'Green sustainability-linked bonds': Getting to the heart of accountability and impact in sustainable financing

Growing pains

The market for sustainable finance has grown rapidly over the last few years and, according to our latest quarterly data, experienced a return to growth after a broader market slowdown in 2022. The relative strength of the Nordic market became even more apparent in early 2023 as the region saw its third consecutive year of Q1 supply growth.

The fast growth has bred much-needed innovation in financial markets and an awareness of the role the financial industry and organisations can play together in providing solutions to sustainability-related issues. There’s a broader recognition that understanding sustainability impacts is central to the long-term success of those on both sides of transactions. However, the pace of change has also invited cynicism and mistrust in some areas of the market, and understandably so.

Some of this mistrust is directed at legitimate issues, such as lack of transparency, poorly structured products and, at worst, intentional greenwashing. However, the fundamental features of both green and sustainability-linked bonds mean that some criticism was inevitable as that market grew. Whether in the allocation of proceeds or in the strength of targets, each of the formats has come under fire at some point in recent history.

Trust issues and increasing sophistication

Each format has its own set of inherent challenges.

Green finance, which focusses on specific projects or assets though defined use-of-proceeds (“UoP”) categories, can lack forward-looking impact and additionality as the projects or assets might not necessarily be driving the company’s transition. As an extension of this, there could be concerns over potential greenwashing, if companies access sustainable finance for a smaller part of their business, while also pursuing other “brown” activities. While corporates issuing green bonds often have transition plans in place and are actively working to reduce emissions across the organization, the issuance of a green bond is alone not a guarantee that sufficient work is being carried out elsewhere. Furthermore, broader sustainability risks, management practices and overall ambition of the organization may remain insufficiently addressed despite the issuance of a labelled bond.

Sustainability-linked financing, which enables general corporate purpose financing linked to sustainability key performance indicators (“KPIs”) and sustainability performance targets (“SPTs”), has received particularly heightened scrutiny over the past year. The format opened the market for sustainable finance to companies previously  excluded due to a lack of identifiable green projects and assets. It thus provided the means for a credible green transition with the forward-looking impact that might be absent in green finance. However, with this greater accessibility came the question of suitability more broadly. Without a clear definition of sustainable use of proceeds, and with sustainable financing now theoretically available to any business through the application of KPIs and SPTs, “sustainable” labels can be accessed by companies operating within sectors that are damaging or controversial from a sustainability perspective.

This initial criticism is tempered, however, by ensuring that the KPIs and SPTs selected meet a certain standard of materiality and ambitiousness, alongside a host of other requirements outlined by the SLB Principles. The market seems to have generally found this approach sufficient, as we are yet to see any large-scale exclusions from access to the SLB format due to industry classification alone. Afterall, all segments of society must be encouraged and enabled to develop an approach to sustainability if we are to achieve a smooth transition for the economy as a whole.

It is the details relating to KPIs and SPTs that are responsible for the majority of recent criticism directed towards SLBs. Requiring case-by-case analysis and trust in the process, data and company – there remain some barriers for sceptical investors. As we reported last year, the setting of KPIs and SPTs for SLBs has yet to be standardized. As such, not all SLBs brought to the market globally meet investors’ expectations from a sustainability or impact perspective.

However, as the recognition for the need to finance all companies has grown alongside the sustainable finance market, so has the acceptance for increasingly complex products. New and sophisticated structures provide much needed reassurance and accountability. The market is now beginning to observe blended structures that allow issuers and investors to pick and choose the use-of-proceeds and sustainability-linked elements that best apply to the organisation, using the strengths of one format to plug the gaps in the other. By using the two structures in combination, investors can be assured that proceeds are directly financing appropriate projects, and that long-term management of material sustainability issues is not being ignored.

Green sustainability-linked bonds and other combined format examples

In March 2021, Japanese construction company Takamatsu issued the first sustainability-linked green bond (“SLGB”), using bond proceeds to fund the construction of a new energy-efficient building in Tokyo, while being tied to the achievement of a revenue contribution to all of the 17 UN Sustainable Development Goals. The SLGB not only supports green real-estate development but also ensures (at least to a certain extent) a holistic alignment of the company’s overarching strategy to sustainable development. Europe’s first issuance of a SLGB followed quickly, through Austrian utility company Verbund, whose issuance is tied to the expansion of both the Austrian power grid and a specific hydro-power plant. In addition, the company committed to meeting two sustainability performance targets related to integrating renewable energy generation into the grid. Other examples of the SLGB format include Japanese real estate investment trust GLP J-REIT and German automotive parts supplier Mann+Hummel.

Another approach to strengthening one of the “classic” formats is to include capital expenditure KPIs as part of an SLB. In February this year, Italian energy-infrastructure company Enel (who launched the world’s first sustainability-linked bond back in 2019), issued an updated SLB, which included targets to reduce scope 1 greenhouse gas emissions intensity and to invest at least 80% of its capital expenditure in EU Taxonomy-aligned projects between 2023-2025. Despite not including defined use-of-proceeds categories, thus remaining unrestricted in terms of volume, the bond ensures funds are channeled towards recognized green projects, thereby incorporating a level of transparency not always present in SLBs.

Other European issuers, such as the aluminium producer Norsk Hydro, the packaging company Bewi and telecommunications giant Tele 2, have published sustainable finance frameworks including both green use-of-proceeds and sustainability-linked KPIs, but so far none have combined the two formats in their issuances. Taking the first step by including and defining both UoP and KPIs might however indicate a recognition that the market will look more kindly on issuers acknowledging both the direct impacts of their investments as well as their overall goals and strategy to reach these.

Ensuring real-world and long-term change

The combined formats allow for real-world and longer-term embedding of changes. By incorporating the forward-looking metrics from a KPI-structure to a defined use-of-proceeds structure, the formats bring the management and oversight into what could cynically be labelled an accounting exercise (UoP). On the other hand, the addition of clearly defined sustainable investments, either through delimited use-of-proceeds categories, or through targeted capex KPIs, ensures short-term sustainability from structures characterized by long-term targets with uncertain impact.

Ultimately, such structures mitigate identified issues and could supply the holistic approach investors want (and the world needs): accountability for where money is being spent AND for the decision making around the organisation that is spending the money. It hits both the what (UoP) and the how/why (SLB) of an organisation.

Sustainability is a topic that has grown somewhat unchecked over the past decades, making its way into companies’ strategies, communication, reporting and financing. Previously mere mention of sustainable intent was sufficient to garner acceptance and support. Now we are moving into a world where expectations are both increasing and tightening.

In the sustainability-reporting sphere, investors and society now expect to see credible transition plans, scenario planning and ambitious yet achievable pathways in place. The bond markets are also becoming more sophisticated in their evaluation of sustainability. Simple allocation of proceeds may soon no longer be enough. Investors will also require evidence that the overall organisation is moving in the right direction and is held to account for meeting appropriate sustainability-related milestones. GSLBs and other mixed formats can provide the assurance needed by mitigating the weaknesses of the single formats.