In September 2019, an Italian power company called Enel announced a bond with interest rates that would be adjusted depending on whether or not it would be able to switch much of the power generation to renewable energy. ‘by the end of 2021. If they fail to produce 55 percent of their renewable electricity by that date, they will pay a one-time additional interest of 25 basis points (0.25 percent) on the bond.
In November 2020, the French electric systems company Schneider issued a bond that will pay a premium to investors if they fail to deliver 800 megatonnes of CO2 emissions saved and avoided for its customers, do not increase the mix of the staff or do not train a million people. people disadvantaged in energy management by 2025.
In Singapore, CapitaLand received six sustainability-related loans between 2018 and 2020 from regional banks, including DBS, UOB and OCBC. These loans may allow reduced interest payments based 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 incentivizes the issuer or borrower to meet environmental or social goals while providing the opportunity to reduce financing costs.
Unlike the majority of green bonds and green loans, sustainability finance can be used for general corporate purposes rather than a low-profile project, and does not require details of the use of the proceeds at the time of completion. the loan. It is up to the borrowing company to determine how to use the money to achieve an agreed set of sustainability goals.
Simply put, sustainability finance is based on performance rather than activity.
Lenders and investors alike are drawn to the prospect of a tangible positive sustainability component in their loan portfolio. It is also a way of making companies accountable for their promises of sustainable development. Financiers may also think that a company that can achieve forward-looking sustainability goals is also a lower risk investment.
The Principles of Sustainability Bonds and the Principles of Sustainability Lending suggest that the objectives of these instruments are measured using predefined Key Performance Indicators (KPIs) that are assessed against performance targets by sustainability (SPT). These must be demonstrated as essential, material and relevant.
Like all ESG instruments, there will be criticisms of greenwashing. The answer to this will lie in whether standards, methodologies and professional integrity can be strengthened as the size of the market increases.
The acceptable environmental and social areas for improvement generally follow the same lines as those contained in the taxonomies of green and social finance. Common areas would include emission reduction, energy efficiency, resource use, waste management and biodiversity. Social KPIs include working conditions, equal opportunities and training.
As with green and sustainable finance, current guidelines for sustainability loans and bonds recommend external verification of borrower performance against pre-defined targets and indicators. Auditors can apply the principles set out in external reviews of green bonds and sustainability finance lending, as they share the goal of measuring achievement of green and social indicators and targets.
Some reports suggest that sustainability finance may replace bridging finance as the preferred way to help companies take tangible steps towards climate and other goals as part of a longer-term path.
The missing “additionality”
Yet despite the laudable motives underlying the conception of sustainability finance, there remain two unresolved dilemmas: the omission of the “principle of additionality” and the risk of moral hazard.
The fundamental difference between finance linked to sustainable development and conventional finance is that the former claims to contribute to an additional positive impact on the environment or social development while the latter does not. A critical issue is ensuring that the impact is “additional”.
In other areas, such as the validation of carbon credits projects under the United Nations Clean Development Mechanism, there are clear rules to ensure that a project would only be eligible if there is evidence to prove that it would not have happened if the particular type of funding had not been available.
Likewise, for an obligation linked to sustainable development to be recognized, the issuer must demonstrate that the company would not be able to achieve the performance objectives in terms of sustainable development without receiving the proceeds of the linked obligation. to sustainable development. At this time, no such evidence is required. This means that investors can never be sure that they are creating an additional positive impact – an idea sold to them by the broker – when they invest their money in instruments related to sustainability.
If the objectives chosen represent fruits within reach, changes already underway, or even objectives almost achieved, then the value of these instruments will be called into question in the same way as the recent critiques of environmental, social and governance funds. (ESG) and odds.
Misalignment of investor incentives
The second dilemma relates to the mismatch between financial and ESG incentives on the part of investors and lenders. Currently, in virtually any sustainability bond or loan designs, investors or lenders will receive additional interest payments or avoid paying additional discounts when companies fail to meet their performance targets by sustainable development.
For investors or bankers who openly claim that they are doing good by buying sustainability bonds or offering sustainability loans, it would be an embarrassment if and when they receive the financial benefit – some might say “Blood money” – which arises from someone’s failure to protect the environment or promote social development. This is clearly a moral hazard that will loom on the horizon as more sustainability bonds and loans mature in the years to come.
There is no easy answer to both dilemmas unless the financial industry and regulatory bodies are prepared for some serious soul-searching.
Structural changes on the horizon
To apply the principle of additionality in finance linked to sustainable development, it is necessary to establish a “business-as-planned” benchmark for companies in a future period, then to formulate performance objectives in terms of sustainable development. beyond this reference.
It is hardly credible to rely on the same bankers or brokers who benefit from financial transactions to design the framework on which these transactions depend. Independent sustainability professionals need to step in much earlier than the external review period: from researching scientific methodologies, to conducting context-specific assessments, to setting credible baselines, to designing measures and solid goals.
To combat moral hazard resulting from the misalignment of investor incentives, one avenue is to explore the viability of pooling all potential penalty payments into recognized concessional 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 appropriate vehicles to assure investors and lenders that their intentions to create a positive impact would be realized even when companies do not. ‘are not meeting their business goals.
So what is left for bondholders and bankers? Previous research has shown that companies that strive to achieve ambitious ESG goals tend to be better managed and therefore less risky proposals. Equally important, aside from the normal financial return they would get from bonds or loans, they can sleep peacefully knowing that their money will contribute to the public good, regardless of how companies perform.
Finance linked to sustainable development will certainly grow and it has an obvious place in the larger market for green and social loans, bonds and funds. Like all ESG instruments, there will be criticisms of greenwashing. The answer to this will lie in whether standards, methodologies and professional integrity can be strengthened as the size of the market increases. Lenders and investors, as well as society as a whole, need to be reassured that money tied to sustainability is financing real and further advances in environmental and social progress.
Carbon Care Asia is a leading service provider in carbon strategy, sustainable innovation and green finance. Operating as a social enterprise, our mission is to achieve a zero carbon economy for all by promoting sustainability practices and improving the climate skills of businesses, governments and community organizations.
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