Just a few years ago, raising finance linked to the achievement of environmental, social and governance (ESG) objectives may have been viewed by borrowers as a “nice to have” and a relatively easy way to enhance their reputations and boost their ESG credentials.
Now, sustainable finance is widely embraced and continues to gain momentum at a rapid pace. The opportunities and incentives it offers to support and fund transition to a sustainable economy mean sustainable finance is an essential part of treasury toolkits and investment portfolios and is expected to grow exponentially. In this article, we explore the market’s growth, key benefits for investors and borrowers, and discuss potential pitfalls like greenwashing.
Through sustainable finance, borrowers apply ESG considerations to their use of the debt borrowed. The rise of sustainable finance is leading to more long-term investments in sustainable economic activities and projects.[1]
ESG in finance
Environmental considerations include climate change mitigation, use of sustainable resources, waste management, biodiversity protection and pollution prevention.
Social considerations include the promotion of human and animal rights, equality, inclusiveness, labour relations, consumer protection, investment in human capital and communities and access to healthcare and education.
Governance considerations include employee relations, executive remuneration and compensation practices and management structures of both public and private organisations.
ESG linked debt is commonly raised through the issuance of bonds to investors or through loans from banks. Each type of debt has a set of voluntary guidelines published by the International Capital Markets Association (ICMA), the Loan Markets Association (LMA), the Asia Pacific Loan Markets Association (APLMA) or the Loan Syndications and Trading Association (LSTA), depending on the market in which the debt is borrowed and whether the debt is borrowed in the form of a bond or a loan. The following table sets out the most common types of sustainable finance.
Green Bonds, Social Bonds, Sustainability Bonds (GSS Bonds) |
Green Loans & Social Loans |
Sustainability-Linked Loans (SLLs) and Bonds (SLBs) |
Bonds where the proceeds are used by the issuer to fund new or existing eligible green projects or social projects or a combination of green and social projects.
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Loans where the proceeds are used by the borrower for green or social purposes.
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Unlike GSS Bonds and green and social loans, the proceeds of SLLs and SLBs are not earmarked and can be used for general corporate purposes. SLBs and SLLs incentivise the borrower’s achievement of certain ESG objectives measured against KPIs and Sustainability Performance Targets (SPTs) with interest rate adjustments applied based on compliance with them.
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Sustainable finance can not be ignored
Global call for action
With increasing global attention and industry support for a transition to a sustainable economy, sustainable finance continues to gain momentum at a rapid pace.
In 2015, important international agreements were concluded with the adoption of the United Nations 2030 agenda, the Sustainable Development Goals (SDGs) and the Paris Agreement. The Paris Agreement includes a commitment to make finance flows consistent with a pathway towards low greenhouse gas emissions and climate-resilient development. More recently, a key objective of the 2021 United Nations Climate Change Conference (COP26) was the promotion of sustainable finance, focusing on mobilising public and private sector finance to support the securing of global net-zero emissions (NZEs).
From a governmental standpoint, Australia has demonstrated its commitment to a sustainable economy by ratifying the Paris Agreement, adopting the SDGs and committing to upholding its obligations under the UN human rights conventions. Australia has also recently released its plan for achieving NZEs by 2050.
From a business standpoint, commitment to ESG goals is driven by strong market forces. The impact of business on the progress of sustainable finance has arguably been greater than that of government.
Rising demand for sustainable investments
It is clear that sustainable finance has become a top priority for corporates, investors and regulators alike. Companies without clear and credible transition strategies in line with the Paris Agreement are beginning to experience an adverse impact on access to and cost of funding.[2] Sustainable finance is no longer just a public relations matter for companies. Investors are shifting their focus from financial returns to broader investment considerations, including environmental and societal impacts as a means of creating and protecting long-term value.
There has been a substantial increase in sustainable investment in Australia in recent years and this trend is expected to continue. Australia’s market trajectory is in line with global developments. The Climate Bonds Initiative forecasts that global sustainable debt issuance will reach US$1.9-2.2 trillion in 2022 compared to US$977 billion in 2021.[3] By 2025, ESG-linked finance is expected to reach US$53 trillion.[4]
For institutional investors with growing ESG mandates, ESG factors play a fundamental role when making long-term investment decisions and are increasingly being viewed as more important than traditional financial metrics. Investors are aware of the positive impact that investing in companies which embed ESG principles into their practices can have on their business performance. Most institutional investors agree that companies which focus on ESG issues are more likely to outperform their competitors, produce better long-term returns and reduce investment risk.[5] Understandably, for these reasons, the proportion of both retail and institutional investors globally who apply ESG principles to at least a quarter of their portfolios jumped from 48% in 2017 to 75% in 2019. It is expected that ESG-mandated assets will grow almost three times as fast as non-ESG-mandated assets to comprise half of all professionally managed investments by 2025.[6]
Supportive regulatory environment
Governments globally are supporting sustainable finance as a means of meeting their commitments to climate change by influencing the actions of the private sector. Policymakers are developing initiatives to incentivise investment in low-carbon business and further ESG objectives. Regulators now consider a business’s assessment of climate risks to be a fundamental component of compliance for organisations that deliver financial services.
