The rise of environmental, social, and governance (ESG) risk factors and green bonds in public finance has produced growing pains regarding labeling and misconceptions about ESG investor motivations. Understanding the current situation’s nuance is crucial for avoiding the pitfalls of blanket regulation and accommodating market demand

Greer, Robert A.

Nelson, Noel

Texas A&amp;M Repository

ESG and Green Bonds in Public Finance NOEL NELSON & ROBERT A. GREER, PHD Texas A&M University VOLUME 14 | ISSUE 10 | OCTOBER 2023 https://bush.tamu.edu/mosbacher/takeaway The Takeaway © Mosbacher Institute The rise of environmental, social, and governance (ESG) risk factors and green bonds in public finance has produced growing pains regarding labeling and misconceptions about ESG investor motivations. Understanding the current situation’s nuance is crucial for avoiding the pitfalls of blanket regulation and accommodating market demand. WHAT IS ESG? ESG is an acronym for environmental, social, and governance, which are non-traditional factors that are increasingly relevant in financial analysis. Federal regulation of ESG metrics does not currently exist, including disclosure, qualification, and labeling. Future regulation remains politically uncertain. In the absence of regulation, non-profits and international agencies have re-leased a multitude of standards, qualifications, and frame-works that attempt to provide market standardization. To date, however, no single standard has been universally adopted. WHAT’S THE TAKEAWAY? ESG assets under management have grown, particularly those with environmental components. Political attention to the term ESG may overlook distinctions between climate risks and sustainability goals. Green bond issuance is growing in both public and private financial sectors, yet label requirements are unstandardized. Green bonds have a modest pricing advantage in the municipal market that is more evident in the secondary market and influenced by external verification of the label. 2 The mobilization of using finance to bring about change has expanded from national catastrophes to routine investment practices in the era of ESG. ESG can be considered an outgrowth of the con-cepts of sustainable investing and socially respon-sible investing, which aim to create a more holis-tic financial analysis process. It has also grown to become an umbrella term for additional environ-mental and social risk factors. The term ESG first appeared in a 2004 United Nations report,1 but the practice of socially responsible investing can be seen as early as the 1980s.  The environmental component of ESG is currently the most prevalent factor due to its perceived ur-gency and the value of assets at risk. Increasing demand by corporations and individuals to com-bat climate change with investing practices has led to the creation of ESG equity funds and green bonds to direct capital towards mitigation efforts. Green bonds are fixed-income debt instruments where proceeds are dedicated to projects that have a positive environmental impact.  THE PREVALENCE OF ESG ESG-related finance has grown drastically in re-cent years. As shown in Figure 1, the Sustainable Investment Forum estimates that total U.S. ESG related assets under management reached $7.6 trillion in 2022, up from $2.51 trillion in 2010.2  The increasing market demand for ESG invest-ments resulted in notable efforts by credit rating agencies to produce this accompanying data. The “big three” credit rating agencies, S&P, Moody’s, and Fitch, as well as dozens of smaller competi-tors all currently produce ESG data. The interest by for-profit credit rating agencies to provide ESG data indicates a sustained market demand for the information by investors. As ESG has gained prevalence in financial mar-kets, two categories of investors have emerged. The first are driven by ethical considerations to advance sustainable investing. The second are investors who include ESG data in their risk anal-ysis process, such as evaluating a city’s chances of flooding before purchasing a municipal bond.  