The ultimate flex is to demand more of capital

Authored by Constance de Wavrin, Founder of In|Flow.

Three years ago was around the time I quit raising capital for traditional fixed income investment strategies, a trade I had engaged with for the best part of 25 years.

At the time, fixed income portfolio strategies sought to integrate Environmental, Social & Governance (ESG) risk factors alongside financial risk assessment as part of bond valuations and their overall investment process and portfolio construction for institutional clients. ESG integration was part of investment philosophies and overarching Corporate Social Responsibility (CSR) policies were hastily pulled together to demonstrate that the firm’s commitment ran deeper than portfolio level. Selecting ESG offerings emanating from asset management houses became a game of comparing apples and pears even for the savviest investors.

At the time this was standard and reasonably sufficient to be in keeping with investment consultants’ tentative additions to due diligence requirements. By then, they only started profiling SFDR art 6, 8 and 9 as the shades of commitment towards, well, some form of non-financial considerations outside delivering returns: 1. Adhoc ESG integration; 2. ESG Investment Objective or 3. Outright use of proceeds. Some understood that E, S & G constituted a risk to returns and therefore should become part of the overall credit risk management picture with direct implications on an investment house’s ability to aptly deliver on their fiduciary duty. 

This became the greyest area in portfolio management spheres. Institutional client preferences would most likely end up determining the “acceptable” level of return trade-off in favour of non-financial considerations to play a part. Who would bear the additional cost of fundamental ESG analysis and integration was still very much in the balance and could vary significantly from one investment house to another. To absorb or pass on to investors largely remains a consideration to this day.

Meanwhile, a cleaner, more direct use of proceeds in debt structures was taking shape and gaining momentum. Green bonds emerged in 2007 as a powerful financial tool for sovereign and private sector corporate issuers to raise finance for dedicated projects, assets and investments. Civil society and NGOs played an important role initiating standard-setting and the development of taxonomy-based usable criteria designed to protect the growth and credibility of the nascent green, blue, social, hybrid sustainable bonds, et al. While initially focused on promoting wind and solar as effective renewable use of proceeds, the work gradually became themed under risk mitigation, adaptation and resilience. This labelled debt market is now totalling usd 7trn worth of aligned issuance.

As financial markets would have it, increasingly more sophisticated credit structures fell into place - not without controversy - to reflect the transitory nature of the journey to net zero. KPI selection and target setting birthed - sometimes ambitious - bond issuances into capital markets, increasing the demands on issuers and investors alike to quantify, disclose, monitor and verify a wide variety of indicators ranging from decarbonising supply chains through to rebalancing social inequalities.

Developing Markets emerged as the most disproportionately and adversely impacted by climate change. Historically the backwaters of development finance, philanthropic and charitable foundations, the blending of public and private capital into structures emerged to profile and serve the risk-return-impact of a variety of investor segments from early stage venture capital through to the most conservative institutions. More recently, tighter spreads in Emerging Markets has meant that corporates in those regions suddenly find themselves under pressure to raise much more capital to fund the transition of their operations and supply chains within increasingly critical timeframes. Acting quickly can afford those in transitions more flexibility in markets where credit and liquidity conditions are vastly different from the deeper and more mature EUR and USD developed markets.

For green, transition-focused and social impact investors, the current rates and credit environment presents both opportunities and challenges. Tighter spreads and stable curves can support refinancing and new issuance which can contribute to advance corporate transitions and turn around the enterprise ecosystem that is part of corporate supply chains. However, they may also mask underlying climate risks if credit pricing fails to differentiate between high- and low-alignment sovereign and corporate issuers.