Letter number 134 of December 2020
- QUESTIONS & COMMENTS
Growth of green and sustainable finance continues to be exponential. September and November saw the development of an (almost) totally new product: green or responsible bonds whose remuneration is indexed to the ESG performance of their issuers, known as sustainability-linked bonds (SLBs).
Our most discerning readers will recall that we first saw a transaction of this type as early as September 2019. The Italian energy company Enel issued a 5-year bond, the coupon of which will increase by 25 basis points (0.25%) if Enel does not reach 55% of its production capacity in renewable electricity within two years. However, this transaction, although welcomed by the market, remained isolated, suggesting that the product had not yet made its mark among investors, unlike issuers who were very keen to use this type of instrument. This type of financial product, the remuneration of which is (marginally) indexed to the ESG performance of the issuer, has become quite common on the banking market. Loans indexed to ESG ratings or targets have been in existence since 2016. For large European companies, it is now commonplace, if not essential, for RCF renewals to include this component (Shell, Pearson, Philips, Danone, Iberdrola, Generali, Gecina, EDF, Edenred, etc.). This trend is now spreading to Asia (Wilmar, Olam), and even to the United States (CMS Energy, Avangrid, JetBlue).
Are banks more advanced than bond investors in their ESG considerations? We don't think so. On the other hand, they are closer to their clients and are able to accept the ESG objectives that the company imposes on itself more naturally.
The bond market has historically chosen a different path by requesting that funds raised by the company be earmarked for environmental investments (green bonds) or responsible/sustainable investments (sustainable bonds).
This practice has the merit of simplicity: investors can be sure that they are financing ESG investments. But it also has its drawbacks:
- companies with low investments cannot issue this type of product, even if their ESG policy is pro-active. The market was thus largely reserved for utilities, industrial and real estate groups;
- the issuer's green or sustainable investments would certainly have been made whether or not they were financed by green/sustainable bonds. Accordingly, investors are not necessarily contributing to a more ESG-friendly policy of the company;
- even if the general ESG policy of the company were to be considered by investors in these products (a company with little ESG scrutiny would not be able to issue a green bond), the instrument itself is not linked to this general company policy, but to one (or more) specific project(s);
- finally, these bonds require additional work from the finance and ESG teams to monitor, document and report on the investments made. This extra work is added to the job of monitoring the overall ESG objectives that the company sets for itself and communicates to the market. While initial buy-in enables teams to get on board and align their objectives, monitoring over time, with contact people changing internally and newcomers who see only the extra work without having had the benefit of the initial communication, is sometimes problematic.
Enel, which prior to its September 2019 bond had already issued three green bonds, launched this new bond with funds raised earmarked for financing general corporate needs, as is the case with most bond issues. The ESG character is guaranteed by a financial penalty (an interest rate penalty) for failure to achieve a clear and measurable ESG objective.
In September and October 2020, five groups came onto the market to issue this same type of bond: the luxury group Chanel, the pharmaceutical group Novartis, the Brazilian papermaker Suzano, Enel again and, most recently, the American electricity producer and distributor NRG Energy. This appears to be an actual market development (and not an isolated attempt as Enel's first issue may have been).
These issues have the merit of aligning financial products with the company's overall ESG strategy. The criteria for margin increase are selected from the company's broader ESG objectives. This makes the company's communication in this area more understandable to investors. The criterion is simple: to reflect only part of the company's ESG policy (CO2 emissions and the share of renewables for Enel, CO2 emissions for Suzano, the proportion of low-income patients for certain therapies for Novartis, greenhouse gas emissions and the use of electricity produced from renewables for Chanel, greenhouse gas emissions for NRG). Qualitative or more complex to measure targets cannot be captured, but that doesn't matter.
The targets offered to bond investors can also be aligned with those offered to banks for the green or sustainable loans that the company takes out.
The diversity of sectors is encouraging. It shows that this type of product is aimed at all companies and not just those with major investments to make. For example, while Enel and Suzano had issued green bonds in the past, neither Chanel nor Novartis had done so. The geographical diversity of the issuers (Italy, France, Brazil, Switzerland and, most recently, the United States) is noteworthy. Finally, the diversity of ratings is also noteworthy: AA-/A1 for Novartis, BBB+/Baa2 for Enel, BBB-/Ba1 for Suzano, BB+/Ba1 for NRG, Chanel being unrated, the full range (excluding pure high yield)!
