By Victoria Judd and Henrietta Worthington
ESG finance continues to gain traction globally, with an increasing variety of financial products becoming available under the ESG umbrella. Bonds, loans, non-bank lending and even mortgage products can be converted to include ESG compliant characteristics. This article considers the advantages and disadvantages which exist across the financing spectrum as these financial products gain momentum and evolve.
Amid a looming global economic recession, there is one area that looks poised to continue to grow: ESG finance. ESG finance has gained traction since the first green bond principles were issued in 2014 and it has come into its own since the adoption of the Paris Agreement in 2015. The subsequent issuance and updating of green bond principles, and green- and sustainability-linked loan principles, have sought to add documentary and process consistency to this rapidly growing and developing market. In numbers, the global green and ESG loan volume has grown by over 15 times in four years and is expected to increase further in 2021.
Looking at this evolution from a high level paints the picture of the global trend, without however considering the elements that make up the sum. There are many different financial products that have come together to bolster the growth of this sector. The vocabulary includes words such as Green Loans, ESG Loans, Green Bonds, ESG Bonds, Social Bonds, Sustainable Bonds, Green Schuldscheine and Green US Private Placements. This article investigates these products in further detail.
What are the main drivers for ESG financial products?
Investing in ESG financial products is beneficial to society, investors and the development of the financial markets. Funding projects that have social or environmental benefits is valuable to our society by improving governance or directly impacting environmental or social improvement goals. It is broadly reported that companies that are conscious of their ESG performance and seeking ESG improvements outperform other market participants who are not; a fact that attracts investors to the ESG space.
The development of ESG financial products is encouraging transparency and consistency in reporting, while concurrently raising awareness and building the expertise of investors in relation to these topical issues.
However, there remains a lack of consensus regarding what constitutes “green” or “social” for the purpose of ESG financial products and there is still a panoply of different criteria that are measured and reported on across the market, from eliminating use of coal to increasing indigenous cultural awareness. Transparency of reporting also still relies on voluntary reporting.
The most common form of ESG lending
ESG bonds, whether described as such, or as “green” or “social” bonds, are the most common form of ESG lending in the market. Such bonds allow for money to be directed towards specific uses or projects, which are geared towards environmental, climate or social outcomes.
A large swathe of projects may fit under this umbrella: green projects could include climate adaptation, renewables or other environmentally friendly projects. Eligible projects for social bonds run the gamut from building affordable basic infrastructure (such as clean drinking water), to access to essential services, affordable housing, employment generation, food security or socio-economic advancement and empowerment.
As a longer-term investment compared to a green or sustainability linked loan (which we examine below), the initial investment towards a specific “use of proceeds” ensures that minimal oversight is needed on an ongoing basis. The financial risk and return characteristics are the same as traditional bonds, but the added ESG characterisation may help reduce the interest rates and thereby help raise more capital.
External ratings are sought for the purpose of these characterisations and there is a marginal further cost of due diligence to validate green credentials early on (typically between £20,000 and £100,000), which means that ESG bonds tend to be cost-neutral at best. Of course, the additional profile raising for ESG projects is an added benefit that is harder to quantify in monetary terms.
The main downside for participants in the bond markets is that there is no real ongoing scrutiny, making it difficult to control how capital is applied to projects, and without such scrutiny, the bond issuer can make investments into projects to hit management targets rather than ensuring that the chosen project will have a genuine positive effect.
As these bonds become more integrated into mainstream funds, indices and other products, it is expected that the cost of issuance may further decrease as additional interest from retail investors augments.
Green Loans and Sustainability Linked Loans (SLLs)
In the loan market, the Green Loan and the Sustainability-Linked Loan are proving popular. Companies are estimated to have raised in excess of USD 180 billion of green and sustainability linked loans globally in 2020. This is up from roughly USD 5 billion in 2017. The large majority of this financing is currently taking place in Europe, however, its popularity is growing across the globe.
In the UK, the Loan Market Association (LMA) published principles for Green Loans in 2018 and for SLLs (also known as ESG Loans or KPI Loans) in 2019. These principles were supplemented by further guidance in 2020. Whilst Green Loans must be used to finance a specific green purpose, an SLL helps borrowers to improve their sustainability profiles by establishing sustainability linked performance metrics. In both cases, borrowers are able to benefit from cheaper funds when they successfully hit certain prescribed green and/or sustainable targets and face rising ratchets where these targets are not met (often in the region of 5-10 bps).
The weakness in relation to this form of financing is linked to the robustness of the structure. Green and sustainability washing is a genuine concern with regard to borrowers who are looking to enhance their reputation and benefit from cheaper loans and lenders who have not developed systems to appropriately audit these metrics.
Other ESG alternatives are gaining traction
The issuance and evolution of the Green Bond Principles, the LMA’s Green Loan Principles and SLL Principles have greatly helped to create guidelines of how to structure ESG bonds and the loan products. As these become more commonplace, they are also continuing to evolve and influence other financial products.
