(Why) Are ESG Sovereign Bonds (Such) Scams?

Mark Weidemaier and Mitu Gulati

Environmental, social, and governance (ESG) investing is all the rage, with heaps of money pouring into sovereign and corporate bonds intended to finance efforts to meet climate-related goals and other worthwhile objectives. We have been skeptical of these commitments for some time, mostly because we aren’t persuaded investors care about much other than yield. And in fact, yields on ESG bonds seem to be a bit—but only a bit!—lower than yields on non-ESG bonds (the so-called “greenium”). As Matt Levine pointed out a couple of days ago, it’s not obvious how socially responsible investing will affect investors’ returns. But we are a little bit suspicious of the market for sovereign ESG bonds.

In part, we’re suspicious for the usual reasons. The basic transaction structure is that the bond issuer says it will use the proceeds for some beneficial environmental or social purpose. But the commitments are often defined so vaguely that it is hard to verify compliance. This is a pretty standard complaint, and a lot of smart people are thinking about how to define “green” investments and develop verification tools. But we’re suspicious for a more fundamental reason: The contracts are absolute b.s. Many issuers don’t commit to anything at all, or so the documentation suggests.

Here are a few examples, taken from the sovereign context. In the Wall Street Journal, Matt Wirz documents a similar issue in ESG corporate bonds. Here’s an example from a 2020 bond issued by Mexico and intended to fund sustainable development goals:

Although the SDG Sovereign Bond Framework contemplates certain practices with respect to reporting and use of proceeds, any failure by Mexico to conform to these practices does not constitute or give rise to a breach or an event of default under the notes…. The SDG Sovereign Bond Framework and any practices contemplated thereunder are not incorporated into this prospectus supplement or the terms of the notes. They do not establish enforceable contractual obligations of Mexico.

And one from a 2021 Chilean bond:

Although the Sustainable Bond Framework contemplates certain practices with respect to reporting and use of proceeds, any failure by Chile to conform to these practices does not constitute or give rise to a breach or an event of default under the notes or any other instrument…. The Sustainable Bond Framework and any practices contemplated thereunder are not incorporated into this prospectus supplement or the terms of the notes. They do not establish enforceable contractual obligations of Chile or any other person.

And one from Hungary in 2021:

While it is the intention of the Issuer to apply the proceeds from the placement to finance or refinance Eligible Green Expenditures, it is under no legal obligation to do so. There is also no legal obligation to ensure that such Eligible Green Expenditures will be available or capable of being implemented as anticipated and, accordingly, that the Issuer will be able to use the proceeds for such Eligible Green Expenditures as intended. In addition, there is no legal obligation to ensure that Eligible Green Expenditures will achieve the originally intended impacts (environmental, social or otherwise) or outcomes in the manner expected.

To be clear, these excerpts are from the prospectus describing the bond; they aren’t part of the contract itself. And the contracts do contain some language that arguably can be interpreted as making a stronger commitment. To the extent the issuer has made such a promise, it probably can’t weasel out of it by pointing to language like this in the prospectus. But, again, the promises in the contract are vague – generally in the form of making it an event of default to breach “any other obligation.” There are no explicit promises to use the proceeds in particular ways, and the prospectus language suggests that no promises are intended.

There are some legitimate reasons why the issuer would not want to tie its hands completely. Technological change and other factors might necessitate changes in the borrower’s environmental strategy. But these contracts do far more than leave the issuer with policy flexibility. They represent that the issuer “intends” to use the funds for ESG objectives but in fact seem designed to allow it to renege entirely on this commitment.

Perhaps this explains why the so-called “greenium” is so small. The deal seems to be that investors get the appearance of ESG investing, while issuers keep the flexibility of ordinary borrowing. Big investment firms can tell their customers they are pursuing green objectives without risking materially lower returns. But contracts like this make the whole thing look like a scam. It’s not impossible to draft a contract that requires the issuer to meet clear, verifiable objectives. These don’t even bother to try. An investor who buys this crap should not get to count it towards meeting ESG targets.