Green finance set to become more popular with new bond instruments

There are now more options for sourcing funding from investors for sustainable, social or environmental projects

The market for green, social and sustainability bonds has been growing rapidly over the past few years, with issuances reaching $1.4 trillion, including last year’s $490 billion. For the time being, the Gulf region accounts for only for a tiny part of it. However, this is about to change, in part thanks to the recent creation of a new financial instrument: the sustainability-linked bond.

Green, social and sustainability bonds are all “use-of-proceeds” financial instruments. While these bond formats provided investors with clarity and transparency in terms of what is being financed or refinanced with the proceeds raised from their issuance, some issuers perceive the use-of-proceeds structure as too restrictive and have stayed away from this market.

To understand why this is the case, we need to take a closer look at the structure of these instruments. To offer a green or social or sustainability bond, an issuer needs to have some existing or planned projects deemed eligible for such financing – such as environmental projects for green bonds, social projects for social bonds and a mix of both for sustainability bonds.

The focus of these instruments is on the issuer’s eligibility as of now, regardless of their ambition for the future. Consequently, some companies that would like to embark on the energy transition pathway or improve their sustainability credentials over time may not fulfil the necessary conditions for issuing these bonds.

This is problematic because the decarbonisation of the economy cannot happen without transforming carbon intensive or otherwise “unsustainable” parts of the economy. This transformation will require significant financial flows, but these are unlikely to be channelled through use-ofproceeds bond formats. This is particularly true for the Gulf region, as it is well positioned to play a leading role in energy transition. For now, it accounts for a fraction of use-of-proceeds bonds issued.

Sustainability-linked bonds, or SLBs, were developed to address these issues with the aim of opening the green and sustainable bond market to new issuers.

Instead of defining eligibility in terms of existing assets and activities such as the use-ofproceeds bonds do, SLBs are general corporate purpose instruments that focus on the issuer’s future trajectory towards the achievement of pre-determined environmental, social and governance objectives.

This means that any issuer can potentially issue SLBs regardless of how sustainable they currently are – what matters is the credibility of their commitment to future improvements.

But it takes two to tango. SLBs can only succeed in the market if investors are willing to buy them. To gauge investors’ appeal and any concerns, Natixis undertook a survey of 40 global investors with combined assets under management worth $20tn.

About nine in 10 surveyed investors said they had an appetite for SLBs, with 40 per cent willing to add them to conventional portfolios and 66 per cent to their ESG investments.

However, some investors also raised concerns, with more than half citing the issue of “greenwashing”, in which some companies or products claim they are more sustainable than the evidence suggests.

These concerns need to be addressed during the structuring phase of each SLB by setting out ambitious sustainability targets whose evolution over time can be used to assess progress.

Another concern among investors was a lack of comparability in terms of the targets being set.

As a rule, key performance indicators should be robust, material and holistic to achieve the predefined objectives of the issuance.

The ambition of KPIs should be embedded in a long-term strategy approach rather than only focusing on short-term deliverables. Moreover, all investors expect impact reporting, including views on the levers put in action to achieve targets.

In terms of the areas of interest, environmental indicators are broadly accepted as a method to structure SLBs, but there is also growing interest in social themes, particularly health and safety topics, which were identified by 70 per cent of respondents.

The growth of the SLB market occurred after June 2020 when the International Capital Markets Association released Sustainability Linked-Bond Principles, voluntary guidelines that define SLBs as a type of bond in which the financial and/or structural characteristics can vary depending on whether the issuers achieve predefined sustainability or ESG objectives. After the ICMA’s guidelines, more than 45 issuers raised financing through this format, with issuances of about $20bn as of last month.

Our conviction is that use-ofproceeds instruments (green, social, and sustainability bonds) and SLBs will coexist in the bond market as each appeal to different types of issuers. This does not mean that one of these bond formats will be greener or more credible than another; they simply take a different perspective and address different sets of investor expectations. Use-of-proceeds bonds provide investors with clarity about what is being financed, but SLBs offer a more forward-looking and holistic view of an issuer’s profile.

Radek Jan is an infrastructure and green bonds specialist at Natixis, which is a member of The Gulf Bond and Sukuk Association

There is concern over companies that claim to be more sustainable than they really are