What are sustainability linked bonds and how can they support the net-zero transition?
Sustainability linked bonds have the potential to move the needle in the transition to net-zero. Image: Freepik.
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- Debt finance, largely bank loans and bond issuances, accounts for 90% of new capital for fossil fuel companies.
- Sustainability linked bonds (SLBS) offer lower interest rates to issuers that successfully implement sustainability or ESG principles.
- Debt financing is often overlooked as a source of capital driving emissions, but with some reforms, SLBs could accelerate the net-zero transition.
The emergence of new debt financing and borrowing tools, notably sustainability linked bonds represents an enormous opportunity to mobilize institutional and privately held capital towards climate investment - but also highlights the imperative to mitigate the risk of greenwashing.
What are sustainability linked bonds?
A sustainability linked bond (SLB) is a borrowing instrument where financial and structural characteristics are based on whether the issuer achieves sustainability or ESG metrics within a given timeframe. If the company doesn’t meet those goals, there’s a penalty: higher interest paid to investors. This performance-based instrument allows issuers to commit explicitly to future improvements in sustainability outcomes while benefiting from discounted interest rates on the bond.
There is growing investor appetite for this type of bond as they offer several advantages that green or social bonds do not. First, unlike green bonds, SLBs are not “use-of-proceed” bonds, meaning the funds provided are not earmarked for specific purposes and can finance any corporate activities. Furthermore, sustainability linked bonds allow a wider array of issuers that are unable to access green or social bonds. Green bonds require heavy capital expenditures in the green areas such as renewable energy, utilities, or green buildings and are therefore inaccessible for most companies.
This has sparked a boom in the SLB market, which ballooned to more than $100 Billion in 2021 from only 9 billion in 2020. In September 2022 alone, $57 Billion in SLBs were issued and all signs point to further exponential growth in the coming months.
Why is greenwashing a risk?
With increased flexibility comes increased risk greenwashing. Because companies can define their own Environmental, Social, and Governance (ESG) strategy and set their own milestones, goals can be easy to reach and the KPIs generate little, if any, material climate impact. The investors on the other side of this bond benefit from an enhanced “green” reputation and often have little incentive to push companies to set more challenging goals.
A Bloomberg study that analyzed over 100 SLBs worth over $70 billion found that the majority were tied to climate targets that are weak, irrelevant, or even already achieved.
How could reforms harness the potential of sustainability linked bonds?
While SLBs in their current form are not revolutionizing the corporate debt market, with a few meaningful reforms, this instrument could move the needle in one of the most overlooked forms of capital driving emissions.
- Defining use of funds from sustainability linked bonds is essential. As it stands, the issuer retains full discretion for use-of-proceeds from SLBs, leaving open the possibility that a funding source meant to promote sustainability could be used to fund carbon emitting activities. At the same time, sustainability linked bonds should not necessarily mandate the same green expenditure allocations as green bonds, or most issuers would be crowded out and unable to access this tool. Mandating that an SLB is not funding carbon emitting activities that directly contradicts sustainability goals is a sensible middle ground that would bring companies closer to net-zero while benefiting from the bond.
- Credible and material KPIs underpin the potential for SLBs to make meaningful climate impact, which likely involves review by an independent regulatory body. The International Capital Markets Association have drawn up principles that can act as voluntary structuring, disclosing, and reporting guidelines. For example, KPIs related to emission reductions should extend beyond a company’s direct carbon output to the scope 3 emissions generated by the manufacturing, processing, and shipping that takes place throughout the value chain.
- Increased transparency in these mostly private agreements between investor and issuer would give credibility to sustainability linked bonds. The efficacy of SLBs depend on accurate and thorough reporting of key sustainability metrics related to emissions and energy uses. The non-profit Sustainability Accounting Standards Board (SASB) laid out a disclosure and reporting framework which facilitates the disclosure of comparable, consistent, a reliable ESG information. Frameworks which increase transparency in the disclosure process will decrease greenwashing and maximize the impact of SLBs.
Aligning the corporate bond market with sustainability goals is critical for moving the financial services sector towards net-zero. Debt financing is one of the most overlooked sources of capital driving emissions, and with some reforms, sustainability linked bonds have the potential to move the needle in the transition to net-zero.
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