Comparing sustainable debt products and standards

Introduction

Sustainable lending is growing in the general and corporate markets. According to Bloomberg New Energy Finance (BNEF), whilst the sustainable lending market represents a relatively small part of the broader capital markets, 2020 saw the highest volume of sustainable debt issued globally in any one year, totalling US$732.1bn, an increase of 29 percent from US$465bn in 2019¹. 

Recent years have seen a proliferation of products and standards coming to market to meet investor demand. BNEF’s analysis highlights a narrower measure of sustainable (also known as responsible) debt, which includes only bonds and loans that strictly follow formal standards.  This article provides an overview of a number of the key sustainable debt products and standards, and explores the main distinctions in their application and availability.

Background

There are two main drivers causing financial institutions to focus on the sustainability of their portfolios. These drivers are fuelling a growing appetite for banks, pension funds and insurance fund managers to assess, monitor and disclose the sustainability of their investments. On the one hand there is a growing pool of capital seeking to invest in sustainable assets, driven by international initiatives to tackle climate change and investor mandates to promote sustainable development and the UN Sustainable Development Goals. On the other hand is the recognition of the critical role which climate change risk management plays in a resilient global financial system, with voluntary measures such as the recommendations of the Task-Force on Climate Related Financial Disclosures (TCFD) beginning to be adopted by regulators. For more information on the regulatory drivers, please see our article: Global, EU and UK sustainable finance initiatives.

Demand for sustainable debt products and standards is growing. At a global and regional level, sustainable lending is gaining traction amongst borrowers who are keen to demonstrate their commitment to sustainable practices. While frameworks designed to implement sustainability standards have been around for some time, such as the Equator Principles launched in 2003, and the Responsible Ship Recycling Standards (RSRS) adopted in 2013, these were sector-specific initiatives which did not have application in wider markets. 

In 2014, the International Capital Markets Association published the Green Bond Principles (GBP) – guidelines detailing the key components involved in launching a credible “green bond”. It was not until March 2018 that the Loan Market Association issued the Green Loan Principles (GLP), providing long-awaited clarification as to what amounts to a “green loan”. Following the launch of the GLP, a diverse array of guidelines designed to incentivise sustainable economic activity have been introduced, the most recent being the Sustainability-Linked Loan Principles (SLLP) in March 2019, the Poseidon Principles in June 2019 and the Sustainability-Linked Bond Principles (SLBP) in June 2020. The Equator Principles have been updated, with the new version 4 adopted in October 2020.

Application in different sectors

These sustainable finance standards vary in their application and purpose, with some having a narrower focus than others. The Equator Principles are fundamentally a risk management framework to identify and manage environmental and social risks, applicable solely to project-related financial instruments (project-related corporate loans, project finance loans, bridge loans etc.). General corporate purpose loans are explicitly excluded as they do not finance an underlying project. Similarly, the RSRS and the Poseidon Principles only apply to shipping finance facilities and are intended to encourage climate alignment of shipping portfolios amongst financial institutions and promote responsible shipping practices. 

In contrast, the GBP, GLP, the SLBP² and SLLP are not sector-specific – they are intended for broad use by the market, and until now have been used particularly in sectors including energy, agriculture and industry, and they are increasingly moving into transport.

Purpose and limits on use of funds

The cornerstone of the GBP and GLP is that the proceeds of the bond / loan must be used to finance specific activities that address key areas of environmental concern. While the GBP apply to bonds, the GLP are available for term loans and revolving credit facilities.  The GBP and GLP both comprise voluntary recommended guidelines clarifying the instances in which a bond or loan might be categorised as ‘green’, essentially on a ‘use of proceeds’ model, based on the underlying characteristics of the transaction; a non-exhaustive list of eligible ‘green projects’ include energy efficiency, pollution prevention and control, clean transportation, climate change adaption and renewable energy. The GBP and GLP require that the funds are ring-fenced for ‘green projects’ and their use tracked. 

As regional and national sustainable finance initiatives develop, these market-led standards are likely to be adapted to take account of emerging national or regional sustainable finance regulation. For example, with adoption in the EU of a taxonomy to determine what economic activities can be considered environmentally sustainable, it is likely that the list of ‘green projects’ within these standards will soon be adapted by financial institutions seeking to ensure consistency with the EU taxonomy.

