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ESG Focus: S&P Eyes APAC As Ukraine Rages

ESG Focus | May 24 2022

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: S&P Eyes APAC As Ukraine Rages

With US$2.8trn of US$4trn APAC debt exposed to environmental risk, S&P Global Ratings hones its sights on the region as ESG debt bears the brunt of the global bond rout.

-Green debt suffers most in bond market rout
-$2.8trn of US4trn APAC debt is exposed to environmental risk
-Integrity of sustainable debt markets to be tested
-Regional ESG haves and have-nots starting to emerge
-Ukraine War spurs rush to dirty debt and humanitarian 'conflict' finance

By Sarah Mills

S&P Global Ratings’ Asia-Pacific ESG & Sustainable Finance Seminar 2022 provides several insights into the agency’s view on ESG developments in the region and its approach to ratings.

The seminar comes as sustainable debt markets appear to have borne the brunt of the recent bond rout in response to rising inflation post-covid and the Ukraine War.

Bloomberg says its index of ESG debt has lagged global bond benchmarks by roughly 64 basis points in the past 12 months.

In Europe, green corporate bonds have slumped -6.7%, compared with -6.1% for vanilla debt in the year to April, and Chinese high-grade corporate green bonds underperformed non-green peers in the first quarter. 

Green issuance is stagnating for the first time in years after posting stellar growth turnover in the past five years, when it rose eight-fold.

The poor performance flies in the face of conventional wisdom that sustainable debt should be a safer bet over the longer term, and given regulatory pressure should ensure portfolios are more sustainable in the long term, and therefore trade at a premium, especially as volumes rise.

Several Reasons Behind Bond Weakness

An obvious reason for the March-quarter weakness is the short-term response to the Ukraine War, which witnessed a sharp run into “dirty debt” – oil, gas and oil (see below).

Some conjecture that the market also recognises the relative “newness” of the debt category and has sought shelter in the familiar, well-rated basket amidst the geopolitical conflict. 

Bloomberg speculates another reason for the relative weakness of sustainability debt in the March quarter is that ESG debt started out more expensive (so it had more room to fall), and most of the debt is longer dated.

Other observers point out that sustainability bonds haven’t really experienced a proper down cycle and this is the first test.

Bloomberg also notes weakness in the secondary market makes it tougher for big institutional investors to liquidate investments.

Most pundits also agree that a major investor concern is nervousness about green-washing and the quality of green debt as their success becomes more evident with maturity, particularly for green use-of-proceeds bonds, as inflation rises and geopolitical tensions escalate. 

Major polluters such as petrostates and airports rushed to take advantage of the flood of sustainable post covid, and perhaps early signs of a reckoning are in play.

Enter the Asia-Pacific S&P Global Ratings seminar

The seminar is timely and, at one level, aims to increase investor confidence in the rigour of the S&P ratings system as well as encourage investors to orient to agency-rated green debt.

In a general preamble, S&P Global says the main challenge facing the region is that of converting long-term net-zero pledges into short-term action, and that corporations will experience growing pressure to meet bond targets over the next two years.

This suggests continued pressure to invest funds into ESG projects, which is likely to underpin regional economic investment.

Also in the next couple of years, the agency believes new regulations and reporting standards will demand greater disclosure and transparency; that boards will experience growing pressure to upgrade their ESG skills; and financial institutions will have to conduct greater climate stress testing.

When it comes to the impact of this on investors, S&P says the debate over divestment versus engagement is expected to escalate. Some may opt to divest assets to keep their book greener, and others may choose to engage with corporations. 

The upshot of this is that the integrity of the sustainable debt market is likely to be tested, with ramifications for corporations and equity markets as rising rates, inflation and profit pressures cascade.

Meanwhile, China is expected to lead APAC green issuance as previous issuance cascades into corporations.

In the relatively opaque Asian markets, S&P says the gaps between the ESG haves and have-nots is starting to become evident, and the cracks/risks are starting to show. ESG reputations are being made and destroyed.

S&P tallies material ESG risks 

Back to APAC, the agency notes nearly 60% of APAC ratings are influenced by ESG factors and says their materiality is high. 

The region holds US$4trn debt and the agency estimates US$2.8trn is exposed to environmental risks.

Governance factors negatively influence about 22% of that, and 19% are social.

