As green loans and green bonds have continued to gain traction in recent years, other financial products tied to ESG indicators also grew in popularity in 2020. Green bonds and loans are debt instruments that require a specific application of proceeds to the financing or refinancing of an eligible green project meeting environmental or sustainability criteria, such as a renewable energy facility. As such, the green bond or loan documentation will typically require the issuer or borrower to monitor the use of proceeds and provide periodic reports in that respect.
Alternatively, sustainability-linked loans provide more flexibility and do not require a particular application of funds but rather include some structural features designed to reward the borrower for achieving pre-determined sustainable performance targets. A common example would be a periodic pricing adjustment (up or down, within an agreed band) based on the comparison between one or more key performance indicators, such as total GHG emissions or water consumption, and specific targets for the relevant periods. With sustainability-linked loans, the focus is on the identification of appropriate key performance indicators and meaningful sustainable performance targets at inception, combined with ongoing monitoring and reporting throughout the life of the loan facility. Often, external verification by an independent third party will be required. In an effort to encourage further growth and standardization of market terms, the LSTA, together with similar loan market associations in Europe and Asia (the LMA and APLMA), published guidance in the form of Sustainability-Linked Loan Principles in May 2020.
These developments reached the bond market as well, and while more common so far with European issuers, the first issuance of a sustainability-linked bond by a North American company occurred in December 2020. As is the case with loans, the proceeds of sustainability-linked bonds can be used for general corporate purposes, but the bond terms have financial or structural characteristics that can vary (most commonly, a coupon step-up) depending on whether the issuer achieves specified sustainability targets. However, the failure to achieve the targets normally will not result in an event of default or mandatory redemption. The offering documentation for such bonds will thus include additional disclosure relating to the issuer’s strategy and objectives for ESG matters. In June 2020, the International Capital Markets Association released its Sustainability-Linked Bond Principles, which place particular emphasis on the selection of key performance indicators that are relevant to the issuer’s overall business and that are measurable, externally verifiable and able to be benchmarked, as well as ambitious targets that represent a material improvement to the issuer’s performance at issuance. Refinitiv, the financial market data company, also began issuing sustainable finance reviews in 2020 to cover the levels of sustainable capital being issued in financial markets regardless of the financial instrument, and launched sustainable finance advisor league tables – this is further evidence of the traction that sustainable finance is continuing to gain.
With the increasing focus on ESG considerations by lenders, investors and other market participants, innovation is expected to continue in order to expand the universe of potential borrowers and issuers for instruments of this type and provide additional tools for sustainable, social and transition finance.
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