The Unresolved Dilemmas of Sustainabilty-Linked investments
In September 2019, an Italian power company called Enel announced a bond with interest rates that would be adjusted depending on whether or not they were able to switch a good portion of the energy generation to renewables by the end of 2021. If they fail to produce 55% of their electricity renewably by that date, they will pay a one-time 25-basis-point (0.25%) extra interest on the bond.
In November 2020, the French electrical systems company Schneider issued a bond that will pay a premium to investors if they fail to deliver 800 megatons of saved and avoided CO2 emission for its customers, do not increase staff gender diversity, or fail to train 1 million underprivileged people in energy management by 2025.
In Singapore, CapitaLand received six sustainability-linked loans between 2018-2020 from regional banks including DBS, UOB and OCBC. These loans may enable reduced interest payments depending on the company’s rating on the Global Real Estate Sustainability Benchmark (GRESB) or its listing on the Dow Jones Sustainability World Index (DJSI World).
A welcome addition of performance-based instruments
These bonds and loans are examples of a growing market for “sustainability-linked” finance, which incentivises the issuer or the borrower to achieve environmental or social targets while providing the opportunity to reduce financing costs.
Unlike the majority of green bonds and green loans, sustainability-linked finance can be used for general corporate purposes rather than a discrete project, and doesn’t require details of use of proceeds at the time of borrowing. It is up to the borrowing company to work out how to apply the money to achieve a set of agreed sustainability targets.
Put simply, sustainability-linked finance is performance-based rather than activity-based.
Lenders and investors are attracted by the prospect of a tangible positive sustainability component in their loan portfolio. It is also a way of holding the companies to account on their sustainability promises. Financiers may also believe that a company which can hit forward-looking sustainability goals is also a lower-risk investment.
Both the Sustainability-Linked Bond Principles1 and the Sustainability Linked Loan Principles2 suggest that objectives of these instruments are measured through predefined Key Performance Indicators (KPIs) which are assessed against Sustainability Performance Targets (SPTs). These should be shown to be core, material and relevant.
Acceptable environmental and social areas for improvement follow broadly the same lines as those contained in green and social finance taxonomies. Common areas would include emissions reduction, energy efficiency, resource use, waste management and biodiversity. Social KPIs include labour conditions, equal opportunities and training.
As with green and sustainable finance, the current guidelines for sustainability-linked loans and bonds recommend external verification of the borrower’s performance against predefined targets and indicators. Verifiers can apply the principles set out in external reviews of green bonds and loans3 to sustainability-linked finance because they share the objective of measuring the achievement of performance of green and social indicators and targets.
Some reports suggest that sustainability- linked finance may displace transition finance as the preferred way to help companies make tangible steps towards climate and other goals as part of a longer-term pathway.
The missing “additionality”
Yet despite the laudable motives behind the design of sustainability-linked finance, there remain two unresolved dilemmas – the omission of the “additionality principle” and the risk of moral hazard.
The fundamental differentiation between sustainability-linked finance and conventional finance is that the former purports to contribute additional positive impact to the environment or to social development whereas the latter does not. A critical question lies with assurance that the impact is “additional”. In other spheres, such as the validation of carbon credit projects under the UN Clean Development Mechanism, there are clear rules to ensure that a project would only be eligible when there is evidence to prove that it would not have happened had the particular type of finance not been available.
By the same token, for a sustainability- linked bond to be recognized, the issuer should need to demonstrate that the company would not be able to achieve the sustainability performance targets without receiving the proceeds from the sustainability-linked bond. At present no such proof is called for. This means investors can never be certain that they are creating additional positive impact – an idea sold to them by the broker - when they put their money into sustainability-linked instruments.
If the chosen targets represent low-hanging fruit, changes already in progress, or even targets nearly met, then the value of these instruments will be called into question in a similar way to recent criticisms of ESG funds and ratings.
Misalignment of investor incentives
The second dilemma is related to the mismatch between financial and ESG motives on the part of investors and lenders. Currently in practically all designs of sustainability-linked bonds or loans, the investors or lenders will either get extra interest payments or avoid paying extra rebates when companies fail to meet their sustainability performance targets.
For investors or bankers who openly claim that they are doing good by buying sustainability-linked bonds or offering sustainability-linked loans, it would be an embarrassment if and when they receive the financial benefit – some might say “blood money” – that arises from someone’s failure to protect the environment or promote social development. Clearly this is a moral hazard that will loom large when more sustainability-linked bonds and loans reach maturity in the coming years.
There is no easy answer to both dilemmas unless the finance industry and standard- setting bodies are prepared for some serious soul-searching.
Structural changes on the horizon
To apply the additionality principle in sustainability-linked finance, there is a need to establish a “business-as-planned” baseline for companies in a future time frame and then formulate sustainability performance targets over and above such a baseline. It is hardly credible to rely on the same bankers or brokers who benefit from the financial transactions to design the framework on which such transactions depend. Independent sustainability professionals need to step in much earlier than the period of external review: from researching science- based methodologies, conducting context- specific assessments, setting credible baselines, to designing robust metrics and targets.
To tackle the moral hazard arising from the misalignment of investor incentives, one avenue is to explore the viability of pooling all potential penalty payments into recognized concessionary funds or grants that contribute to the public good. The Green Climate Fund established under the Paris Agreement, for example, could be one of the suitable vehicles to assure investors and lenders that their intentions to create positive impact would be realised even when companies fail to meet their corporate targets.
So what’s left for bond holders and bankers? Past research has shown that companies striving for ambitious ESG goals are generally better managed and hence less risky propositions. Of equal importance, apart from the normal financial return they would get from the bonds or loans, they can sleep peacefully knowing that their money will contribute to the public good regardless of how the companies perform.
Sustainability-linked finance will certainly grow and it has an obvious place in the larger market of green and social loans, bonds and funds. Like all ESG instruments, there will be criticisms of greenwashing. The answer to that will lie in whether standards, methodologies and professional integrity can be strengthened as the size of the market grows. Lenders and investors, as well as society at large, need to be reassured that sustainability-linked money is financing genuine and additional advances in environmental and social progress.
1 International Capital Markets Association. June 2020. Sustainability-Linked Bond Principles: Voluntary Process Guidelines https://www.icmagroup.org/assets/documents/Regulatory/Green-Bonds/June-2020/Sustainability-Linked-Bond-Principles-June-2020-171120.pdf
2 Loan Market Association. July 2021. Sustainability Linked Loan Principles: Supporting environmentally and socially sustainable economic activity. https://www.lsta.org/content/sustainability-linked-loan-principles-sllp/
3 International Capital Markets Association. June 2020. Guidelines for Green, Social and Sustainability Bonds External Reviews. https://www.icmagroup.org/assets/documents/Regulatory/Green-Bonds/June-2020/External-Review-GuidelinesJune-2020-090620.pdf