Not all ESG bonds are created equal. Many of them, particularly within the real estate sector, often lack “additionality,” which is one of the key measures that we assign to the incremental positive social or environmental impact created by an ESG-labeled bond as part of our assessment of its quality.
Real Estate Investment Trusts (REITs) issued $42 billion worth of green, social, and sustainability (GSS) bonds in 2022, but most of the proceeds were used to purchase green buildings, a practice we believe carries very little additionality. Currently isolated to Europe, a new trend has also emerged where some REITs are giving traditional bonds an ESG label several years post issuance. Our analysis of these newly “requalified” bonds and REIT issuances with proceeds allocated to purchasing green buildings suggests they don’t provide the positive environmental impact ESG investors are seeking, making many of these securities less suitable for inclusion in ESG-oriented portfolios.
The effortlessness of ESG issuance in real estate
Since the generation of electricity and heat used in buildings is responsible for around 19% of total global CO2 emissions, green bonds could play a critical role in decarbonizing real estate portfolios.1 According to the Climate Bonds Initiative, a hefty one-quarter of total GSS bond proceeds have historically been used to purchase green buildings, which are resource-efficient buildings that have received one of the few, rigorous independent certifications needed to be considered “green” according to the International Capital Markets Association’s (ICMA) Green Bond Principles – the gold standard used to determine which capex projects meet eligibility for green bond proceeds. Notably, buying a green building is one of the few projects specified by ICMA that involves simply purchasing an asset, as opposed to making transformational, but perhaps more complex, investments to help transition an issuer’s existing property, plant, and equipment. This may partially explain why green bond issuances are so common for REITs and why the real estate sector makes up the third largest share of GSS bonds in the Bloomberg Global Corporate Index (Figure 1).
Real Estate Accounts for 18% of GSS Bonds in the Bloomberg Global Corporate Index (%)
PGIM Fixed Income, Bloomberg. As of February 12, 2022.
It’s not uncommon for a REIT to purchase green buildings as part of its day-to-day operations. After all, there are heavy incentives to do so: in addition to lower energy costs, research has indicated the benefits of greener buildings include higher occupancy rates, higher sale premiums, and better tenant retention.2 This makes it difficult to make the case that the proceeds from a green bond are not just akin to a REIT’s run-of-the-mill capital expenditures.
Put differently, are the funds from an ESG-labeled bond issued by a REIT that’s only purchased green properties the last five years actually funding new, transformational projects that would not have occurred without the issuance?
Also reducing the additionality of ESG real estate debt is that at an aggregate level, transferring ownership of an asset from one owner to another has no absolute impact on the environment if other assets are not concurrently being redesigned to be more resource efficient. This is why, for example, many ESG investors prefer engagement to simple divestment. Certainly, purchasing a green building is better than purchasing a non-green building, and a REIT should get credit for having a substantial portfolio of green properties. But REIT issuances with proceeds that fund other, more transformative eligible green projects, such as retrofitting existing buildings to improve their energy efficiency or constructing on-site solar, provide more additionality.
Plain vanilla to ESG
Another questionable trend that’s emerged involves a handful of European REITs “requalifying” their outstanding bonds as ESG by retroactively changing their prospectuses, often years after the bonds were first issued. Some issuers have also gone to the extent to requalify all of their outstanding debt as green, creating “100% Green Bond” programs. Thus far, this trend has been limited to European REITs, to the tune of $15 billion, or 30% of total European REIT green bonds outstanding.
In a sector where green issuance is so common it may raise eyebrows if an issuer hasn’t tapped the ESG-labeled debt market yet, this has become a quick way for some REITs to improve their ESG profile without taking any new actions, while also taking advantage of the ability to fund portfolio growth on more advantageous financing costs associated with issuing GSS debt. A high-quality ESG-labeled bond allocates capital towards projects that likely would not have been financed in the absence of the issuance, funding activities that aren’t just part of business-as-usual. But if these recently minted ESG bonds weren’t explicitly issued to fund new projects, it’s hard to claim that they help the issuer transition its business model from “brown” to green, or really add value beyond their routine debt financing.
A shrinking “greenium”
Additionally, research has demonstrated that green bonds experience stronger secondary market performance compared to their vanilla counterparts.3 This “greenium” can be partially attributed to higher demand and reduced liquidity as investors in ESG-labeled debt are predominantly institutional buy-and-hold managers. Although estimates vary, some research has identified an average greenium of 4-6 bps, with evidence of higher-quality and more credible green bonds that have been externally reviewed by a Second Party Opinion (SPO) provider commanding a higher greenium.4
Currently, we see no evidence the secondary market is pricing requalified REIT bonds any differently than typical ESG-labeled real estate debt. As the market becomes better at discerning high quality GSS bonds from those of lesser quality, we anticipate the greenium associated with requalified bonds to gradually diminish over time, and trade more in line with their vanilla counterparts.
The big takeaway
As part of PGIM Fixed Income’s security selection process, we assess each ESG-labeled issuance based on the overall credibility and additionality of the bond (Figure 2). The higher the individual green bond’s impact, the more attractive the issuance might look for our ESG-focused strategies.
Additionality Factors into an ESG-Labeled Bond’s Impact Assessment
PGIM Fixed Income
However, given some of the trends outlined above, our analysis has found that the majority of REIT green bonds receive a “low” impact rating, which is well below the ratings we see across non-REIT corporate ESG-labeled issuances.
Ultimately, we need to recognize some ESG-labeled bonds make a bigger impact than others. While GSS use-of-proceeds bonds have the potential to improve the environmental profile of existing building stock, one of the largest global sources of greenhouse gases, evidence has shown that up until now, such instruments have been employed by issuers to reward themselves for naturally growing their portfolios or simply requalifying outstanding issuances. We have concerns about the caliber of these “requalified” bonds and question whether ESG-labeled debt issued to purchase green buildings makes the positive impact ESG investors are seeking. Therefore, we are far less likely to buy GSS bonds issues by REITS for our ESG-focused portfolios. We anticipate these trends might also creep into other sectors where issuers have historically been funding eligible green or social projects as part of their day-to-day operations, like financials, or sectors where issuers may have a significant amount of eligible green assets on their balance sheet, like utilities. Active fixed income managers with the capabilities to look beneath the surface of ESG-labeled debt will continue to be better positioned to ensure ESG-labeled debt meets the needs of ESG-oriented investors.
1 IEA (2022), Buildings, IEA, Paris. September 2022.
2 International Finance Corporation, “Green Buildings: A Finance and Policy Blueprint for Emerging Markets,” 2019.
3 Climate Bonds Initiative, “Green Bond Pricing in the Primary Market,” July-December 2021.
4 European Central Bank, “Pricing of Green Bonds: Drivers and Dynamics of the Greenium,” September 2022.