In recent years, the size of the sustainable debt market has increased dramatically, in parallel with rising investor demand for environmentally-oriented debt products. BloombergNEF estimates that, the total volume of sustainable debt issued in 2021 surpassed $1.6 trillion, more than double the volume of sustainable debt issued in 2020. Green bonds accounted for the largest portion of the total sustainable debt market, with more than $620 billion issued in 2021 (and to date, green bonds account for 45% of the $4 trillion of sustainable debt issued through 2021), but sustainability-linked loans and sustainability-linked bonds were the fastest growing category of sustainable debt and accounted for more than $530 billion in issuances in 2021. Banks, direct lenders, private equity funds and other participants in the commercial debt market have lined up to commit to sustainable financing targets, and borrowers have responded by issuing an array of sustainable debt products.
Increased interest and participation in the sustainable debt market has also generated concern among investors and ESG activists that many of the products being offered do not incorporate ambitious and material sustainability goals. Many expect continued and rapid growth in sustainable debt issuances in 2022, but with it, tighter guidelines and increased scrutiny from investors, market observers and possibly regulators.
Green Bonds and Green Loans
Green bonds generally look like regular bonds other than requiring a specified use of proceeds. The indenture and notes for green bonds often do not include any identifying features regarding their “green” nature. However, in the offering document, the use of proceeds reflects the application of the funds to exclusively finance (or refinance) eligible green projects meeting certain environmental or sustainability criteria.
In addition, the offering document typically describes the categories of eligible projects for which the funds may be used and includes commitments from the issuer to describe on its website or in other reports how the funds have been allocated. For example, some issuers include a report that includes qualitative and quantitative environmental performance indicators such as greenhouse gas (“GHG”) emissions avoided.
Similarly, the defining feature of green loans is the requirement to dedicate loan proceeds to finance or refinance specified eligible green projects providing clear environmental benefits that can be assessed, quantified, measured and reported by the borrower. Pursuant to the Loan Syndications and Trading Association (“LSTA”) guidelines, borrowers should clearly communicate to lenders the process for selection of eligible projects (including environmental and sustainability objectives), track and manage loan proceeds to ensure appropriate allocation towards the specified project, and provide up-to-date reporting with respect to use of loan proceeds.
Green bonds and green loans provide a valuable financing option for issuers looking to expend capital on “green” projects, but the restrictions on use of proceeds also make these instruments less accessible for many other issuers of debt who require flexibility to apply proceeds to a variety of corporate purposes. For many issuers who are not in a position to dedicate the entirety of the proceeds of a debt financing towards a green project, sustainability-linked bonds and loans (discussed below) provide an appealing alternative.
Sustainability-Linked Bonds and Loans
Unlike green bonds, sustainability-linked bonds do not require that proceeds be dedicated to a specific purpose. Instead, sustainability-linked bonds contain one or more specific key performance indicators (“KPIs”) and related sustainability performance targets (“SPTs”) that are applicable to the issuer’s operations as a whole. In the event the issuer fails to satisfy the applicable SPT, the bond interest rate increases by a predetermined amount. The intent is to incentivize the issuer to achieve ambitious and meaningful sustainability-related goals, including environmental and social initiatives.
For example, a company may have a SPT based on a specified reduction of greenhouse gas emissions by a specific date. The indenture for the bonds would provide that if the issuer does not deliver a written confirmation of its achievement of the SPT by the specified date, which is typically confirmed by an external verifier with expertise in the industry, the interest rate on the bonds will increase by an agreed number of basis points (e.g., 25 basis points).
The offering document for sustainability-linked bonds would describe the KPI and the issuer’s efforts to achieve the SPT, and issuers often include a sustainability-linked bond framework on their website. This provides the issuer’s sustainability objectives and quantitative data behind the applicable KPI.
Approximately 85% of the KPIs used for sustainability-linked bonds relate to environmental targets, with the most common KPI based on greenhouse gas emission reductions, followed by renewable energy, waste reduction and water consumption. Others that are less frequently applied involve community involvement, gender, biodiversity, employee training initiatives, patient outreach and service quality.
Sustainability-linked loans are similarly structured; in lieu of dedicated use of proceeds provisions, sustainability-linked loans include pricing adjustments if predetermined SPTs are not achieved by the borrower by the target date.
Typically, for both sustainability-linked bonds and sustainability-linked loans, failure to achieve an agreed SPT does not trigger a default under the related debt instrument; the pricing adjustment is generally the sole consequence for the issuer.
For both sustainability-linked bonds and sustainability-linked loans, selection of the applicable key performance indicators and calibration of the related sustainability performance targets is crucial to the credibility of the instrument. The International Capital Market Association (“ICMA”) and the LSTA have promulgated similar guidelines for sustainability-linked bonds and sustainability-linked loans which specify that KPIs should be material to the issuer’s core sustainability and business strategy, measurable, externally verifiable and able to be benchmarked using an external reference. The related SPTs should be ambitious, representing a material improvement over a “business as usual” trajectory, and failure to meet the specified SPTs should result in a meaningful financial or structural impact under the related debt instrument. Both the ICMA and the LSTA recommend publication of up-to-date and accessible information with respect to the issuer’s progress towards achieving its SPTs. And, finally, independent and external verification by an auditor or environmental consultant is recommended.
In 2021, regulators and participants in the debt market placed increased emphasis on addressing “greenwashing” in the sustainable debt market. Many critics have noted that KPIs selected by sustainability-linked debt issuers often appear to be lacking in ambition, too easily achievable, or not sufficiently material, and the consequences for failing to achieve the specified SPT often appear to be minor. In July of 2021, the Loan Market Association and the European Leveraged Finance Association introduced tighter guidelines for sustainability-linked loan instruments, with the goal of discouraging easily attainable sustainability targets and providing a roadmap to implementation of sustainability principles in loan documents. In addition, the EU has introduced its voluntary Green Bond Standard to provide even more information about green financial products and to expedite development and standardization in the green bond market. Within the leveraged loan market, where selection of sustainability criteria and publication of relevant information have traditionally been opaque, there has been increasing focus by ESG-oriented investors on providing more transparent and meaningful reporting. For now, there remains significant variability and discretion in selection of relevant ESG criteria in the sustainable debt market, but market trends suggest that 2022 will see additional scrutiny of sustainable debt instruments by investors, market observers and possibly regulators, and an increase in standard setting and harmonization in the market.
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