The growth of ESG investing is accompanied by increasing politicization of the term and disagree-ments on how non-financial factors are priori-tized. Several states have passed legislation to limit the consideration of ESG factors in state and local government financial decision-making. By over-politicizing ESG, useful risk mitigation data may be ignored. ESG REGULATION ESG regulation varies by country. The United States has no federal ESG regulation, although the Security and Exchange Commission (SEC) asked for public input on climate disclosures in 2021.3 The European Union has adopted the Sustainable Finance Disclosure Regulation,4 which requires financial market participants to disclose how sus-tainability information is used in their investment procedures through enhanced product labeling. Climate-related disclosure is generally voluntary with few mandatory regulations in place. The lack of regulation of ESG-focused financial products, including green bonds, is due to disa-greements on what information and metrics dis-Nelson & Greer | ESG and Green Bonds in Public Finance | Volume 14 | Issue 10 | October 2023 Source: US SIF Trends Reports, 2010-2022  Figure 1: U.S. ESG Assets Under Management ($Tn) closures should include, reporting complexity, and political opposition.  ESG IN PUBLIC FIXED INCOME Public fixed income refers to debt issued by gov-ernments in the form of bonds. Green bonds are the most prevalent ESG investment vehicle for the fixed-income market. Governments and corpora-tions are the two primary issuers of green bonds. Municipal bonds are issued by state and local gov-ernments to fund public infrastructure. Many are tax-exempt. Due to the public nature of these pro-jects, they often align with ESG goals. Their infra-structure focus may also make ESG bond designa-tions easily attainable for municipal issuers. Global green bond issuance for public debt has steadily increased over the previous five years (see Figure 2), peaking at $187.1 Bn in 2021. De-spite that increase, private green bond issuance currently has a larger market share. While still less prominent, Social Bonds, Sustainability Bonds, and Sustainability-Linked Bonds have also grown in the fixed income market.  GREEN BOND REQUIREMENTS To address the increasing issuance of green bonds, two internationally recognized labeling standards have emerged in the fixed income mar-ket.6 The first is the more stringent Climate Bond Standards (CBS),7 which require third party veri-fication of compliance by an approved vendor. The second labeling standard is the self-certified Green Bond Principles (GBP).8 Although CBS and GBP are the primary labeling standards, other standards exist, increasing market confusion around the labeling of green bonds. The existence of different standards also adds to the challenge of regulating the green bonds market. RISKS AND REWARDS OF GREEN BONDS One motivation for debt issuers to pursue a green label is to receive a speculative asset pricing ad-vantage in the form of a lower interest rate. This phenomenon, known as a green bond premium or greenium, is the difference between the green bond’s yield and the yield on an equivalent non-green bond. The increased information disclosure of green bonds minimizes investment risks relat-ed to ESG factors. The reduced risk creates a safer investment, which may lower the yield investors require for their capital.  Current academic research shows mixed results on the existence of greeniums as well as the varia-bles that influence their prevalence. The majority of studies find that, on average, the expected green bond premium is positive and statistically significant.9 Additionally, green bonds that re-ceive third party labeling verification10 and trade in the secondary market11, 12 generally experience higher premiums.  The political attention given to ESG policies has impacted state pension systems and municipal bond investors. One study estimated that local governments in Texas will pay an additional $303 to $532 million in interest on $32 billion in bor-rowing during the first eight months following the passage of one restrictive Texas law.13  The appeal of a greenium has introduced the risk of “greenwashing” where bonds will falsely claim 3 Nelson & Greer | ESG and Green Bonds in Public Finance | Volume 14 | Issue 10 | October 2023 Source: Climate Bond Initiative5  Figure 2: Global Public Green Bonds Issued ($Bn)  Published by: Mosbacher Institute for Trade, Economics, and Public Policy  The Bush School of Government and Public Service 4220 TAMU, Texas A&M University College Station, Texas 77843-4220 Email: bushschoolmosbacher@tamu.edu Website: https://bush.tamu.edu/mosbacher The views expressed here are those of the author(s) and not necessarily those of the Mosbacher Institute, a center for independent, nonpartisan academic and policy research, nor of the Bush School of Government and Public Service.  