Some may regret that the bond spread is only adjusted in one direction: upwards if the ESG targets set are not achieved (which is the case for bank loans indexed to ESG performance). On the face of it therefore, it would always be the company that would potentially lose. Would bond investors demand ESG without wanting to pay? This would be a reality if the issue were initially made on the same terms as a standard issue. However, it can be seen that the company benefits from advantageous conditions at the time of issue. Some bonds are even issued with a negative issue premium, whereas depending on market conditions these are generally between 5 and 20 basis points.
Note that the market seems to be moving away from the idea of indexing a financial product to an ESG rating (determined by a specialised agency such as Vigeo Eiris, Sustainalytics, for example). This option had been used for certain bank loans with an ESG label. It is true that these ratings are often black boxes for companies that do not have a clear understanding of the methodology applied by the agencies and how it may evolve in the future. Even if these agencies are respectable and serious, companies prefer to tie themselves to criteria that they have set and over which they have some influence (which does not mean that the objectives are easy to achieve, of course). We certainly understand them!
We therefore believe that this is a major development in the market, opening up ESG products to a much wider world than has been the case up to now.
The approach even seems to be spreading to other products: in mid-November Schneider issued a sustainable convertible bond with the same principle of indexing remuneration to ESG objectives.
Long live sustainability-linked bonds, alias SLBs!
We were already talking to you in May 2008 about the SPACs, these listed vehicles, which have no initial activity and have no other purpose than to complete an acquisition, thus allowing a company to go public without going through the classic and more cumbersome procedure in the United States of listing on the stock exchange. As reported in the September 2018 Vernimmen.net Newsletter, this SPAC structure has continued to flourish, mainly in the United States. It is even a euphoria in 2020 with more than 125 new vehicles with a firepower of nearly $50bn, and the year is not over...
This craze remains mainly American. There are a few examples in Europe and a few projects. The SPAC is therefore a vehicle that goes public to find funds on the stock market, based solely on the credibility of its management likely to make an acquisition and manage it.
There is more or less the same concept in the private equity field, namely the search fund. An investment fund identifies a top manager seeking to take over a company. The fund gives him/her the financial means and time (one to two years) to find the right target. The fund then finances the acquisition and the manager invests alongside the fund. This type of transaction is implemented for small transactions (€10 to €50 million); it facilitates the takeover of a company whose shareholder-manager has no natural successor. It is therefore a kind of private SPAC... Search funds have existed since the 1980s on the other side of the Atlantic, and are now making their appearance in Europe.
We have a friend who applies this principle to make start-ups blossom: he identifies entrepreneurs he considers talented, then works with them on the idea of the project in a second phase. So the concept also exists in venture capital (even if it is less formalized to our knowledge).
With the collaboration of Simon Gueguen, lecturer-researcher at CY Cergy Paris University
The scorching summer we have experienced has shown once again that attention paid to global warming is largely dependent on actual experience. Reports on this phenomenon have multiplied, on television and in the written press. Conversely, in 2017, US President Donald Trump joked about a particularly cold New Year on the US east coast, almost as if it denying the need to fight global warming. The confusion between local temperature and general climate change is in fact the manifestation of a bias that is well known to economists: individuals tend to give more importance to a phenomenon observed locally than to long-term global trends that are more difficult to understand. The article we present this month shows that this bias can be observed even in the behaviour of retail investors, and can even influence stock prices.
Choi et al proceed in two stages. First, they show that people are more concerned about global warming when they notice abnormally high temperatures in their region of residence. Then, they study the consequences of this concern on their transactions on the equity markets.
