Responsible finance has taken a growing importance for economic stakeholders, institutional investors and corporates over recent years, making it vital for issuers to provide increasingly detailed non-financial information on their sustainability strategy, and be in a position to measure the environmental and social benefits of their businesses. Financial institutions have therefore been developing increasingly specialized green financial instruments in response to this challenge, such as sustainability-linked bonds, with the International Capital Market Association (ICMA) publishing its principles on these products in June. These new instruments are an extension of green and social bonds that already exist on the fixed-income markets.
Rationale behind this new instrument
When issuers launch a green bond, the proceeds are earmarked for specific projects, with pledges on use of proceeds and a report for investors to provide disclosure on the environmental and social impacts.
“With sustainability-linked bonds, proceeds are intended to be used for general corporate funding purposes” explains Julien Duquenne, originator at Natixis’ Green & Sustainable Hub. The issuer pledges to meet certain detailed medium- to long-term sustainability objectives, such as a timebound decarbonization goal, while key performance indicators (KPIs) measure progress and are included in the bond structure.
Both green loans as governed by the LMA1 Green Loan Principles and green bonds share a key feature – the obligation to track the use of proceeds targeting eligible sustainable projects. However, several companies pursue policies with a positive environmental or social footprint – responsible procurement policy, applying ESG criteria to select suppliers – without necessarily implementing specific investment projects, thereby disqualifying them from refinancing on the green bonds market. The Loan Market Association had already included this notion of KPIs in its Sustainability-Linked Loans Principles that were published over 18 months ago, so as not to penalize these companies: this has now influenced the bond market with the scope for taking on board sustainability indicators.
Can sustainability-linked bonds support companies in their transition?
“With today’s climate emergency, sustainability-linked bonds2 are excellent instruments for supporting companies’ transition” notes Julien Duquenne. “They are a good way to assess an issuer’s efforts to pursue the company’s transition, and are very useful in sectors that are not naturally green, helping investors assess companies’ progress towards the 2°C goal set out in the Paris Agreement and what concrete actions they are taking to achieve this aim”.
This instrument is therefore a natural fit for companies that see tackling the climate emergence as a priority: with this in mind, it is crucial for KPIs and their trajectories to be ambitious and externally verifiable and that performances be measured using a scientifically proven methodology to incorporate these aspects into the bond’s structure, for example increasing the coupon in the event that certain intermediate targets are not met.
“By ensuring the correct selection and appropriate calibration of KPIs, this new instrument will provide a decisive advantage for companies that can thereby enhance their responsibility credentials and meet high demand from investors who have already demonstrated clear interest in this area” concludes Julien Duquenne.
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