The ESG-labelled bond market1 has experienced rapid growth over the past several years, with global labelled bond issuance having reached USD$3 trillion at the end of the first half of 2021.2 While Canada represents just ~2% of global labelled issuance,3 that volume more than doubled between 2019 and 2021, and a growing number of investors are looking to understand the evolving language, structure, and intent behind these instruments. This primer is meant to be an introductory document explaining this new and evolving landscape, as well as an opportunity to share our thoughts on the role labelled bonds may play within fixed income portfolios today and in the future.
Figure 1: Canadian labelled bond issuance
Source: RBC GAM, Bloomberg, as at March 31, 2022.
Similar to conventional fixed income securities, labelled bonds are typically senior unsecured instruments issued by entities for the purposes of funding projects or expenditures with ESG benefits or facilitating improvements to an issuer’s sustainability targets. Some of the reasons entities might wish to issue labelled bonds include to fund specific ESG-related projects, to improve or diversify their access to debt capital markets, and/or to attempt to secure a lower cost of funding. On the other hand, labelled issuance tends to come with higher reporting and administrative burdens for the issuers and, thus, may not always be the most optimal path to choose.
The market for ESG-labelled bonds can be broadly separated into two categories: use of proceeds (UOP) and key performance indicators (KPI) based.
Use of proceeds bonds:These instruments include green bonds, social bonds, and sustainability bonds, with projects funded in accordance with the issuer’s labelled bond framework. Proceeds must be tracked and allocated to specific spending, and allocations must be publicly reported (typically on an annual basis).
Green bonds fund projects or initiatives with an environmental benefit. Examples might include a waste reduction project or the development of a new solar field. Green bonds can be allocated to a specific asset or a number of eligible environmentally friendly expenditures. The first-ever green bond was a Climate Awareness Bond issued by the European Investment Bank in 2007; the following year, The World Bank issued the second.4 Meanwhile, the first Canadian entity to issue a green bond was Export Development Canada, which brought a USD$300 million security in January 2014. Later that year, TD Bank issued the first CAD-denominated corporate green bond and the Province of Ontario issued the first CAD-denominated government green bond.5 Today, the Canadian green bond market is $24 billion in size and growing rapidly.6
An example of a recently issued green bond is Allied Properties REIT’s $600 million 1.726% 2026 security, brought to market in February 2021. Approximately 79% of the proceeds were used toward green building projects, such as The Well in Toronto, and 21% went toward resource efficiency and management projects, such as lighting, heat recovery, and ventilation improvement in various buildings owned by the REIT.7
Social bonds fund projects or initiatives with a social benefit. Examples might include a project to reduce health-related issues in a particular community, or to fund education opportunities in low income neighbourhoods. The first social bond issued in Canada was a “Woman in Leadership Bond,” issued by CIBC in 2018, but overall we have seen very little dedicated social issuance in Canada.8
Sustainability bonds are becoming an increasingly popular option. Sustainability bonds allow proceeds to be used to fund green and/or social projects or initiatives, giving the issuer greater flexibility in its allocations. An example of a recent sustainability bond is the $500 million Bell Canada 2.2% 2028 security, issued in May 2021. 50% of the bond was allocated to green initiatives such as deployment of an energy efficient fiber network, and the other 50% was allocated to social initiatives such as improving wireline access to underserved communities.9
KPI-based bonds: These instruments include sustainabilitylinked bonds (SLBs) and sustainability-linked loans (SLLs). The instruments do not fund specific projects, and proceeds can be allocated to any corporate activity, including those that may be contributing to negative environmental outcomes. Instead, the issuer of these instruments makes a commitment to improve one or multiple ESG-related performance metrics. If the issuer does not meet its ESG targets, a coupon penalty or step-up will apply.
SLBs and SLLs are any type of bond or loan instrument for which the issuer makes a contractual promise to improve a predetermined ESG metric. Relative to UOP bonds, these instruments may be a better fit for carbon-intensive sectors, or issuers with limited spending that would qualify as making a positive contribution to ESG factors. Instead, the idea is for the issuing entity to set company-wide ESG improvement targets. If the issuer is unable to meet its commitments, the bond’s coupon would increase by a predefined step-up amount. The penalty should be large enough to serve as an incentive to meet the stated objectives. The first Canadian SLB was issued by Telus in 2021, along with a commitment to reduce its absolute Scope 1 and 2 greenhouse gas (GHG) emissions10 by 46% from 2019 levels by 2030. If Telus does not achieve these targets by December 31, 2030, the coupon on the bonds would increase by 100bps effective November 13, 2030, and would remain at this level until the bonds matured a year later on November 13, 2031.11