TWN Info Service on Biodiversity and Traditional Knowledge (Dec23/05)
19 December 2023
Third World Network

Dear friends and colleagues,

Caution sounded over sovereign ESG bonds in the Global South

Public and private entities – particularly in Europe and the US – have increasingly embraced environmental, social and governance (ESG) criteria as financial risk benchmarks. In the past five years, at least 22 countries in the Global South have issued sovereign ESG bonds, raising over US$60 billion. These include so-called ‘green’ and ‘social bonds’ and derivatives, including ‘sustainability-linked bonds’ and ‘blue bonds’. Sovereign ESG bonds have been largely concentrated among middle and high-income countries.

A new report from the European Network on Debt and Development (Eurodad) highlights key risks for low-income countries to use ESG as a way to close the ‘financing gap’ for Sustainable Development Goals and climate/biodiversity action.

For starters, the ESG industry operates according to voluntary guidelines and principles. The voluntary nature of ESG bond labelling means that any issuer can declare their bonds, ‘ESG’. Unclear definitions, together with rising pressure to meet demand, is resulting in misleadingly packaged products. Moreover, companies typically charge higher fees for ESG-related services, creating questionable incentives linked to sustainable financing.

Another claim made for ESG bonds is that they provide issuers with preferential and cheaper access to capital, which is referred to as a ‘greenium’. However, evidence for this is weak. Generally, Global South countries can expect to pay interest rates on ESG-themed bonds similar to those paid for other non-themed bonds. Interest rates are, therefore, largely dependent on international credit ratings. This makes ESG bonds expensive debt for the least developed countries and Small Island Developing States (SIDS).

ESG bonds are often referred to as ‘sustainable debt’. However, sovereign borrowing through ESG bonds is usually raised in foreign currency and close to, if not at, commercial lending rates. Inevitably, the expansion of the ESG markets in the Global South will come with risks of worsening the debt vulnerabilities in these countries.

In addition, and given the extent of greenwashing, there is also the risk that the use of proceeds does not result in the promised ‘sustainable growth’, limiting the possibilities that governments can increase revenue and, therefore, pay back investors without incurring spending cuts. For many countries, their precarious economic situation and high levels of debt distress mean that further borrowing from international capital markets is increasingly difficult.

The report concludes that ESG bonds are yet another debt instrument that will build on the already unsustainable debt levels of most Global South countries, resulting in the transfer of wealth from the South to rentiers concentrated in the North.

With best wishes,

Third World Network

Sovereign ESG bonds in the global south: 10 questions for those concerned about debt and climate justice
European Network on Debt and Development, December 2023
https://www.eurodad.org/sovereign_esg_bonds_in_the_global_south

Executive summary

The past few years have seen a surge in interest in ethically labelled bonds for southern countries. This includes so-called ‘green’ and ‘social bonds’ and derivatives, including ‘sustainability-linked bonds’ and ‘blue bonds’, now being heavily promoted for small island developing states (SIDS). In the past five years, at least 22 countries in the global south have issued sovereign environmental, social and governance (ESG) bonds, raising well over US$60 billion. Most international organisations view this as a positive development, and the expansion of ESG bonds is now a common recommendation made in international meetings and agreements on climate and biodiversity.

This report, therefore, offers a succinct introduction to sovereign ESG bonds and explores some of the limitations and risks around the push for ESG financing as a way for global south countries to close the financing gap for Sustainable Development Goals (SDGs) and climate action. It is organised into 10 basic questions. The answers to these demonstrate not only the complexity of the ESG bond market but also point to several problems with its expansion. Indeed, the enthusiasm for ESG bonds reflects a highly questionable ideology that promotes private finance as the optimal solution to our multiple global crises.

This paper aims to serve as a basis for further discussions, particularly within civil society, in order to be able to define a well-informed and strategic position. Ultimately, the paper will help Eurodad, civil society allies and policymakers define future actions towards mainstream narratives and public support for expanding ESG financing for global south countries.

Rapid evolution of ESG sovereign bonds
The growing market in green bonds, first issued in 2007/8, has inspired various ‘ethically’ labelled bonds, such as gender, blue and SDG bonds. Recent innovations in the so-called environmental, social and governance (ESG) bond market include bonds where investors are given higher rates of return if issuers fail to meet key performance indicators, commonly called ‘sustainability-linked bonds’. ESG bonds do not have an agreed formal and functional definition.