In contrast, the SLBP and SLLP are the most flexible standards in terms of application of funds – unlike the GBP and GLP, the SLBP and SLLP contain no use of proceeds requirements - borrowers are able to use the loan proceeds for general corporate purposes, which may or may not be ESG-related.  Instead, sustainability performance targets are linked to the borrower’s wider sustainability / ESG strategy. The borrower benefits from a margin reduction, if it achieves these sustainability targets. This means the SLBP and SLLP are not strictly investment-focused and can be used to incentivise the adoption of policies / practices that help borrowers to meet their sustainability performance targets. The sustainability performance targets encompass a wider measure of “sustainability” than the GBP and GLP (which are focussed on environmental benefits), including targets related to governance matters. This includes, for example, increasing board diversity, which impacts a company’s ESG rating. 

Hybrid standards

It is possible that a green loan or bond may incorporate another standard, for example where a lending bank is a signatory bank to the Equator Principles or Poseidon Principles, and if the facility meets the requirements of these standards. Where this is the case, there is nothing to preclude the standards from being used in conjunction with one another. Depending on the borrower, the loan or bond purpose and the assessment of risk associated with that purpose, compliance with two sets of sustainability standards does not necessarily mean that the borrower must act to a higher standard. However, in some circumstances, a higher standard may result from combining two standards. For example under the GLP, the borrower is obliged to provide a high-level report on the use of proceeds annually, until fully drawn and as necessary thereafter only in the event of ‘material developments’. Under the Equator Principles, the borrower’s obligation to report on environmental and social matters comes into force at financial close and continues for the life of the loan. The reporting required of the borrower would be greater in this instance than if the GLP were applied alone.

Consequences of non-compliance

All of the guidelines discussed in this article are voluntary, but in practice some are enforced rather than encouraged. For example, some banks have agreed to apply the Poseidon Principles when acting in the shipping industry. Complying with the Poseidon Principles will be mandatory for borrowers transacting with signatory banks. This will also be the case if a borrower is transacting with one of the financial institutions which have agreed to apply the Equator Principles. 

In some cases, failure to comply with the guidelines may have an impact on the pricing on the loan. This is a key component of the SLLP, whereby the pricing of the loan is directly linked to the ESG performance of the borrower. If the borrower meets specific pre-determined sustainability performance targets (SPTs), the margin under the loan agreement may be reduced. The SLLP are the only guidelines examined in this article which expressly contemplate pricing consequences, but, in practice, under the terms of any “green loan” a margin ratchet may be included by some lenders for certain products, particularly if there is evidence that the ‘green’ component of the loan reduces the associated credit risk to the lender. A one-way or two-way margin ratchet may be employed. A two-way pricing mechanism provides for a reduced margin if certain criteria are met, and an increased margin if not. 

Those sustainable finance principles, such as the Equator Principles, the Poseidon Principles and the RSRS, which require a covenant package to be included in facility agreements will also have contractual impacts. A failure to comply with these undertakings could give rise to an event of default under the facility agreement allowing lenders to accelerate the loan. However, in some industry sectors, such as the shipping industry, other options to sanction non-compliance may be more likely such as attaching pricing conditions to the loan. Some of the guidelines, such as the Poseidon Principles, use publicity as a tool to encourage compliance: requiring participating banks to publish the carbon alignment of their shipping portfolios on a globally accessible website serves as an incentive to ensure that vessels being financed are as environmentally sound as possible. In relation to a breach of the GLP, this is more likely to result in de-categorising the loan as a “green loan”, than an event of default – the lender will require the borrower to cease representing the loan as “green”, and the lender will no longer treat the loan as part of its sustainable finance portfolio.  In the case of the GBP, bondholders may have to establish misrepresentation or rely on the market to help maintain issuer discipline.

Comparison

For a comparison of the standards mentioned in this article, please download the comparator table.

Conclusion

With demand for sustainable finance and investment continuing to rise, investors, financial institutions and regulators are beginning to demand greater disclosure and transparency to assess the integrity of investments labelled as “sustainable”. The quality of disclosures will drive capital flows. This is likely to drive further innovation in debt products and standards, as well as the review and refinement of existing standards.

Norton Rose Fulbright has experience in both financial services regulation and sustainable lending products and standards. For further articles on this topic, please visit our sustainable finance and investment web-page.