Do Rating Agencies need to be at the Forefront of the Fight Against “Social Washing”?
So, what are social bonds? Social bonds, like green bonds,
are bonds issued by an entity that seeks to garner funds but for a very
specific purpose or, sometimes, for a varied set of goals within a larger
ideology. That may be to make a company more ‘green’, or for a particular project
that will have benefits for the environment, to provide crude examples. Social
bonds work in the same manner, but are relatively new compared to their green
counterparts. A relevant example of the social bond may be the new ‘coronavirus
bonds’ that are being issues by governments, supranational organisations,
and companies. It has been reported that the market for these particular bonds
is growing massively, with the FT reporting that, as of May, has reached $65
billion and could top $100 billion by the end of the year. Governments have
issued such bonds, as well as organisations like the World Bank and the
European Investment Bank. Companies have also issued such bonds, with companies
like Pfizer and Bank of America being cited, who recently issued a $1 billion
coronavirus bond to help fund lending to hospitals, healthcare manufacturers,
and other entities in need of funding in the fight against the virus; Bank of
America were offering these bonds at the same rate as their normal bonds. If we
count coronavirus bonds to be in the same category as social bonds, then in
2020 it was the first
time that social bond issuance has outgrown the issuance of green bonds.
Analysts have suggested that this growth and outpacing of green bond issuance
is purely down to the pandemic and response to it, with green bond issuance
having been predicted to have a strong year before the virus took hold.
However, as the FT article on the growth of social bonds states, ‘investment
banks are now scrambling to understand what use of proceeds from these new
classes of coronavirus bonds will be accepted by socially conscious investors’.
Since that article was published in May, it seems that there has been little in
the way of progress with regards to clarity on the situation.
To assist with this, the International Capital Markets
Association (ICMA) has updated its ‘Social
Bond Principles’, with S&P suggesting that the update could encourage a
greater rate of issuance of social bonds, ‘potentially
leading social bonds to emerge as the fastest-growing segment of the
sustainable debt market in 2020’. The voluntary principles define a social
bond as a bond instrument ‘where the proceeds will be exclusively applied to
finance or re-finance in part or in full and/or existing eligible social
projects’. Furthermore, the issuer should appropriately describe the project(s)
for which the funds will be utilised for, and if the funds are for re-financing
then this should be made clear in the documentation. Typical and popular
projects may include developing affordable basic infrastructure, essential
services, housing, employment generation, food security and sustainable food
systems, and socioeconomic advancement. There is no cap or direction on who may
benefit from such projects, but suggested ‘target populations’ include those
living below the poverty line, excluded/marginalised groups, people living with
disabilities, the undereducated, underserved, and unemployed (amongst a longer
list of other groups). The bond issuer must communicate with investors the
social objectives of the project for which the bond is for, the process by
which the issuer has selected the project(s), and any related criteria
including any potential excluding criteria. All of this, of course, is
particularly relevant. But, for our purposes here, the suggested approach to
managing the proceeds is crucial. ICMA suggest that the proceeds of the bond
should be separated from other funds and accounts within the issuer, with a
clear line of demarcation being visible. Further, any funds that are outstanding,
say because a project has come in under-budget, should be tracked and made
known to investors. It is stated that ‘the SBP encourage a high level of
transparency and recommend that an issuer’s management of proceeds be supplemented
by the use of an auditor, or other third party, to verify the internal tracking
method and the allocation of funds…’ Such information should be kept and made
readily available. The annual report should include a list of all the social
projects the issuer is engaging with, as well as the amount allocated to it
from the bonds together with their expected impact (where this is not
possible, say because of confidentiality agreements, then aggregates should be
used). ICMA then go on to encourage all of the above to be verified by external
review providers, with transparency being the key according to the set of
principles.
Yet, there are a number of issues outstanding with regards
to this concept of transparency. S&P, in reviewing the data and the
development of the field, have highlighted this issue of social washing. In a
report recently, they noted that although the market is developing rapidly
because of the pandemic – with development banks leading that charge – there are
issues in conflating social bonds with coronavirus bonds, which may be
developed with more haste and thus may not be aligned to the goals of
investors; as one expert noted, ‘COVID-19
is a little bit of a different animal… it’s an emergency and consequently a
number of people might do faster financing to make sure they get urgent funding’.
