Interest in sustainable finance continues to grow as activity across global markets reaches record volumes. As opportunities to enter the market expand, some issuers and lenders are looking for clarity on the various financial instruments available to support their needs.
Several of the most popular sustainable finance instruments sound similar, but differ from each other in the way they are structured. In this blog post, we provide definitions for the most common sustainable finance instruments, break down the differences between them and detail common use cases for each.
What is Sustainable Finance?
Sustainable finance refers to any form of financial service that integrates environmental, social and governance (ESG) criteria into business or investment decisions for the lasting benefit of both clients and society at large. It consists of many different financial instruments, such as labeled use of proceeds bonds and loans, sustainability-linked bonds, loans and revolving credit facilities (RCF), and more.
When comparing standard bonds or loans with sustainable ones (e.g., green, social or sustainability bonds), in principle, there is no real difference in the way the bond issuance is handled or the loan is agreed. The differences relate more to the big picture – channeling funds to finance projects and programs with positive environmental and social benefit – rather than the details.
Ultimately, a company does not have to be considered “green” to access the sustainable bond or loan market; the most important factor is how the funds are being used and their impact. However, companies should be aware of the role sustainability plays in their business and be committed to continued improvements in related areas.
Use of Proceed Bonds
Issuers of use of proceed bonds agree to allocate the funds raised to finance or refinance eligible projects or assets within specific categories. Several types of use of proceed bonds fall under the sustainable finance banner:
- Green bonds: The funds from these bonds are committed to environmental or climate projects, such as investing in renewable energy.
- Social bonds: The funds are committed to social impact projects, such as investing in low-cost housing for people with restricted access to the housing market.
- Blue bonds: The funds are committed to marine or water projects, such as investing in the transition to sustainable fish stock.
- Sustainability bonds: The funds are committed to a mix of social and green impact projects. These projects may also be aligned with the UN Sustainable Development Goals (SDG).
The International Capital Market Association (ICMA) has outlined the requirements for green, social and sustainability bonds. Although the industry guidance is voluntary, issuance in accordance with ICMA principles and guidelines is expected by the market for a bond to be considered credible. For more details, please read the Green Bond Principles, the Social Bond Principles and the Sustainability Bond Guidelines.
Green and Social Loans
Loans are similar to bonds, but differ in how the funding is raised. With bonds, funds come from the investor market, while funds for loans come from a bank. Like bonds, loans can be classified under the green, social or sustainability label.
- Green loans: The funds are committed to environmental or climate projects, such as green retrofits for office buildings.
- Social loans: The funds are committed to social impact projects, such as training people with disabilities to improve employability.
- Sustainability loans: The funds are committed to a mix of green and social impact projects.
A consortium of international financial associations developed the Green Loan Principles and the Social Loan Principles, which provide a consistent methodology for use across the green and social loan markets.
Sustainability-Linked Loans and Sustainability-Linked Bonds
A key component of sustainability-linked loan (SLL) and sustainability-linked bond (SLB) agreements is the linking of the finance terms to the achievement of predetermined sustainability performance targets. The targets should be both ambitious and relevant to the issuer or borrower’s operations and sustainability strategy.
The targets, and the key performance indicators on which they are based, should also be benchmarked either internally to the company’s past performance and/or externally to science-based targets or other independent assessments such as an ESG score.
Unlike labeled bonds or loans, the proceeds from an SLL or an SLB can be used for general corporate purposes. The flexibility of the sustainability-linked structure enables companies from industries not traditionally considered green (or those without a portfolio of eligible green or social assets or projects) to access the sustainable finance market and a more diverse pool of investors.
SLL and SLB Structure
For SLLs, the interest rate of the loan may increase if the borrower fails to achieve the agreed-upon sustainability performance target, and vice versa. Revolving credit facilities can also be included in this category because while the funds are only drawn when needed, the same agreement – interest rate paid is based on achieving sustainability target – can be made.
In an SLB agreement, the bond’s coupon rate will increase, or the issuer may pay a penalty when the bond matures, if it fails to achieve the sustainability or ESG objectives.
Forward-looking issuers are also linking the terms of their use of proceed green, social, or sustainability bonds to the achievement of sustainability performance targets. This combination “sustainability-linked labeled bond” has added credibility and appeals to both issuers and investors. The issuer demonstrates its commitments to sustainability by tying the coupon rate to sustainability targets, and the investor can be assured that the funds raised will be allocated to projects with a positive benefit, while also incentivizing corporate sustainability improvements within the issuer organization.
The Role of ESG Performance in Sustainable Finance
Companies can leverage their ESG performance to support their sustainable bond issuance or to help secure a green loan. For instance, some companies have highlighted their ESG performance (e.g., Sustainalytics’ ESG Risk Ratings) at their bond issuance roadshows to demonstrate their management of key ESG issues.
ESG factors are often used to determine how advanced a company is with respect to sustainability:
- Environmental performance looks at factors such as contributions to climate change through greenhouse gas emissions, waste management and energy efficiency.
- Social performance covers issues like human rights and labor standards both within the company and in the wider supply chain, adherence to workplace safety, and diversity.
- Governance performance looks at a set of rules or principles defining rights, responsibilities and expectations between all parties involved in the company. This covers such items as the make-up of the board and policies on bribery and corruption.
Sustainable finance will continue to play a significant role in tackling environmental and social issues, driven by demands from regulatory and industry bodies, investors, shareholders, and, of course, clients. The evolution of sustainable finance enables companies from all sectors to access funds to help finance the innovative projects, programs and initiatives focused on benefiting the environment and society. To remain relevant as well as competitive, companies need to be engaged with sustainable finance. The first step is understanding the financial instruments on offer and choosing the ones that help them achieve their strategic (sustainable) growth objectives.
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