The data used covers 74 large cities around the world, each corresponding to a large financial centre. The aim is to be able to make the link between the attention paid to global warming and the stock market performance of companies in the local financial centre. The first series of tests examines the volume of searches carried out on the Internet (using Google) on the topic of global warming. The authors find that the number of searches on this topic is much higher when the local temperature is high. They use the fact that temperature peaks do not occur everywhere at the same time to show that there are many more searches on this topic at the time of the local peak. This is a clear manifestation of the bias: local experience of heat induces greater attention to the global phenomenon
On the financial side, the Choi et al ranked companies according to their levels of greenhouse gas emissions. Companies with a high emission rate are assumed to suffer from global warming, because the latter can lead to the implementation of more restrictive regulations for them, to an increase in their production costs, and possibly to financing difficulties (as the environmental criterion tends to develop among investors). They therefore created a long-short portfolio for each city (corresponding to a financial centre): buyer of GHG emitting companies (long), seller of clean companies (short). They then studied the performance of the portfolio according to temperature variations.
As expected, the profitability of this portfolio dropped during heat peaks. This means that GHG emitting companies tend, at this time, to underperform the clean companies. Economically, the effect is not negligible. When the temperature rises from the first to the last quintile, the portfolio thus constructed sees its profitability lose about half a percentage point. The measured effect covers all of the cities observed and takes into account various factors that may influence relative performance (in particular, the size of the companies).
Finally, the Choi et al study the source of this performance gap. To do so, they distinguish between institutional investors, large local investors, and retail investors. The results of this part of the study are particularly interesting. Only retail investors tend to buy clean companies and sell GHG emitters during heat peaks. Institutional investors are insensitive to the phenomenon. As for large local investors, they even tend to trade in the opposite direction, perhaps to take advantage of the behavioural bias of retail investors.
To be clear, the article absolutely does not say that retail investors are wrong to be concerned about global warming. On the contrary, Choi et al insist on the fact that consensus on this subject is much more massive among the scientific community than among the population, and they regret that the risks associated with this phenomenon are still too often underestimated. Simply, the behaviour of individuals at the time of heat peaks (Internet searches, investment in clean businesses) is a sign of a form of irrationality that tends to favour the immediate local experience, while global warming is a long-term global phenomenon.
 D. Choi, Z. Gao et W. Jiang (2020), "Attention to global warming" Review of Financial Studies, vol.33-3, pages 1112-1145.
If taxing was the only solution to problems, most countries where taxes are at or near all-time high would have solved them all a long time ago! Let's stop thinking that taxing is the only way to influence behaviour.
At least three reasons make us think it's a bad idea.
Can we imagine a system more contrary to its objective? How do we believe that manufacturers and operators of wind, solar or biomass power plants (including groups such as Orsted, NEOEN, but also mid-sized companies such as Voltalia) finance themselves, if not - at least in part - through regular capital increases? However, investors in these "green" companies find the necessary funds by reinvesting dividends from other companies. Taxing dividends thus reduces the flow of capital and reduces the funds available to investors to finance the green transition.
Furthermore, it is absurd to discourage citizens from investing in corporate capital at a time when it is clear that a number of companies will need more equity capital to deal with the consequences of the current pandemia.
Finally, it should be recalled that France and Belgium were condemned in 2017 by the European Court of Justice for their dividend taxes introduced in 2012 and 2013, which were found to be contrary to European law. However, in the French case, these taxes brought in just over €2 billion per year.
The urgency of the energy transition and the scale of the investments required require other measures than the expedients worthy of the 18th century. If we want to change the tax system in favour of the energy transition, let's take away the tax benefits given to savings that are not invested in favour of the environment. As an illustration, in France, around €1,400 billion are invested in life insurance contracts with special tax breaks, and most of this money is used to buy government bonds.
Even if the elimination of this tax niche would only result in a redirection of 10% of the funds invested in this way towards green bonds, €140 billion would be channelled towards the energy transition. That's 70 times more than the last dividend tax... Not to mention what the government would save in tax benefits, which would now be eliminated in favour of investments that do not favour the energy transition. And there's every reason to bet that the reorientation would be well over 10%, given the essentially tax interest of life insurance contracts.
Regularly on the Vernimmen.com Facebook page we publish comments on financial news that we deem to be of interest, publish a question and its answer or quote of financial interest.
Here are the last ten quotes that we have added to our database as we read and that will appear on these pages in 2021 and beyond. And we suggest that you try to find their authors, so that you don't leave your brains idle those days.
Answers are given after the next paragraph.