On the environmental risk front, the agency estimates large capital expenditure will be required to strengthen compliance, fund retirement of large assets, or pay for clean-up liabilities.

The agency also observes that concentrated asset bases magnify physical risks, high pollution costs could hit profits, and companies face risks from product substitution.

The agency also spies liquidity risk for companies exposed to climate transition, deforestation, certain social factors and weak governance.

S&P also observes emerging risk to demand profitability as companies confront limitations on consumer and business mobility, and ageing population trends.

Social risks include provisions for past health and safety litigation, magnifying cash-flow ratio volatility because of exposures to social mobility.

On the governance front, companies with a history of regulatory, tax or legal infractions outside industry norms are perceived as a liability risk.

Financial risks tend to be subject to cross-country comparisons. These include: legacy debt; profitability or ROI exposed to industry risk; compliance costs; transition costs; and repositioning of capital expenditures. Comparisons of ESG credit risks across countries. 

Other environmental risks such as emissions and water useage are rated against community and industry peers.

Governance is compared against peers.

The Ranking System

S&P’s ESG scores are measured on a scale of 0-100 where 100 represents the maximum score, based on points designated at a basic criteria level.

This is enhanced though standalone ESG Dimension Scores.

Basically, S&P has a 1-5 ESG rating system, with Positive being the highest and Negative being the lowest.

The scale is: Positive; Neutral; Moderately Negative; Negative; and Very Negative.

Each is designated a number 1 being Advanced, 2 being Aligned, and 3 being non-Aligned. 

Such a score might look like this: 86 (for the 0-100 criteria-level component) and Neutral: E1, S2, G2 for the dimensional component.

Some prefer their own radar

While some might question the value of agency-rated debt post the global financial crisis, and may prefer their own ethical radar, once established, ratings agencies ratings will have a significant impact on the corporate and sovereign debt markets.

This will be amplified by the fact that an agency rating will qualify as a sustainability-linked bond KPI in its own right.

When it comes to corporate debt, Bloomberg says advisers are recommending investors seek companies with products and services that are naturally aligned to long-term sustainability rather than just ESG debt, and to examine the company’s ESG profile rather than individual issuance.

Bloomberg interview respondents believe regular bonds with rights to a company’s cash flow for general use should prove superior to ESG use-of-proceeds bonds – which would also benefit sustainability debt not-linked to specific projects.

Ukraine War Spurs A Run On Dirty Debt

Dirty debt has also outperformed bond markets recently as oil and gas prices soared on the covid reopening and the Ukraine war, as has debt from coal miners.

Although as the war accelerates the shift from fossil fuels to green energy, some believe the latter is the better long-term debt.

But Moody’s Investors Service believes the European push for energy security post the Ukraine crisis will spur long-term investment in strategic renewable energy plans (although expects the region will remain heavily reliant on fossil fuels in the near term).

Moody’s ESG Solutions expects sustainable bond issuance will be flat in 2022 at roughly US$1trn, after volumes moderated in the March quarter, due mainly to the Ukraine War, which has intensified inflationary pressures.

This compared with the agency’s previous 2022 forecast of US$1.25trn.

S&P notes that, while the market is taking a breather after an eight-fold increase in five years, it is growing in breadth. S&P retains hope that issuance may exceed US$1.5trn this year, once stability returns.

Moody’s reports global issuance of green, social, sustainability and sustainability-linked (GSSS) bonds fell -11% to US$203bn in the 2022 March quarter, down -28% on the previous corresponding period.

Green bonds were particularly hard hit, issuance falling -29% in the March quarter (albeit still comprising roughly half of total debt).

European markets, which hold the bulk of green bonds, were hardest hit due to the war, green bond issuance falling -37% year on year.

Rising Social Issuance Raises The Prospects For Conflict Finance

The main exception to the trend was social issuance, which rose in the March quarter (and now accounts for 18% of the total bond market). The agency suggests this has perhaps been strengthened by the Ukraine war, issuers bringing humanitarian labelled debt to the market.

In April, the International Capital Market Association published a Q&A document on how bonds can be used to raise capital for social projects to support “fragile and conflict states”, highlighting the growing role financial markets are likely to play in future conflicts.

Moody’s also notes there is growing demand for gender-equity bonds, given it has been estimated that global gender inequality costs the global economy US$160trn in human capital wealth and markets are keen on capturing that.

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