Sustainability in the Capital Markets is Here to Stay
Sustainability in the Capital Markets is Here to Stay

Tackling climate change is a race against time – and companies worldwide are accelerating their shift to sustainability to take advantage of key changes unravelling in the capital markets.


Green and sustainable finance has moved from being a niche play to taking pole position in the global economic race over the past decade. It has been transformed from a nice-to-have agenda item to an urgent discussion in the global capital markets.


As the pace of growth for sustainable finance and impact investing continues to speed up, green and sustainability-linked bonds have gained significant traction among businesses seeking to capitalise on their long-term sustainability performance. 


Forecasts say sustainable bonds are expected to hit US$650 million in 2021.
Sources: Moody’s Investors Service, Climate Bonds Initiative and Dealogic

Transitioning to a more sustainable economy requires huge amounts of investment. According to recent research by Moody’s, the global issuance of sustainable bonds hit record volumes in 2020 with US$491 billion issued. Continued momentum is expected with a forecasted new high of US$650 billion in 2021 – comprising approximately US$375 billion of green bonds, US$150 billion of social bonds, and US$125 billion of sustainability bonds. 


So how do we define these bonds? Green and social bonds are bonds where the proceeds will be exclusively applied to finance or refinance environmental projects and social projects, while sustainability bonds refer to bonds which finance or refinance a combination of environmental and social projects. 


As companies and governments map out their net-zero commitments, transition bonds, which are typically used to fund a firm’s transition to a lower environmental impact, are also emerging as a popular solution to finance carbon-reduction projects.


Raising capital from the debt market for sustainable or transition projects will require companies to gauge the confidence of financiers by communicating their ESG propositions effectively. 


Here are some insights on how ESG disclosures steer a company’s cost of capital:


Building a winning machine

There is a lack of hard evidence about the causal link between the level of ESG disclosures and a company’s cost of capital.


This may be because of the highly variable factors involved, including the social responsibility values, economic system, financial transparency, and sustainability of the jurisdictions in which investors and businesses operate. Prevailing company and industry resources, and potential data lags in many ESG data sets may also make them difficult to quantify using traditional investment criteria.


However, numerous studies do show a positive correlation between a company’s ESG performance and its financial performance. They suggest companies that fall behind in integrating ESG considerations into their business strategy put their long-term competitiveness at risk, while companies that fail to communicate their ESG propositions and performance risk losing opportunities to attract long-term investors. 


Moving into a larger pool of investment funds can drive greater buying pressure and higher valuation metrics. Financial institutions are increasingly defining the universe of stocks for investment by banking on negative and best-in-class screening techniques to identify leaders, improvers, and laggards in ESG strategy. 


As quality of disclosures may have growing implications for a company’s ability to capture a lower cost of capital and larger fund allocations with reduced demanded rates of return, demand for transparency and comparability is also rising to understand potential risks and uncertainties associated with future investment flows.  


The ESG scores of the MSCI All Country World Index stocks with market capitalisation of US$10 to 20 billion are compared against the cost of capital of these companies from 2015 to 2020.
Source: Bloomberg

From the monthly average data of the MSCI All Country World Index stocks with market capitalisation of US$10-20 billion from January 2015 to December 2020, the average cost of capital for the highest-ESG-rated quintile was 7.44% compared with 9.59% for the lowest-ESG-rated quintile. 


Considering how higher-ESG-rated companies are generally less exposed to systematic risks, the results have also been consistent with the capital asset pricing model, where lower systematic risk implies lower cost of equity. 


Similarly, as corporate governance standards are known to reduce a company’s default risk, which directly impacts the cost of debt, the average cost of debt for higher-ESG-rated companies was also found to be less than for lower-ESG-rated companies. 

How to get a head start

Effective ESG integration can often lead to competitive advantages in the management of resources, human capital, and company-specific operational risks, which can in turn result in lower costs of capital. 


For instance, stronger ESG propositions help companies tap new markets and expand into existing ones. As social responsibility increasingly becomes a licence to operate, strong integrity can also lead to greater strategic and regulatory freedom, facilitating a company’s long-term growth.

Someone is giving a bag of money to another person on a green background with sunrise.
A strong ESG proposition has numerous competitive advantages that can result in lower costs of capital.

Better management of raw materials can also drive cost reductions. Enhancing investment returns by allocating capital towards more promising and sustainable opportunities also helps companies avoid investments that may not pay off due to longer-term environmental issues. 


In addition, companies that perform well in ESG management tend to attract and retain quality employees by instilling a sense of purpose while increasing overall productivity. 


Twists and turns in the race ahead

Changing government policies are expected to add incentives for sustainable market development in future. In Hong Kong, for instance, the Green and Sustainable Finance Cross-Agency Steering Group, co-chaired by the Hong Kong Monetary Authority and the Securities and Futures Commission, announced a strategic plan in December 2020 to strengthen the city’s green and sustainable finance ecosystem in support of the government’s target of achieving carbon neutrality by 2050. 


The plan focuses on areas including promotion of the flow of climate-related information across the finance sector to facilitate risk management, capital allocation, and investor protection. One of the near-term actions the steering group agreed is to mandate declarations in line with recommendations from the Task Force on Climate-related Financial Disclosures by 2025. 


In March 2021, the European Union set in motion its Sustainable Finance Disclosure Regulation, which requires fund managers and financial advisers, among others, to disclose how sustainability risks are integrated into their investment decisions and how their investment decisions impact sustainability. The regulation is aimed at promoting responsible and sustainable investment and is likely to shape the fast-growing sustainable-finance industry.


While ambition and the need for speed is essential for companies to join the race, it is no longer enough if you want to stay ahead in driving a sustainable future. Companies should shift into gear by engaging with the financial sector to optimise ESG reporting instruments and capitalising on sustainable finance solutions. That is the challenge if you want to take the lead in the critical and increasingly competitive race ahead.