For instance, the Sustainability-Linked Bond, which combines reported characteristics from SLLs with a fixed income product is gaining momentum. ICMA published principles for this market in June 2020, and it is expected that the market size for these issuances will be about $125 billion by the end of 2021. These vehicles do not need a clear purpose for expenditure as with a green or social bond but instead align closer with SLLs and Green Loans by reporting on key performance indicators (KPIs). External parties are sought to assess and review changes to the main KPIs.
Other financial products like Schuldscheine, a medium to long-term bond-like product that does not need to be registered at a stock exchange, and private placements also exist in an ESG format. These debt products are characteristically cheaper to enter into than a publicly listed bond, which can offset some of the costs associated with sustainability reporting. Borrowers also benefit, as with other ESG products, from the reduction in the cost of capital through the ESG characterisation.
Schuldscheine exist in a green “purpose” format and in a “sustainability linked” format, with reporting akin to the Green Loan and SLL respectively and at the current time between 10 and 15% of Schuldscheine issued follow an ESG format.
The private placement market is also steadily evolving and at the start of 2020, already represented 9% of all sustainability labelled debt. As with other products, the US lags behind Europe in respect of private placement issuances. This could be because the longer-term maturities of seven to 12 years for US private placements make it more difficult to compile sensible key performance indicators to track a company’s performance. It could also be because without the relationship building aspect that comes with bank lending, concentrating efforts on a borrower’s ESG efforts is an indulgence for institutional investors. Such investors may be less interested in giving up some of their return where there is less market pressure. In time, it seems a fair prediction that US private placements will grow in numbers.
As investors become more interested in ESG products, CLOs are also expected to become more commonplace. At the current time, negative screening against oil and gas companies, big tobacco and gambling companies tend to differentiate products that fill ESG criteria from those that do not, though it is expected that the market will become more sophisticated.
What about consumer facing financial products?
No financial products are immune from the ESG trend. Some green mortgages are already available to homebuyers in Europe and the US. Customers obtain better borrowing rates in return for purchasing more energy efficient homes or implementing energy saving works. Further work is required though to allow energy performance to be included in the calculation of mortgage affordability calculations, so as to increase the market opportunity. In Europe, over 40 banks are already participating in the Energy Efficiency Mortgages Action Plan and, in the US, green mortgages are issued by the Federal Housing Administration (FHA), the Department of Veterans Affairs (VA), and some banks.
Reporting
ESG finance is still a relatively nascent market, and as a result, there are significant inconsistencies and gaps in current reporting systems which threaten to undermine the efficacy of many of these products. There is no established market approach to reporting, with different methodologies and conventions creating confusion for market participants. Specific reporting obligations will typically depend on the size and nature of a transaction, the relevant parties, and the financing structure.
By way of example, in relation to green financial products, companies will commonly report an external ESG rating, CO2 emissions and/or consumption of green energy. However, corporates could also set targets to demonstrate their interest in sustainability and may therefore report on bespoke KPIs, such as reductions in food waste for a large supermarket chain or flying with a sustainable fuel for an airline company. The factors that are reported are still very much led by the borrower, who is best able to set its own sustainability ambitions. Whilst the flexibility of these products is a clear advantage, it makes the task of standardising reporting extremely challenging.
Certain bodies have taken steps to address these issues, for example, the LMA’s guidance on Green and Sustainability Linked Loans suggests annual reporting and encourages borrowers to increase transparency with regard to their reporting methodology.
There are also signs that regulators will start stepping in to standardise ESG disclosure metrics and reporting. Again, the EU is leading the charge in this area with the Sustainability-Related Disclosure Regulation due to come into effect in part on 10 March 2021. The regulation will require that certain regulated entities in the EU make ESG related investment disclosures. Similarly, unregulated businesses that are seeking investment will need to show that they meet the criteria to be categorised as “sustainable” under the Sustainability-Related Disclosure Regulation.
Conclusion
From a reporting perspective, there is clearly work to be done. However, the lack of uniformity does not seem to have stemmed from the growth of ESG financial products, which continue to soar in popularity.
Given palpable social pressures (from the climate crisis to the Black Lives Matter movement, to name but a few) this is an area that companies and investors are increasingly looking to, and whose strength lies in its flexibility. As external agencies and financiers advise on how to provide consistent information, and regulators consider standardisation, the challenge will be in providing clarity whilst maintaining the integrity of a flexible model which provides for a broad definition of what falls within “ESG”.
After all, this will ensure that we are more open to progress in ESG matters, whatever form they may take.
About the Authors
Victoria Judd is a multispecialist financing counsel at Pillsbury Winthrop Shaw Pittman LLP who advises borrowers and financial institutions on a broad range of transactions, with a focus on sustainability, the energy transition and project development. She advises on diverse structures including project finance, acquisition finance, leverage finance, restructurings, sustainable finance and corporate finance.
Henrietta Worthington is a counsel at Pillsbury Winthrop Shaw Pittman LLP who focuses her practice on a broad range of international transactions including sustainable lending, energy and infrastructure projects, international trade, export finance, restructurings, acquisition finance, general corporate finance and fintech. Henrietta also has extensive experience advising clients on regulatory, sanctions and ESG compliance requirements.
