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The ESG or Green Bond Conundrum

image credit: Credit: WSJ

Does a rose by another name smell just as sweet? 

At least in the case of bond markets, the answer to that question might be a yes. 

In the alphabet soup of acronyms that have emerged in wake of the climate change crisis, Environmental, Social, and Governance (ESG) is one of the most popular. It is also one of the most confusing. 

This is mainly because ESG bonds have a broad and eclectic mandate to better society. They encompass an array of objectives at an organization, from better worker compensation to racial equality to generating or boosting green power sources. The mandate translates to a fairly broad range of tasks and activities being characterized as contributing to ESG initiatives.  

But the lack of clarity around ESG bonds has not deterred issuers or investors. Everyone, from sovereigns to tech companies to banks, has begun issuing ESG bonds. Corporate pressure and greater awareness of the threats of climate change means that investors are also taking serious notice and pouring funds into them. 

Investment bank Morgan Stanley estimates that $48.5 billion worth of ESG bonds were issued in April this year, approximately a month after the global economy came to a grinding halt due to the pandemic. That figure is an increase of 272 percent from a year ago. 

In the fevered alternate reality of the pandemic, it might be easy to construe an uptick corporate issuances of ESG bonds as a sign of consensus around climate change and social justice issues. They might power a green recovery from the current recession, some say. 

But the grand nomenclature of these bonds masks the fact that they are, in fact, general purpose obligation bonds used for projects that may already be in the works or may have nothing to do with ESG objectives. Lax standards for reporting or accountability means that the intended purpose of such bonds - to foster societal equity - is hardly enforced.

ESG Bonds and Electric Utilities 

At least in the case of American electric utilities, ESG bonds may not move the needle much. Technically, electric utilities are ideally placed to take advantage of these bonds. The electricity sector accounts for approximately 40 percent of global carbon dioxide emissions. Investor-owned utilities are under pressure to pay out dividends from profits and, at the same time, make a transition to renewable energy by retiring or discontinuing fossil fuel plants.  

The thinking is that ESG bonds can provide funding for green projects at utilities and free up cash flow for such projects from political exigencies. They also help improve the reputation of a much-maligned sector blamed for a wide variety of societal problems, such as fossil fuel pollution to customer service inefficiency. In fact, electric utilities accounted for the maximum number of green bond issuances in 2017 and 2018. 

“Utilities see them (ESG and green bonds) as a win-win because they can use them to raise cash and, at the same time, signal their intention of moving in a specific direction,” said Jeffrey Schub, executive director at Coalition for Green Capital. That win comes at a relatively cheap cost for them. 

Consider the case of New York’s Consolidated Edison’s $1.6 billion ESG bond offering of two tranches in March this year. The offering consisted of two issues that will mature in 2030 and 2050 and have coupon rates of 3.35 percent and 3.95 percent. respectively Those rates are not significantly different from the usual rate at which the utility issues its bonds. But the ESG patina has made ConEd the fifth-biggest issuer of these bonds this year and burnished its green credentials. 

According to the prospectus, the company intends to use proceeds from the March offering for “green expenditures”. But those expenses are not new. The projects have been in the works for several years and include smart meter installations, customer-focused energy efficiency programs, and infrastructure development for EV charging. Interestingly enough, a week after the offering was announced, the company discontinued smart meter installation and energy efficiency initiatives due to Covid-19 but the impact on ConEd’s bond prices has been minimal. Interest payments are also not based on the success or failure of their green expenditures, meaning the utility is not accountable for its spending. The only leeway made to investors is that of providing updates through the website. 

There’s also the case of Georgia Power’s $325 million bond offering in 2016. Again, funds raised from the offering were earmarked for “eligible green expenditures” and to support investment in solar power generation. Only one, out of the total six solar projects that were allocated capital from the bond proceeds, was built after the offering. The remaining projects were either already operational or were inaugurated later that year. According to its website, Georgia Power has a total of twelve solar plants. Apart from the six projects mentioned earlier, three were built with corporate support and another one is a community solar plant. 

A study at NYU’s Stern School of Business suggests that green bonds are mainly used to refinance existing capital projects within municipalities and coat them with a green varnish. “Our results suggest that as much as 60% of green bonds reflect refunded or continuing projects rather than new capital aimed at climate benefits,” wrote the study’s author. “These findings suggest that stronger regulation is needed to both appropriately define what can be considered a green bond and more clarity can be given as to how that capital is being used to finance environmentally supportive projects.”

American utilities also lag their European counterparts in issuing such bonds. This is due to several factors. The jury is still out on the so-called Green Premium, in which investors are willing to pay a premium to hold these bonds because their yield is higher than conventional bonds. Because a secondary market for such bonds is still under development, there is little incentive for utilities to incur the additional issuing costs of these bonds in the absence of higher premiums.  

If they were serious about boosting their green credentials in the bond market, investors might want to consider bonds, whose returns are based on project performance. But the market for this type of bonds is declining due to the pandemic. Green bonds, which are a type of ESG bonds linked to projects, worth $33.9 billion were issued in the first quarter of this year, a 49 percent decrease from the last quarter of 2019, according to research and ratings firm Moody’s. The company stated recently that it expects green bond issuance of $175 billion to $225 billion in volume this year, down from earlier estimates of $300 billion.

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Thank Rakesh for the Post!

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