Mana Nakazora: Sustainable Finance and Post-COVID Economic Recovery

2021/01/20

Since the adoption of the Paris Agreement at COP21 in Paris in December 2015 as a new international framework for reducing greenhouse gas emissions from 2020 onwards, the global trend has been moving toward the SDGs (Sustainable Development Goals). It goes without saying that the COVID-19 pandemic since early 2020 has further accelerated this trend.

While Prime Minister Suga declared in his policy speech, "I hereby declare that Japan aims to reduce greenhouse gas emissions to net zero by 2050, achieving a 2050 carbon-neutral, decarbonized society," it has also become clear that Mr. Biden is expected to be elected as the new U.S. President and will tackle environmental and energy issues all at once. With Japan and the U.S., which had previously been hesitant, joining Europe—which has been proactive—and China—which has adopted Europe-leaning policies to differentiate itself from the U.S.—the global shift toward the SDGs will undoubtedly accelerate.

To aim for such a sustainable society, financial backing through sustainable finance is crucial.

In 2020, the sustainable finance market expanded rapidly within the bond market (see figure). Sustainable finance is a general term for fundraising related to ESG investment, which stands for Environment, Social, and Governance. Furthermore, this article does not strictly distinguish between SDGs and ESG, but rather views the flow of funds toward these as a whole as sustainable finance.

The rapid expansion in 2020 was due to the issuance of COVID-19 bonds. Previously, the primary means of fundraising for green projects was the issuance of green bonds. COVID-19 bonds were flexible for issuers because they could be used not only for funds to find antibodies against the coronavirus but also for funds to pay employees forced into temporary leave due to the pandemic. At the same time, because COVID-19 bonds were classified as social bonds, they met the needs of investors seeking social investment methods.

  Source: Created based on materials from Bloomberg and BNP Paribas Securities  View Enlarged

Following the recommendations of the High-Level Expert Group on Sustainable Finance (HLEG) published in January 2018, the European Commission published an Action Plan on Sustainable Finance in March of the same year. This action plan includes the disclosure of non-financial information aligned with the Taxonomy (the criteria for sustainability) and the TCFD (Task Force on Climate-related Financial Disclosures).

Ultimately, TCFD is about how to conduct scenario analysis. The U.S. utility company PG&E, which has already filed for bankruptcy twice, is called the first ESG-related default. If a company owns many mountains with dead trees, it is not impossible to imagine that dry trees rubbing together could cause a wildfire through spontaneous combustion. If the wildfire had been anticipated, it would have been possible to respond by shortening the distance between sprinklers, for example. In that sense, the evaluation is that the default was due to a failure to conduct accurate scenario analysis. In light of one's own business, it is becoming increasingly important to exercise imagination regarding how much one notices potential risks from upstream to downstream in the core business and how one can respond according to each scenario.

Equity investment is overwhelmingly the easiest approach for ESG investment. Looking at investment returns from a medium- to long-term perspective, equity investment at least yields long-term returns. Even in the short term, a trend is emerging where stock prices tend to rise when, for example, a company announces a policy to transition away from coal-fired power or discloses progress on its sustainability policies.

On the other hand, in the case of bond investment, there was initial skepticism about whether returns could be obtained. Since bonds issued by companies with good credit ratings do not carry a relatively high spread (additional yield), investing in bonds of companies with excellent ESG or SDG performance is difficult to link directly to profit. However, as the flow of funds into sustainable finance strengthens and the number of investors participating in ESG investment increases, supply and demand have improved, and the seeds of return are beginning to emerge in ESG bond investment as well.

In the primary market, comparing green bonds and plain vanilla bond issuances (the most basic transaction form) by the same company, the spreads on bonds with an ESG flavor have become relatively tighter. It has been confirmed that there is a tendency for the premium to narrow due to strong demand compared to the initially intended bond price; this is called a "greenium," meaning the premium for green issuance is discounted. Meanwhile, regarding the benefits from the investor's perspective, although not yet confirmed for all bonds, some cases have begun to emerge where the cumulative returns of ESG or green bonds are superior to others. Furthermore, it was found that during the turmoil of the COVID-19 pandemic, the prices of green bonds were more stable compared to others.