In line with these developments, the recently established Australian Sustainable Finance Institute (ASFI) has launched its own sustainable finance roadmap, establishing new frameworks, standards and practices to realign the Australian finance sector to support better environmental, social and economic outcomes, including the achievement of the NZE target by 2050.[7]
Benefits for borrowers
Sustainable finance is not only beneficial for the planet, it is also beneficial for borrowers. Why?
Better terms and pricing
Borrowers can expect better terms and pricing for their debt as the market for green, social and sustainable investments continues to grow and develop, as the cost of capital is being driven down and investors view borrowers that pursue sustainable finance as better-placed to deal with future risks and opportunities.
The pool of investors and lenders has also grown and diversified, driven by pressure from stakeholders of banks and investors to boost their own ESG credentials. This meant an increase in demand for sustainable financial products.
Reputation
It is increasingly the case that without committing at least part of its debt to ESG objectives, the reputations of corporate borrowers will suffer. Sustainable finance serves to boost a borrower’s green credential and its social licence to operate.
Better ESG outcomes
Sustainable finance can help to mitigate the exposure of borrowers to ESG-related risks by helping them to meet their ESG commitments and objectives.
Beware of greenwashing
Its not easy being green,” – Kermit the Frog
In the context of sustainable finance, “greenwashing” refers to the practice of gaining an unfair competitive advantage by marketing a financial product as environmentally (or socially) friendly, when in fact basic environmental (or social) standards have not been met.[8] Greenwashing can occur when borrowers exaggerate the green or other credentials of a financial product or project or set ambitious or unrealistic targets which they are unable to meet.
As there are a variety of principles which may be applied in setting green or social goals and a lack of metrics to evaluate and measure whether green or social targets are being met, there can be a lack of rigour around the selection and measurement of KPIs by borrowers when raising green finance. There are generally few consequences under ESG loan and bond terms for breaching ESG undertakings and reporting obligations.
Greenwashing may constitute misleading or deceptive conduct under Australia’s consumer and corporate laws, which may lead to scrutiny and enforcement action from regulators and/or actions by investors and lenders. Even if it doesn’t constitute misleading or deceptive conduct, greenwashing could adversely affect a borrower’s reputation, its ESG credentials and its relationship with investors and lenders.
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Reputational risks
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Legal and regulatory risks
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Uncertainty of future regulation
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How is the risk of greenwashing being addressed?
Regulation
There remains a real risk of greenwashing in the absence of a clear regulatory framework and global standardisation of ESG, with a wide range of approaches being taken,[9] in part, due to the range of products, assets, sectors and financing markets in this space. However, the market is evolving, maturing and moving towards greater harmonisation and the development of market norms as a result of the work done by leading industry bodies (such as the LMA, APLMA, LSTA, ICMA and others).
There is a general consensus among market participants that increased regulation of sustainable financing is needed. This will assist borrowers in demonstrating the legitimacy of their products and differentiate them from those who are merely greenwashing. It should also allow for the development of reliable market data against which the risk, return and ESG objectives of various sustainable finance products can be better assessed, positively influencing demand and pricing.
Reporting
ESG reporting involves the disclosure of performance in relation to material ESG risks and opportunities, both qualitatively and quantitatively, to explain how these aspects inform a company's strategy and overall performance.[10] There are several frameworks and approaches for reporting and reporting comes with its own set of challenges as a result.
Companies have broad discretion over which standard-setting organisation to follow, and what information to include in their ESG reports. Moreover, borrowers set goals on the basis of their capabilities or aspirations, rather than following corporate emissions allocations or adopting science-based targets.
Although strides are being made in setting tangible targets and goals, and accurately reporting on these, there is still progress to be made. Another challenge is the gaps in reporting metrics, as not all information can be credibly or as easily disclosed. For instance, from a governance perspective, it is easy to report on ‘hard’ information, which is quantifiable and verifiable, like the number of jobs created for women in a year; it is more difficult to report on ‘soft’ information, such as the quality of those jobs, which is difficult to quantify.[11]
Disclosure
Investors are demanding more transparency and accountability from borrowers on ESG matters. In response to this, a new standard-setting board known as the International Sustainability Standards Board (ISSB) was established at COP26. The ISSB aims to provide a comprehensive global baseline of sustainability-related disclosure standards that provide investors and other capital market participants with information about borrowers’ sustainability-related risks and opportunities to help them make informed decisions[12]. The ISSB will work alongside and operate in conjunction with the IASB.[13] ASIC and other key standard setting bodies in Australia have welcomed the establishment of the ISSB.[14]
Third-party verification
By having a credible third party verify the framework under which ESG finance is raised, lenders and investors are less likely to be concerned about the potential for greenwashing. In the absence of regulatory standards, third-party verification may provide greater certainty to investors of the climate, reputational and other risks associated with the product or asset.
Borrowers should exercise restraint in their disclosure
Borrowers should ensure that any statements or KPIs relating to an ESG loan or bond don’t overstate the potential ESG benefit of the project, activity or asset being funded by the proceeds of the loan or bond. In the absence of clear regulation and with differing ideas of what constitutes dark green, light green, vanilla or even brown in different financing markets and by different market participants, this is of vital importance.
Conclusion
While sustainable finance might once have been considered niche, it is now the new normal and is expected to continue to grow rapidly. Borrowers financing for the future must embrace sustainable finance in order to maintain stakeholder support and remain competitive, while at the same time being mindful of the risks and opportunities presented in this fluid and evolving environment.