To share your thoughts on The Takeaway, please visit http://bit.ly/1ABajdH  to be green in order to get an interest rate ad-vantage. The prevalence of greenwashing in the bond market is difficult to quantify, but its exist-ence is generally accepted.14 Studies have shown that receiving external verification of labels re-duces the chances of greenwashing for bonds.15 The reputational risk to issuers accused of green-washing further disincentivizes this practice. SUSTAINABLE INVESTING AND ESG AS A RISK MITIGATION TOOL  Investors are attracted to the ESG market for dif-ferent reasons. Some recognize market and demo-graphic trends and try to incorporate these trends into financial products to attract investments. Others value the risk-mitigation information dis-closed in ESG investments, as a way to incorpo-rate transition risk into their investment process. Still other investors are attracted to the ESG mar-ket for altruistic motivations related to responsi-ble investing and climate change. The green bond label provides a mechanism to signal to these in-vestors, but it is an imprecise signal. Similarly, the anti-ESG policies enacted in some states contrib-ute additional uncertainty to this market. The reality of unique investor motivations should inform the creation of future regulation and pub-lic perception of ESG. Blanket regulation that treats all ESG investors the same is likely to re-ceive pushback from the wide range of stakehold-ers. The continued standardization of voluntary investment in ESG will help advance market ac-ceptance of this new dimension of finance.  4 Nelson & Greer | ESG and Green Bonds in Public Finance | Volume 14 | Issue 10 | October 2023 Noel Nelson is a financial analyst at USAA in the Chief Investment Office. He earned Master of Financial Management and Bachelor of Business Administration degrees from Texas A&M’s Mays Business School.  Robert A. Greer is an associate professor in the Bush School of Government & Public Service at Texas A&M University and a Mosbacher Research Fellow.   Notes: 1 (2004) Who Cares Wins. rep. United Nations and Swiss Federal Dept of Foreign Affairs. 2 2010-2022, US SIF Trends Reports. US SIF: Sustainable Investment Forum. The US SIF modified their data collection methodology in 2022, requiring more granular information for inclusion in the data set, which could contribute to that year’s steep decline in ESG assets under management.  3 Public Input Welcomed on Climate Change Disclosures. SEC. (2021, March). https://www.sec.gov/news/public-statement/lee-climate-change-disclosures 4 Sustainability-related disclosures in the financial services sector. EUR. (n.d.). https://eur-lex.europa.eu/legal-content/EN/LSU/?uri=CELEX%3A32019R2088 5 Climate Bonds Initiative (2022). Interactive Data Platform. https://www.climatebonds.net/market/data/  Accessed 10/12/2023. 6 Making an impact: ESG investing and municipal bonds, Municipal Securities Rulemaking Board. https://www.msrb.org/Making-Impact-ESG-Investing-and-Municipal-Bonds  7 Climate bonds standard and certification scheme (2020). Climate Bonds Initiative. https://www.climatebonds.net/standard  8 Green Bond Principles (GBP) International Capital Market Association (ICMA). https://www.icmagroup.org/sustainable-finance/the-principles-guidelines-and-handbooks/green-bond-principles-gbp/  9 Dorfleitner, G., Utz, S. & Zhang, R. (2022). The pricing of green bonds: External reviews and the shades of green. Review of Managerial Science, 16(3), 797–834. https://doi.org/10.1007/s11846-021-00458-9 10 Ibid. 11 Partridge, C. & Medda, F.R. (2020). The evolution of pricing performance of green municipal bonds. Journal of Sustainable Finance & Investment, 10(1), 44-64. https://doi.org/10.1080/20430795.2019.1661187  12 MacAskill, S., Roca, E., Liu, B., Stewart, R. & Sahin, O. (2021). Is there a green premium in the green bond market? Systematic literature review revealing premium determinants. Journal of Cleaner Production, 280(2), 124491. https://doi.org/10.1016/j.jclepro.2020.124491  13 Garrett, D. & Ivanov, I. (2022). Gas, guns, and governments: Financial costs of anti-ESG policies. SSRN 4123366. 14 Yu, E.P.Y., Van Luu, B. & Chen, C.H. (2020). Greenwashing in environmental, social and governance disclosures. Research in International Business and Finance, 52, 101192. https://doi.org/10.1016/j.ribaf.2020.101192  15 Yeow, K.E. & Ng, S.H. (2021). The impact of green bonds on corporate environmental and financial performance. Managerial Finance, 47(10), 1486-1510. https://doi.org/10.1108/MF-09-2020-0481  

ESG and Green Bonds in Public Finance

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ESG and Green Bonds in Public Finance

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