Increasing consumer demand and growing greenwashing concerns are pushing policymakers toward regulating ESG-labeled bonds differently. We reflect on what lies ahead for ESG in fixed income in 2023.
Increasing focus on climate change, the clean energy transition, and the political backlash against it have brought mainstream awareness to environmental, social, and governance (ESG) investing. As investors become aware of the need for the financing of climate-focused projects to meet global climate goals and the social and financial benefits they can reap, two major themes are emerging in ESG in 2023:
Will ESG fixed income continue to grow through 2023?
There are some notable data points to mention in the ESG investing space looking back on 2022. For the first time, fixed income ESG outpaced equity ESG fund flows. According to Morningstar, ESG bond funds pulled in $2.4 billion in 2022, accounting for just over two-thirds of ESG fund flows for the year, versus $1.2 billion in ESG equity. This is down from $11.1 billion for ESG bond funds and $56.4 billion in ESG equity funds in 2021. Overall, mutual funds saw net outflows of $957.6 billion in 2022.
Although overall inflows were lower in 2022 than the previous year, ESG inflows still outpaced those into the broader fund market. Lower ESG bond flows can also be attributed to macroeconomic headwinds, such as inflationary pressure, increased interest rates, and fears of a looming economic recession, which led to a slowdown in contributions to fixed income strategies.
We also saw a decline in sustainable bond issuance from 2021 to 2022, with a total of $863 billion of ESG-labeled debt issued globally, according to Bloomberg. This is a decrease from the record of $1.06 trillion of issuance set in 2021. S&P is predicting global sustainable bond issuance of green, social, sustainability, and sustainability-linked bonds to return to $1 trillion in 2023. But sustainable debt issuance declined due to macroeconomic uncertainty in 2022. With the easing of inflation and interest rate hikes, we could also see overall debt issuance return to more normal levels and, in turn, an increase of sustainable bonds in line with the growth we saw prior to 2022.
Given the rising necessity of financing climate-focused projects, there will likely be an increase of global sustainable bond issuance. A big cause of growing investor interest in ESG fixed income strategies is the ability to finance projects with the use of proceeds that are directly connected with sustainability and social impact. The S&P is predicting that a 14% to 16% share of overall global debt issuance in 2023 will be labeled as green, social, sustainability, and sustainability-linked bonds. This is an increase from 13% in 2022 and 12% in 2021. The share of sustainability-labeled issuance has increased yearly, in fact, and that trend is forecasted to keep going up. Green bonds in particular continue to see growing sustainable bond issuance, representing 55% of overall sustainable debt in 2022 compared with 52% in 2021, according to S&P Global. This is attributable to two factors: increasing financing for climate-focused projects and decreasing social bond issuance from what the market needed during the COVID-19 pandemic.
Will sustainable bond issuance grow to meet government climate pledges?
Recent policies and commitments to address climate change by governments around the world could also lead to increased sustainable bond issuance over time. The Inflation Reduction Act of 2022 contains $368 billion in funding earmarked specifically for climate-focused projects, aiming to reduce US greenhouse gas emissions to 40% below 2005 levels by the year 2030. Clean-energy and energy-efficiency initiatives like this will likely be partly funded through the municipal bond market. The act could also incentivize corporations to issue more sustainability-labeled debt through tax credits. These could be used for investments in clean energy projects and Leadership in Energy and Environmental Design (LEED)-certified building projects. This should increase the overall issuance of green and sustainability-labeled debt in coming years, since these projects are aligned with the US government’s climate goals.
The 2022 United Nations Climate Change Conference also brought fresh new climate pledges from governments around the world as the need to address increasing global temperatures becomes crucial. To limit the rise in global temperature to 1.5 degrees Celsius, the International Energy Agency estimates that the investment in clean energy needs to triple by the year 2030, which could cost upward of $4 trillion. While some countries, including the US, increased their financial commitments to reach this goal, private capital and funding through the capital markets will be necessary for the clean energy transition as well. This will require more financing through the public debt markets and will also contribute to greater green-labeled global bond issuance as we get closer to the 2030 timeline.
Will scrutiny over greenwashing lead to more ESG bond regulation?
Investor appetite will be a contributing factor in whether we’ll see higher sustainable debt issuance in 2023. And as demand increases, the SEC has continued to conduct industry-wide audits on ESG funds. There may be growing regulation over the ESG investing space as a result. Tightening regulations and more standardization and transparency will likely create more integrity around the responsible investing markets. This includes increasing standards for both the issuers of sustainable bonds and the managers of responsible investing funds and strategies.
Investors and regulators are placing larger scrutiny on greenwashing, or the misrepresentation of the environmental practices of an issuer or the environmental benefits of a bond issue. Since corporations and municipalities are issuing ESG-labeled debt in increasing numbers, it’s important for managers to have policies and procedures to avoid greenwashing in responsible investing vehicles. Issuers also need to undertake more due diligence when self-labeling bonds as sustainable without third-party verification. The lack of standardization on sustainability-labeled bonds demonstrates that investors need to do additional investigation before making their selections. They need a comprehensive look at the overall ESG footprint of the issuer and use of its proceeds. Until improved standardization comes to the industry, managers should rely on a proprietary, holistic research framework that can capture all material ESG factors when determining the issue’s suitability for a responsible investing portfolio.
The bottom line
As 2022’s fund flows demonstrated, investors have an increasing interest in fixed income responsible investing strategies. As issuance and investment in the sustainable debt markets grow, transparency along all steps of the investment process is critical. Managers should demonstrate this transparency to investors with a holistic and comprehensive approach to ESG research and reporting.