal.

The problem for investors is that anti-greenwashing legislation appears weaker in application to the finance markets than in consumer markets.

Misrepresentation has often been prosecuted under false and misleading commercial practices but that may be about to change as the regulatory environment catches up with the rollout of ESG priorities.

Regulations need to tighten

In an article titled ‘ESG and the SEC: A Regulatory Sea Change’, Morgan Stanley notes that the US Securities and Exchange Commission (SEC) has done an about-face under the Biden and has undertaken at least eight actions to improve the quality and the oversight of ESG and Climate Disclosures.

In particular, the SEC will “review the proxy voting practices of some sustainability funds to ensure voting aligns with investors’ expectation and funds’ state sustainable investing strategies,” says Morgan Stanley.

“It will also seek to identify funds using false or misleading advertising of ESG features.

“… The SEC is determining the extent to which guidance regarding shareholder rights needs to be adapted and updated to address ESG issues.”

Given the amount of activity afoot, it would not be surprising if an example were to be made in the not-too-distant future.

Also, it has been argued that greenwashing by companies with a large market share, could be tackled as an abuse of dominant position contrary to competition laws.

As mentioned in previous articles, disclosure nets are tightening and companies globally will have to report on social and environmental performances in their tax filings. 

It is expected that the IFRS Sustainability Board will become the global standard for global corporate sustainability reporting.

The horse has already bolted

But it might all be a bit too late for these first rounds of stimulus, which are expected to flow within the next few months.

After all, who will be watching and regulating on these issues? 

At a Bloomberg presentation on sustainable finance this week, Australian banks identified one of the major risks for their organisations was simply a lack of skilled staff in sustainable finance.

Global regulators and other corporates will face similar issues.

It really is a matter of buyer beware and the markets are shaping up more like a game than a well-organised, well-regulated destination for funds.

But, much like the Hunger Games, corporations will be forced to play or be deprived of capital and the tax advantages that also often accrue from financing.

Uneven playing field in indexes concern for passive investors

Meanwhile, EFT Stream reports that asset manager Scientific Beta says even sustainability indices are flawed.

The manager believes this particularly poses a threat for passive investors – particularly in exchange traded funds (ETFs), which have been the recipients of billions of dollars in recent years.

The asset manager calls out construction methodologies; the EU Technical Expert Group on Sustainable Finance’s choice of decarbonisation metrics; and “primitive approach” to sectoral issues in a report entitled A Critical Appraisal of Recent EU Regulatory Developments Pertaining to Climate Indices and Sustainability Disclosures for Passive Investment.

Scientific Beta stressed that a lack of public data used in benchmarks created “an uneven playing field” that was harming competition in the index provider space.

The main criticism was that the benchmarks promoted the outright divestment of high-carbon intensity assets crucial to the transition but does little to encourage transition leadership.

Scientific Beta also criticises as “counterproductive” the TFCD’s calculation that is based on enterprise value including cash “EVIC”, which attributes greenhouse gas emissions to a company’s enterprise value rather than its revenue, which will skew the investors’ views to carbon intensity between growth companies and value companies, a core objective for ESG investors.

As a result, EVIC, “encouraged greenwashing” as it introduced equity market volatility into measurement and incentivised index construction on unreliable data, says the company.

That said, there is very little to replace the existing benchmarks. 

Investors are advised to conduct due diligence on index methodologies to avoid greenwashing.

The agency also notes that self-reports from companies should not be considered a reliable source of information (no surprises there).

The battle for funding

Some of this debate boils down to a battle over funding between pure impact investors and ‘transition investors’ for want of a better term.

Pure impact investors focus heavily on additionality: yielding a change that would not otherwise have occurred were it not for the investment. They would argue that transitioning would have occurred regardless. 

But its strictest interpretation can be extreme, prohibiting investment in any existing markets.

Transition investors prefer a loser prescription, claiming that transition is in itself an impact.

This is the crux of the ‘additionality’ debate, which we will explore in more detail in the second article of this series, as it is argued that the level of additionality and genuine impact is what will yield the sustainability premium (the wheat) in the decades to come. 

The chaff is likely just the funds directed to corporations to refit and redirect existing businesses into a new energy model, which in itself is unlikely to yield a long-term advantage given the whole world is doing the same thing. However, those that excel in this area will out-compete their peers.

Meanwhile, Biden is launching the US’s stimulus program, and the EU taxonomy was agreed yesterday and is due to be formally adopted at the end of May.

Let the games begin.

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