Inadequate voluntary guidelines for ESG bonds
International regulations for ESG bonds are based on voluntary guidelines and principles, with those provided by the International Capital Markets Association (ICMA) being the most influential. However, the inadequacies of these have motivated the European Union to develop an EU Green Bond Standard, although it is unlikely governments outside the EU will use this. The voluntary nature of ESG bond labelling means that any issuer can declare their bonds ESG-labelled. However, for most ESG bonds, an external evaluator is employed. Companies that offer these evaluations provide differing methodologies and grading systems, and these have been subject to multiple revisions. Traditional credit rating agencies headquartered in the US have also taken over the businesses of rating and evaluating ESG bonds.

ESG sovereign bonds trends in the global south
Over the past five years, while sovereign ESG bonds have become more prevalent in the global south, few lower-income countries have entered the market. This likely reflects the increasing difficulties such countries face in borrowing from international capital markets due to their deteriorating financial situations and poor credit ratings. Most ESG bonds issued by developing countries have been classified as social or sustainability bonds. Most have been issued in foreign currencies and are targeted at foreign investors.

Donor strategies to advance ESG bonds
The expansion of sovereign ESG bonds for global south countries, particularly for SIDS, is now high on the agenda of international development organisations, including the World Bank, the United Nations and the European Union, and most bilateral donors. Collectively, they provide various forms of financial and technical assistance to southern governments to issue ESG bonds, making these financial instruments an emerging area for blended aid and public–private partnerships (PPPs). A range of mechanisms are being used by international financial institutions (IFIs) to ‘de-risk’ ESG bonds for developing countries and crowd-in investors, including credit guarantees, technical support, provision of direct subsidies, cost coverage of issuing ESG bonds, design of bankable projects and the provision of independent analysis, as well as verification reports on projects for investors.

The rise of sustainability-linked bonds
While issuing traditional ‘use of proceeds’ sovereign ESG bonds has not taken off in global south countries, sustainability-linked bonds (SLBs) are gaining more interest, being viewed as more appropriate for lower-income countries. Unlike the use-of-proceeds bonds, capital raised through SLBs does not need to be ringfenced for ESG spending and can be used for refinancing existing debt. SLBs also offer a way to address the lack of investor confidence in the ability of governments to deliver on ESG promises, as they come with clearly defined and measured key performance indicators and financial penalties for non-delivery.

The missing ‘greenium’ in sovereign ESG bonds
A claim made for ESG bonds is that they can provide issuers with preferential and cheaper access to capital, which is referred to as a ‘greenium’. However, evidence for this is weak. Generally, southern countries can expect to pay interest rates on ESG-themed bonds similar to those they pay for other non-themed bonds. Interest rates are, therefore, largely dependent on international credit ratings. This makes ESG bonds expensive debt for the least developed countries and SIDS. There appears to be limited international attention to the risks for developing countries in raising unsustainable debt levels through these instruments. Another concern is that ESG bonds can also come with unique costs that can add up, thereby negating the greenium, if it exists. This includes the expense of establishing reporting processes required by investors.

Greenwashing: a major issue in ESG bonds
ESG bonds are widely discredited because of greenwashing. Accountability mechanisms, including external evaluations and impact reports, offer limited assurances. ESG bonds that link dividends to the delivery of specific environmental or social targets are considered by some to address greenwashing. However, these performance-based bonds have their weaknesses and are unlikely to be effective. It is also morally dubious to reward investors for the failures of southern countries to meet environmental or social targets.

A (failed) transparency claim
In theory, ESG bonds are better than normal sovereign Eurobonds regarding transparency. However, public access to information on ESG bonds and the use of resulting proceeds is limited. Public participation in deciding the purpose of ESG bonds – including among those most affected by them – is absent from international guidelines and is overlooked by international development organisations.

ESG bonds as fuel to the debt fire
ESG bonds are often referred to as ‘sustainable debt’. However, sovereign borrowing through ESG bonds is usually raised in foreign currency and close to, if not at, commercial lending rates. Inevitably, the expansion of the ESG markets in the global south will come with risks of worsening the debt vulnerabilities in these countries. In addition, and given the extent of the greenwashing problem, there is also the risk that the use of proceeds does not result in the promised ‘sustainable growth’, limiting the possibilities that governments can increase revenue and, therefore, pay back investors without incurring public spending cuts.

ESG bonds as a magic wand for the ‘financing gap’
Sovereign ESG bonds can be understood as the cause and effect of a superficial narrative that equates social and environmental problems with a lack of finance. This falsely equates things such as biodiversity loss and unsustainable natural resource management with poverty in southern countries, as opposed to affluence and the behaviours of external organisations and global finance. A considerable risk of ESG bonds, therefore, is to divert attention from the cultural and political changes needed to achieve a more sustainable and just society. At the same time, they may also operate as a convenient distraction for policies urgently needed to tackle the unjust and unsustainable transfer of wealth from the south to the north.