Sustainability-linked instruments best practices
Ben specialises in sustainable finance, with a focus on sustainable fixed income. He helps connect environmentally and socially conscious capital to sustainable solutions through ESG advisory to structuring agents, ESG due diligence, financing framework development and tailored second party opinion production. Ben has a rigorous understanding of the best practices in bond and loan markets, produced by the ICMA, LMA, APLMA and the LSTA, as well as a thorough understanding of SFDR and the EU Taxonomy Delegated Act, conducting alignment exercises for issuers, borrowers and projects.
Those paying close attention to the rapidly moving discourse that now typifies the ESG space will have likely come across the adage ‘alphabet soup’ when discussing the seemingly infinite range of ESG reporting standards, initiatives and organisations in between. The term can be extended more widely, to the ‘sustainable fixed income’ space.
After the European Investment Bank launched the Climate Awareness Bond in 2007, there have been several innovations to the traditional debt instruments. Labels attached to bonds and loans now include green, social, sustainable, climate, SDG, blue and more recently nature performance and even mangrove bonds and loans…pause for breath.
Balancing Profitability with Sustainability Goals
Of particular interest is the sustainability-linked bond or loan. A differentiating property from previous bond and loan innovations is that the margin (interest payable) is linked to the borrower’s performance against pre-agreed sustainability performance targets (SPTs).
Unlike green bonds, where proceeds cannot be used for general corporate purposes, these instruments enable organisations to transition towards sustainability and move upwards on the ESG maturity curve, without being tied down to use the proceeds in a particular way. Under these circumstances, it is even more crucial to ensure the integrity of the product, as the risk of [perceived] greenwashing is higher.
If the issuer or borrower achieves its SPTs then its margin on the debt instrument is reduced, acting as an incentive to move towards sustainability by a cost-saving mechanism. The mechanism can work the other way too. If the SPTs are not achieved, then the interest payable is increased by pre-agreed basis points.
Example SPTs can range from CO2 emission reductions, reduction in the use of single use plastics or quantitative improvements in ESG ratings such as Ecovardis, MSCI or Sustainalytics; targets being calculated from a baseline year.
To maintain market integrity and adhere to best practice, structuring agents (also known as the Sustainability Coordinators) and lenders need to conduct adequate pre-transaction due diligence as part of the bond issuance or loan inception process, or alternatively outsource the due diligence to a specialist ESG provider.
Conducting adequate pre-investment due diligence allows for the checking of the underlying data availability and credibility, calculations as well as the data capturing processes before the transaction takes place.
From an issuer or borrower perspective, adequate due diligence is beneficial too, as the SPTs need to be certifiable through an assurance exercise by an independent third party (Sustainability Expert), on an annual basis – the issuer or borrower receiving a sustainability compliance certificate if successful.
If a transaction is entered into without adequate pre-transaction due diligence, then the possibility of prompt certification is less, and if certification cannot take place then the loan loses its sustainability label – with knock-on consequences for parties involved.
Likewise, the sustainability-linked bond or loan’s SPTs should be relevant to the ESG challenges of the sector and firm. The sustainability-linked bond or loan’s SPTs should be ambitious and not too easily achievable as to undermine the sustainability element of instrument, as specified by International Capital Market Association (ICMA’s) Sustainability-Linked Bond Principles and the Loan Market Association’s, Asia Pacific Loan Market Association’s and the Loan Syndications & Trading Association’s Sustainability-Linked Loan Principles.
How We Can Help
As part of our core ESG Advisory services, SLR offers solutions at every stage of the sustainability-linked bond or loan lifecycle. We foster integrity in the structuring phase, acting as advisors to Sustainability Coordinators, supporting in the selection of relevant and ambitious SPTs and through rigorous ESG due diligence to ensure certification is possible after bond or loan origination.
We also have the in-house expertise to act as a Sustainability Expert, providing independent verification of underlying data, calculations and outputs, essential in the supply of the Sustainability Compliance Certificate.
If accessing the sustainable finance markets through sustainability-linked bonds or loans is of interest to your organisation or if access has already been achieved and specialist ESG support is required, please get in touch.
