Sustainability-linked products could be the key to mainstreaming sustainable finance.
This year has seen an increase in sustainability-linked bonds, and the sustainability-linked loans market continues to grow.
Bloomberg New Energy Finance records 13 sustainability-linked bonds issued up to the end of October this year, along with 103 sustainability-linked loans.
That issuance has continued into November, when LafargeHolcim became the first issuer from the building materials industry to issue a sustainability-linked bond. Mid-month, it launched a €850 million deal tied to CO2 reduction.
These products originate from the outcomes-based model of social impact bonds.
In 2016, the idea of key performance indicators (KPIs) was woven into supply chain financing at Puma. The sports brand partnered with the International Finance Corporation (IFC) to offer financial incentives for its emerging-market suppliers to improve environmental, health and safety, and social standards.
It seems a bit of dream at present, but … it will only be a matter of time
Ana Carolina Oliveira, ING
Then in 2017, the first sustainability-linked loan was issued by Philips – the first deal in the syndicated loan market where the pricing was linked to a Sustainalytics rating.
In 2019, Enel launched the first sustainability-linked bond, where the power producer pays an increased coupon if it fails to hit its renewable energy targets.
As growth continues, bankers believe sustainability products could act as a bridge to traditional financing that could see this type of risk pricing become business as usual.
“Sustainable finance, such as green bonds, tend to fund green projects that, while important to the transition to net zero, do not necessarily take into account what is happening at the entire firm level,” says Hervé Duteil, chief sustainability officer for the Americas at BNP Paribas.
“We need this of course, but the next step would be for a broader set of financings to include KPIs and risk pricing tied to progress towards global sustainability goals.”
For some companies, sustainability-linked bonds have become “transition products” while the market works towards a universally agreed-upon transition finance taxonomy or transition bond principles.
Duteil points out that sustainability-linked finance mechanisms are also a means to ensure that companies are continually stepping up their environmental and social ambitions.
Next step
Dan Shurey, vice-president, sustainable finance at ING, agrees that mainstreaming sustainability-linked products is a step towards ensuring that all finance is sustainable finance.
“The next logical step from sustainability-linked products is to embed risk pricing broadly, rather than having prices that go up or down depending on whether targets are hit,” he says.
Whenever principles are launched, a market begins in earnest
Dan Shurey, ING
Essentially, sustainability will simply be part of broader credit risk.
“We’re already starting to see this happen,” says Ana Carolina Oliveira, head of sustainable finance Americas at ING, highlighting Moody’s downgrade and then subsequent upgrade of Brazilian mining company Vale – the former after a mining accident, and the latter following improvements in practices.
Issuance of sustainability-linked bonds is poised to increase next year – particularly in light of the International Capital mark Association’s (Icma) launch of its sustainability-linked bond principles in June.
ING’s Shurey says: “When you look at the last few years, whenever principles are launched, a market begins in earnest.”
He also highlights that the flexibility of use of proceeds is attracting borrowers.
Sustainability-linked bond proceeds are used for general purpose and are not earmarked for green or social projects. That flexibility has allowed the finance industry to engage with sectors that “may not be able to align with climate goals at present, or emit lower carbon in the near future, but who can make incremental improvements,” says ING’s Oliveira.
Shurey also points out that investors are attracted to the impact measurement included within sustainability-linked products, saying: “It’s a sweet spot of marrying the bottom line with impact.”
As with green bonds, investors have expressed concerns that KPIs being set by firms may not be “stretch goals”. However, BNP Paribas’s Duteil says choosing KPIs is not about being “overly ambitious”.
“You have to pick KPIs that are a bit of a stretch, but also reachable – and striking for that balance shouldn’t be underestimated. It’s constant progress that we need,” he adds.
Sovereign bonds
As corporate sustainability-linked bonds become more prevalent, discussions are also circulating about whether or not sovereign bonds could also include KPIs.
Earlier this year, for example, the idea of a nature performance bond was floated by Finance for Biodiversity, which looks at the possibility of tying sovereign debt repayments of developing economies to environmental KPIs in a new form of debt-for-nature swaps.
Duteil says for now it is unlikely that we will see sustainability-linked sovereign debt.
“There’s no reason all of finance cannot include sustainability KPIs,” he says. “However, the fact of the matter is that it is preferable to keep structures simple when accessing public markets.”
There’s no reason all of finance cannot include sustainability KPIs
Hervé Duteil, BNP Paribas
Duteil points out that while sustainability-linked loans may include as many as five or more KPIs tied to metrics such as deforestation, gender balance or biodiversity, sustainability-linked bonds that tap public markets typically have just one or two metrics, such as lowering emissions, that investors are more familiar with.
“If you want to target a wide audience – as in the case with a bond – then KPIs tied to marine conservation, water preservation, or conversion of agriculture are most likely too complex for now,” says Duteil.
“Typically for these emerging economies, the impact goals are much more involved – it could mean transitioning millions of farmers to sustainable agriculture, and you would need measurement as well auditing for that. Such goals would be best suited at the moment to blended finance or a more bespoke private placements.”
For sustainability-linked products to become ubiquitous, it will require greater data and metrics, Duteil continues.
“When we have reliable, simple measurements that can be verified, then it becomes easier to incorporate more diversified KPIs within public market sustainability-linked products like bonds,” he says. “That will come.”
Oliveira says “an ideal” would be the market in which both sustainable use of proceeds and KPIs were used together in debt issuance.
“It seems a bit of dream at present, but with more disclosures and metrics and a growing market, it will only be a matter of time,” she says.