In Europe, which led the world in declaring carbon neutrality by 2050, nations and central banks are already actively involved in sustainable finance. In NextGenerationEU, declarations have been made to reduce greenhouse gas emissions by 55% (compared to 1990), issue green bonds equivalent to 225 billion euros, and increase energy efficiency by 32.5%, with funds to be allocated to fields such as green infrastructure, electric vehicles, and CO2 capture. Starting with France's issuance of green sovereign bonds in 2017, countries like Belgium and Germany have followed suit.

Furthermore, ESG investment strategies by central banks are also progressing. The Riksbank (Sweden's central bank) has actively excluded Alberta provincial bonds from Canada and Queensland state bonds from Australia from its investment targets on the grounds that they emit greenhouse gases, and the Bank of France has excluded the bottom 20% of ESG scores. It is not hard to imagine that such proactive ESG investment is also used when supervisory authorities conduct stress tests to manage the loss risks of financial institutions.

Furthermore, new investment schemes contributing to the expansion of this market include KPI-linked bonds (bonds, loans) and transition bonds. The former are bonds (loans) where the use of proceeds is for general corporate purposes, but the coupon fluctuates depending on whether pre-determined KPIs (Key Performance Indicators) are achieved. The latter are bonds where the use of proceeds is tied to technologies or initiatives that enable energy transition, used by carbon-intensive companies to strategically demonstrate their commitment to a transition while maintaining economic activity. Better today than yesterday, better tomorrow than today. These can be called fundraising methods that make it possible to contribute to climate change and other issues even if a company belongs to a non-green sector. We can expect an overall raising of the floor.

Finally, I would like to point out three things necessary for the further development of the sustainable finance market.

First is appropriate guidance. It is necessary to set regulations and tax benefits appropriately. If regulations determine what percentage of assets should be held as ESG assets, the market will expand. Also, if tax benefits can be obtained for green bond investment, the scope of investment will broaden. For example, how about granting benefits such as exempting inheritance tax when green bonds held by the elderly are transferred to children or grandchildren? If this were done with local government green bonds, funds would remain in the regions continuously, killing two birds with one stone. Also, how about regulations that add penalties for not conducting ESG investment?

Second is how to make ESG scores usable as a basis for investment decisions. It is necessary for a standard practice to be established among users by using ESG scores to the same extent as credit ratings provided by rating agencies. Furthermore, companies that provide these ESG scores might need an official endorsement, similar to designated rating agencies.

Third, while disclosure in accordance with TCFD is becoming the trend, there is a need for templates to be developed. If disclosure can be made according to a template, it will save companies some effort. It will also make comparisons easier from the investor's perspective.

Funds are necessary for the grand goal of achieving carbon neutrality worldwide. For that reason, the expansion of the sustainable finance market is an urgent task. As we have seen, sustainable finance has the potential to transform the flow of funds through requests for disclosure to operating companies, the emergence of investment appeal for investors, and the active involvement of nations. In that sense, the issuance of green Japanese Government Bonds (JGBs) and the announcement of an investment stance by the Bank of Japan in line with green bond guidelines may also be necessary. Furthermore, efforts will be required to discover excellent stocks with ESG-related technologies among SMEs and regional companies, and to create funds collecting such entities to attract capital from around the world.

We are currently in a situation where it is not even clear when the post-COVID era will begin. Naturally, it is also difficult to map out that economic recovery. Since structural changes have been brought about through the pandemic, it would be impossible to accurately predict the situation 10 years from now.

That is precisely why we must not let the sustainable finance market slide backward. The world is currently far from achieving carbon neutrality by 2050, and a mountain of problems must be solved. For that reason, changes and support from the financial markets are indispensable.