Issuers have been advised that whilst investors may welcome issuers who have
reacted quickly to the crisis, social bond investors have specific goals and
will ‘continue to demand information on the outcomes and the impact’. However, the
concern is two-fold; one concern is that issuers may overstate the impact seems
as the verification protocols are not yet consistent across the sector, with
another concern being that the funds will not be used as they are intended –
these two elements are making up the proposed fears for ‘social washing’. As
one expert noted, ‘if
you think about the heavy emphasis on risk and disclosure around climate, we’re
nowhere near that on the social side’. An example has arisen recently with
the company Pfizer. In March it issued a $1.25 billion bond, aiming to use the
money for ‘eligible projects’, which the company would choose. However, in the
prospectus, the company admitted that the fund ‘might
temporarily be used for short term investments or to repay other borrowings’.
Pfizer have not commented on this issue, but did admit that ‘there can be no
assurance that such net proceeds will be totally or partially disbursed for
such eligible projects’. The article in the FT cites investment managers who
are rejecting a number of bonds in this area because of the vagueness within
the information provided: ‘we didn’t
feel like there was sufficient information or assurance’. So, how will that
asymmetric gap be bridged between the issuer and the investor?
The Principles for Responsible Investment initiative has
been putting
the pressure on investors to do more to hold issuing companies to account,
but how would they do this? One credit fund manager noted that ‘it’s not
very easy for our analysts to track the proceeds until a company reports [how
they have been spent]’, so is it a question of being held hostage to the
disclosure regimes of issuing companies, which as we know are being developed
on a voluntary basis? In reviewing S&P’s website for rating methodologies,
there does not seem to be anything in particular for these social bonds –
please do let me know and correct me if this is not the case. If this is the
case, then the rating agencies are not currently contributing to the credit
risk assessment with these bonds. We know that the rating agencies are keen to
push the narrative that, with regards to rating ESG-related issues, then ‘materiality’
is key. With regards to these social bonds, materiality could be a very broad
gambit. For example, would it be material if a company had any sort of record
of not utilising the social bond funds for the purpose they were designed for?
Would it be material if there issues regarding disclosure within a particular
company? The ‘second-party
opinion’ verification process is currently being undertaken by the Sustainability
Rating Agencies – here
is an example from Sustainalytics – but is this enough for an investor base
that is, for the most part, seemingly operating in the dark according to their
declarations? If leading investment managers are rejecting bonds because of a
lack of detail, then surely there is space for more providers to bridge that
asymmetric gap.
The question then becomes whether credit rating agencies are
well suited to that role. It seems that the biggest issue is that of
disclosure, and knowing what happens to the investment once it has been
received. Technically speaking, the credit rating agencies should be in a good
position to alleviate for this problem, on account of being closer to the
issuer because of the issuer-pays model, and their size compared to Sustainable
Rating Agencies in terms of operating power. Auditors clearly have a role to
play in verifying what has happened to the resources, but this is after the
fact and does aid the investor in their decision-making processes, especially in
such a nascent environment. There will naturally be a high correlation between
those entities that are issuing social bonds and those who have credit ratings
attached to them as a corporate entity, but does this help the socially-conscious
investor? We have seen only recently how important it is to take into account
factors from a wide-range of sources – see the last
post on the demise of Wirecard – but there seems to be a massive dearth of
credit risk-related information in this growing field, and that is as surprising
as it is worrying. Concerns
over the efficacy of Sustainable Rating Agencies will not help this issue
either. It is therefore arguable that there is a greater role for the rating
agencies to play in this growing marketplace. However, the agencies are
consistent in their view that they are, essentially, dependent upon the issuers’
approach to disclosure, so if there are clearly disclosure-related issues in
this growing field, then rating agencies may just add to the problem and not
provide a solution – the entrance of their conflicted business model may cause more
harm than good. Therefore, it may be the case that regulators need to intervene
and stipulate some rules on disclosure which are enforceable and then enforced,
rather than voluntary guidelines set at an international level. It is true that
investors can ‘vote with their feet’, but this does not help the investor at
the point of entry.
It appears that, as it stands, there is a particular need
for more information in this marketplace. On top of this, the very nature of
the ‘S’ in ESG is more
qualitative than quantitative, which further muddies the water for
investors. It will be interesting to see if the credit rating agencies step
into this apparent void, or whether the height of external review and rating
of these products is that which the Sustainable Rating Agencies provide. Either
way – and again please do alert me if I have this wrong and it is the case that
such bonds are adequately rated – one of the key elements in this dynamic is
that of disclosure. It is seemingly the case that only regulators, or even
perhaps legislators, can enforce disclosure in this regard so the development
of the social bond market may have to continue dealing with a lack of
consistent and reliable credit risk data for some time yet.
Keywords – social bonds, investors, business, @finregmatters
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