Sustainable Debt Instruments: What are the Benefits and Drawbacks?

By Heather Lang, Principal, ESG Global Advisors

Capital markets have emerged as one of the fastest growing and innovative market segments for ESG, fueled by ambitious sustainable finance commitments from leading banks and corporate issuers. With a growing number of instruments in the sustainable finance toolkit, cumulative issuance of sustainable debt has surpassed $3 trillion USD.

Yet this momentum is being put to the test in the context of a volatile market and unprecedented scrutiny of greenwashing.

Against this backdrop, what are the benefits and drawbacks of these instruments, and how can market participants strengthen confidence in sustainable transactions?

Use of Proceed Instruments

Labeled green, social and sustainability (GSS) bonds and loans finance and/or refinance sustainable assets and activities based on their defined use of proceeds, selection process, management, and reporting in accordance with market guidelines (see text box). Since the first green bonds were issued by leading supranationals in 2008, the market has steadily soared, expanding into social and sustainability bonds/loans (the latter combining social and environmental proceeds). While green bonds continue to drive the market, they have decreased in relative market share with the emergence of new instruments.

Benefits: The impacts of use of proceed instruments are clear and direct.

• Green financing targets activities with environmental benefits, such as renewable energy, water management, biodiversity and climate adaptation.
• Social financing can flexibly address timely socioeconomic issues (e.g., the direct and indirect impacts of the pandemic), while targeting disadvantaged groups.
• Pre-issuance frameworks and annual reporting requirements for GSS instruments promote transparency to investors and lenders on allocation and impact of proceeds.

Drawbacks: They are not indicative of an issuers’ broader ESG performance.

• Concerns over the credibility of issuers are prompting many investors to conduct additional ESG-related due diligence.
• Despite extensive efforts to develop overarching taxonomies, there is still a lack of consensus on whether certain activities qualify as green or transition.
• There is even more ambiguity in defining socially impactful projects in varying regional contexts.
• Many issuers lack sufficient assets that qualify for inclusion in GSS bonds, revealing barriers to entry for smaller companies and heavier industries.

(Sustainability) KPI-linked Instruments

Sustainability-linked instruments (also known as KPI-linked) provide general purpose financing while incentivizing issuers’ sustainability performance by linking coupon/interest rates to predetermined KPIs and sustainability performance targets (SPTs).

With sustainability-linked loans (SLLs) ebbing and flowing since first introduced in 2017, the tipping point for KPI-linked instruments came two years later with the emergence of sustainability-linked bonds (SLBs). Since 2020, KPI-linked bonds/loans have experienced the highest year-on year growth within the sustainable debt market. Notable steps have been taken to raise the bar for KPI-linked transactions via enhancements to the Sustainability-Linked Bond and Loan Principles in response to growing scrutiny.

Benefits: KPI-linked instruments provide maximum flexibility to issuers.

• As general-purpose bonds/loans, companies from hard-to-abate sectors do not face barriers to entry as per use of proceed instruments.
• The emphasis on sustainability improvement of the issuer on material KPIs is well-aligned with many investors’ ESG strategies.
• Lower interest rates linked to meeting predetermined targets make SLLs particularly appealing to borrowers in the wake of rising interest rates.

Drawbacks: Their flexibility predisposes them to mounting scrutiny of greenwashing.

• Growing concerns have been raised by investors and other stakeholders over strength of KPIs and level of ambition of SPTs, especially for SLBs.
• Decisions to convert vanilla debt to sustainable debt are sometimes treated as an afterthought, leaving insufficient time to develop credible targets and frameworks.
• Scrutiny of bond characteristics has called into question whether a step-up in coupon rate is a reasonable financial deterrent relative to any potential “greenium” experienced upon issuance.    

The Path Ahead

Sustainable debt finance has a vital role to play in supporting our transition to a low carbon economy while addressing other pressing sustainability challenges. Despite its extraordinary traction to date, we must recall that this is still a nascent market, at least a decade behind ESG in equity investment. With demand for sustainable bonds far outstripping supply, the first step was to broaden the tent of issuers and embrace innovation with a critical eye. But as the industry matures, its challenge is to safeguard the integrity of this highly scrutinized market through greater rigour and transparency.

Despite a temporary market slump, sustainable debt is expected to keep growing, propelled by ambitious commitments and massive pools of earmarked capital. Opportunities abound for companies to access these new pools of capital, while diversifying their investor base and showcasing their sustainability performance. Yet sustainable transactions require foresight and strategy, and companies that embed sustainable finance into their broader corporate ESG targets and objectives will be best positioned for success as the market expands and matures.

In our next issue of this series, ESG Global Advisors will outline foundational steps that position companies for sustainable transactions, aligned with rising market expectations.