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Sustainable finance set for a recovery in 2023

  • Sustainable equity funds started recovering in the last quarter of 2022, led by Europe, Canada and Australia
  • Greeniums will surge in 2023, while sustainability-linked bonds are likely to fall out of favour
  • Sovereign ESG bond issuance will pick up in 2023 as well

According to the Institute of International Finance, ESG debt issuance fell to US$1.3trn in 2022, down from US$1.5trn in 2021. However, a recovery is likely to occur in the second half of 2023, as central banks halt or slow down their interest-rate increases, providing some stability to the market. ESG debt issuance is likely to reach US$1.7trn in 2023, driven by the launch of green bonds in China, Europe and Latin America. The Inflation Reduction Act of the US will also give ESG debt issuance a boost. However, fluctuations in the greenium (the higher price and lower yield associated with green bonds relative to their plain-vanilla counterparts) will pose a risk to the market, as will the waning popularity of sustainability-linked bonds.  

Sustainable equity funds have rebounded

ESG equity mutual funds attracted US$37bn of flows in Q4 2022, according to Morningstar, compared to US$24.5bn in the third quarter of the same year. Most of this rebound is attributable to Europe, Canada and Australia. Strong demand from investors for instruments that focus on ESG concerns and the launch of several new ESG funds were pivotal for the recovery of European sustainable funds.

In the US sustainable funds have yet to reach their Q1 2021 peak, following the outflow of US$6.2bn from US sustainable funds in Q4 2022. This outflow can be attributed to a fear of recession and a politicisation of concerns about ESG investment.

Around US$22m flowed out of Asian (excluding China and Japan) sustainable funds over the fourth quarter, while around US$ 557m flowed out from Japan in Q4 2022. In China, around US$1.5bn flowed out in the same period, largely owing to slower economic growth in 2022. 

Sustainable bonds and sustainability-linked loans are likely to recover in 2023

A total of US$863bn in green, social, sustainability and sustainability-linked bonds were issued by firms and sovereigns in 2022, a 19% drop from US$1.1trn issued in 2021, according to Bloomberg.  

Green bonds, which focus on environmental issues, fell by 11% to about US$480bn in 2022, with support coming primarily from Chinese demand. China (along with Europe) is also likely to lead the revival in 2023, bolstered by changes to its local taxonomy.

Throughout 2022, however, greeniums have been decreasing, particularly in Europe. According to the Association for Financial Markets in Europe, greenium levels declined from more than 9 basis points in 2020 to around 2 basis points in July 2022, albeit with a small rebound in September 2022 (latest data). 

Greeniums continue to exist largely because demand for green bonds is significantly higher than supply, despite the boom in green bond issuance. Additional regulatory pressure, such as the launch of the EU taxonomy, is likely to raise the scarcity of green bonds, pushing up greeniums in 2023. However, it is unlikely that they will regain levels seen in 2020. It is also likely that green debt instruments that comply with the EU taxonomy regulations will be able to command a higher greenium.

Social bonds, targeting the social pillar, dropped by 34% year on year to US$141bn in 2022, as the use of social bonds to fund pandemic relief declined. Major social bond issuers, such as Caisse d’Amortissement de la Dette Sociale, a French Public Finance Agency, the EU and the Union nationale interprofessionnelle pour l’emploi dans l’industrie et le commerce, all pulled back. Social bonds issuance will probably see another decline in 2023, unless the pandemic resurges.

The issuance of sustainability bonds, whose proceeds are used to address a combination of green and social issues, fell by 22% to US$154bn, for similar reasons to social bonds. According to Bloomberg, sustainability-linked bonds issuance fell by 21% to US$86bn in 2022, compared to 2021.

The flexibility offered by these bonds meant they were being used by businesses in sectors such as the materials and healthcare sectors (non-financial firms represent 90% of sustainability-linked bond issues, according to S&P Global). There are doubts about whether such bonds help companies reach their desired ESG targets. Companies that have been downgraded in ESG ratings systems, such as Poland’s PKN Orlen, are required to pay a higher coupon rate. The legal risks for such bonds are also increasing. The majority of sustainability-linked bonds with measurement dates in 2023 are likely to miss their targets, which, in turn, will reduce sustainability bond issuance. 

These concerns led the ICMA (International Capital Market Association) to announce its plans to issue a set of KPIs (Key Performance Indicators) for sustainability-linked bonds (in May 2022), which might bring some clarity into the issuance of such bonds from 2023.

Sustainability-linked loans have also taken a hit in 2022 compared to 2021. According to Bloomberg, sales of these loans fell to US$362bn in 2022, from US$506 bn in 2021. This is largely due to inflation, tighter monetary conditions and a strong US dollar. Issuance dropped most in the Americas, Europe, the Middle East and Africa, while holding up in Asia. Issuance is likely to pick up in 2023, largely due to easier monetary conditions and a weaker dollar, both likely later in the year.

Sovereign ESG bonds will become popular

Issuance of sovereign ESG bonds has picked up after the pandemic. According to BIS, the share of sovereign issuers in total outstanding GSS (green, social and sustainable) bonds was 4.2% at the end of 2019. This share increased to 7.5% by end-June 2022. With 43 sovereigns having issued GSS bonds in 2022, further increases are likely in 2023, supported by firmer KPIs and reporting standards. 

One small hitch in the issuance of GSS bonds is the fungibility of fiscal revenues. This means that there is no guarantee that the funds raised by sovereigns via GSS bond issuance will be used for investing in green ventures. However, some sovereigns will turn to issuing sustainability-linked bonds to signal their commitment to their sustainability goals.

The analysis and forecasts featured in this piece can be found in EIU’s Country Analysis service. This integrated solution provides unmatched global insights covering the political and economic outlook for nearly 200 countries and six major industry sectors. You can learn more about our subscription services here.