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Bonds with a Social, Environmental, or Governance Focus

Investing with a focus on a particular social, environmental, or governance (“ESG”) impact is all the rage right now. Investing with an ESG focus can be made through investing in equities or bonds. This article will focus on the latter.

Whether you’re an investor considering an ESG investment or a corporate CEO or a municipal entity manager considering a bond issue, what follows are a few basics to get you started…

For starters, bonds issued for social or environmental reasons come with a variety of labels and acronyms. Here are the most common:

  • Green bonds are bonds that focus on the “E” in ESG and are issued for a specific “green” project purpose. Green bond purposes include renewable energy production, energy efficiency, clean transportation, and waste management activities like recycling.
  • Social impact bonds are of course the “S” in ESG and are issued with a focus on social causes like workplace diversity.
  • Governance impact bonds tend to be a blend of green and social impact bonds and focus not only on environmental related projects but on an organization’s employment and workplace related structure.
  • Sustainability-linked bonds take ESG bonds a step further. They are bonds that can be issued for any purpose, including, but not limited to an ESG purpose, but require the bond issuer to meet specific targets such as cutting emissions or hiring more diverse executives. If targets are met, the bond issuer may enjoy lower borrowing costs such as a lower interest rate but if targets are not met, the bond issuer may be penalized with higher interest rates and/or fees.
  • Transition bonds are a subset of sustainability-linked bonds that feature interest rates or other cost adjustments depending on the bond issuer’s satisfaction of certain climate-related goals. These bonds are often issued by corporations that produce energy in some form and are attracted to potentially lower borrowing costs if climate-related metrics are achieved.

Bonds issued with an ESG focus are issued by for-profit corporations and municipal entities alike. For example, the Buffalo Sewer Authority recently closed a $49 million ESG focused bond issue, thought to be the largest tax-exempt municipal ESG bond issue to date (CUSIP 119732 AA3 to AS4). The proceeds of the bonds will be used for stormwater infrastructure improvements. The objectives of the bond issue, which include adding 200 new acres of impervious surface area, will be evaluated by an independent third-party to determine whether the Buffalo Sewer Authority qualifies for certain financial benefits.

The Buffalo Sewer Authority bond issue was influenced by corporate bond issues similarly focused on environmental impacts. For example, Enel SpA (ENEL (Italy: Milan)), the largest single bond issuer in the ESG corporate bond market, has issued over $8.2 billion of corporate bonds over a three-year period with lowering carbon emissions as the stated objective. Enel SpA intends to lower carbon emissions through increasing its renewable share of electricity-generating capacity and it will benefit by lower interest costs if it meets certain targets.

To date, ESG bonds have largely focused on energy related and infrastructure objectives. However, additional environmental objectives may be on the horizon such as reducing deforestation by lowering agricultural activities that cause deforestation. See, for example: ESG in Action: Protecting the Amazon by Investing in Brazilian Beef, Alliance Bernstein, October 21, 2020

Although there have been bond issuers and investors focused on ESG for years, during the last three years, inflows into ESG focused investments have significantly increased. And, investors are interested in return as much as they are interested in the non-financial aspects of their investment. Accordingly, investors and bond issuers alike will need to evaluate the financial and non-financial aspects of an ESG bond issuer prior to investing or issuing.

See also: The New Math of Socially Responsible Investing, Wall Street Journal June 27, 2021 and Market for Bonds Meant to Keep World Cool Heats Up, Wall Street Journal, July 6, 2021