Most of us are familiar with green/social bonds and loans. These are bonds/loans whose proceeds must be used for projects that fulfill certain “green” criteria or advance certain “social” or “sustainability” causes. The first ‘use of proceeds’ green bond was issued by European Investment Bank and World Bank in 2007 but the market only really took off after the International Capital Market Association (ICMA) published a set of guidelines for bond market participants known as the “Green Bond Principles” or GBP in 2014. ICMA followed with publishing the “Social Bond Principles” and “Sustainability Bond Guidelines” in 2017. The loan markets responded by setting out the Green Loan Principles (GLP) issued by the Loan Markets Association in 2018. The growth in this market has been commendable with almost USD 1 trillion of cumulative green bond issuances alone by December 2020.
However, there are only that many “green” or “social” or “sustainability” projects out there and many potential borrowers wanting to grow their businesses sustainably were unable to access the growing pool of ESG funds through the strict confines of a ‘use of proceeds’ model. In fact, a large swathe of the corporate world (including much of the consumer, technology, and services sectors) are largely excluded by the ‘use of proceeds’ model simply due to the nature of their businesses. These industries also need to transition their business operations to become more “sustainable” (to meet growing regulatory, consumer, ethical or reputational pressures) but most of their capital requirements are tied to business-as-usual activities rather than any specific “sustainable” projects. A specific purpose “use-of-proceeds” model would just not work for them.
To address this funding gap and to encourage a larger set of corporates to transition to more sustainable operations, the Loan Markets Association came up with new product guidelines and published the Sustainability Linked Loan (SLL) Principles in 2019. ICMA followed with issuing the Sustainability Linked Bond (SLB) Principles in 2020. No longer were borrowers ring fenced by restrictions on how to use the capital raised. These sustainability-linked loans and bonds allowed them to use their proceeds anywhere in their business and incentivized them to make improvements in their ESG practices as measured by certain pre-defined targets.
The targets are related to Environmental Social and Governance (ESG) metrics and must be ambitious and aligned with the firm’s corporate sustainability strategy. To determine this, there is a designated “sustainability coordinator”, usually the lead banker, who undertakes a materiality assessment of the company’s chosen sustainability metrics and benchmark targets against the company’s own historical performance and against its industry peers. This is to pre-empt concerns around “sustainability-washing” where firms may try to present “business-as-usual” improvements as targets.
The incentives to achieve these targets can be positive (firm pays a lower margin or coupon if it achieves the target) or negative (firm pays a higher margin or coupon if it misses the target). For SLBs, the market typically opted for a 25-basis point step-up if issuers fail to meet targets. For SLLs, a step-down of 5 to 10 percent of the initial margin is common if the target is met. To align interests between borrowers and investors, many investors pledged to donate profits obtained due to their borrowers’ failure to meet their targets (termed “blood money” by some) to sustainable causes.
Usually, SLBs tend to have just one ESG metric as their target, while SLLs can have up to four or five metrics as the target. This is because investors for a bond issuance tend to be much larger in number and a rather varied group ranging from institutions to retail investors, so an SLB needs to have a simple and easy to track pricing mechanism. On the other hand, SLLs are usually syndicated by a small and homogenous group of banks, making it easier to track more complex structures with multiple metrics.
The sustainability linked finance market seems to have tapped into an unmet need in the market and has simply exploded since its inception in 2017. Going by the way its tracking, it may well match or even overtake the traditional “use of proceeds” market in the next few years. Since 2017, over USD 809 billion of sustainability-linked financing has been raised globally, of which 85 percent was SLLs.
Most early issuances used carbon emission reduction metrics, but recently the measurement of social and additional environmental indicators is rising. Demand for more innovative and diverse set of metrics is growing as companies attempt to address various sustainability priorities, with new metrics emerging around freshwater consumption, waste reduction, and workplace diversity.
In Asia Pacific, the Sustainability-linked loan (SLL) issuance overtook green loans for the first time in 2021, underlining its growing popularity in the region. According to Bloomberg, at the end of October 2021, APAC Ex-Japan SLL volume posted a 332% growth year-on-year with about US$21 billion from 49 deals.
As expected, green loan issuances tied to specific “use of proceeds” remained concentrated within sectors like renewable energy, real estate and power generation, accounting for 60% of volume, while for SLL, sector distribution is more diverse - real estate (28%), consumer staples (29%), refining & marketing (12%), hardware (8.6%), and health Care (5.5%).
SLLs are a varied lot and used across multiple sectors. While Europe has been a clear leader in these instruments, Asia Pacific is catching on. Given below are some examples of SLLs in the APAC region.
It is inevitable that sustainability linked finance will continue to grow exponentially, particularly as we move closer towards 2030, the target date for achievement of UN SDG’s and a milestone year in the path towards Net Zero. However, as the volume of sustainability linked investments surges, so will the concern around “sustainability-washing.” Already there is substantial concern among investors and lay public about the integrity and meaningfulness of ESG data published today. As ESG linked financial instruments become mainstream, setting meaningful targets, putting in place credible and scalable monitoring systems to track progress against such targets together with independent verification are all a must to sustain their healthy growth.