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October 2020

Sustainable Finance is Here to Stay — But What Does That Actually Mean for Your Company?

Once an obscure tool of altruistic leaders and investors, sustainable finance crept toward mainstream acceptance and widespread use over the last decade. Then came 2020, with a global pandemic, an American racial reckoning, and a series of environmental disasters. In the course of a few months, what had long remained a peripheral financing alternative transformed into something approaching a corporate mandate.

“Sustainability isn’t just a concept anymore,” says Thomas Kim, a partner in Sidley’s Washington, D.C. office. “Five to seven years ago, this was kind of a fringe issue. This year, we’ve seen what business sustainability means in very concrete terms.”

“Five to seven years ago, this was kind of a fringe issue. This year, we’ve seen what business sustainability means in very concrete terms.”

Yet if these crises have taught corporate leaders anything, it’s that talk means nothing without tangible action. In the world of sustainable finance, taking such action is rarely simple. For despite all the rhetoric, fundamental questions about sustainable finance remain – made more complicated by a steady stream of new regulations, reporting frameworks, and products. Questions like:

    Which products are right for my company?
    Who regulates ESG products and practices – and what do those regulations entail?
    How do I ensure proper reporting so I can avoid the appearance of “green washing”?

In what follows, we will answer those and other questions and provide crucial context on this hot-button topic. The hope: that perhaps, as Benedetta Pacifico, a senior associate in Sidley’s London office, notes, “we won’t ignore these calls for change in finance any longer.”

What Sustainable Finance Product Is Right for Me? A Short Primer

According to data from Refinitiv, capital markets raised $275 billion in new sustainable financing in the first half of 2020 – a strong showing for such a young market.

These financings took many forms. Some were simply equity capital issuances tied to sustainability outcomes: in other words, investors tethering their investments to the integration of environmental, social, and governance (ESG) principles, related to either a corporation’s operations (e.g., diversifying the board) or their own investment decisions. As in sustainable finance more broadly, the pandemic upped the ante on these efforts, reminding organizations and investors that ESG principles are inextricably linked to the long-term success of a corporation.

Others took the form of debt products that share a sustainability angle but vary in crucial ways. Here’s a quick primer on some of the most common sustainable loans and bonds.

Source: Refinitiv

Green Bonds

Green Bonds are debt products used to raise funds for an eligible environmental project or asset; for instance, building an energy-efficient office building in downtown Chicago. Though typically not defined at the outset, the proceeds will be used to finance (or refinance) a specific project or asset that complies with the issuer’s eligibility criteria set forth in its ESG framework.

Pros: Since the first Green Bond appeared in 2007, swelling demand has created a $200 billion market – and paved the way for sustainable finance writ large. In that time, the International Capital Market Association (ICMA) developed its widely accepted standards – the Green Bond Principles – allowing the bonds to expand into global markets. The EU’s issuance of €225 billion worth of such bonds as part of its Coronavirus Recovery Fund will further accelerate this product’s growth.

Cons: According to Leonard Ng, a Sidley partner in London, the specificity of the product means that “many issuers don’t have existing or potential green assets or projects of sufficient value to require a bond issue to finance/refinance – therefore limiting the number of potential issues.” As such, demand for Green Bonds greatly exceeds supply, with some issues oversubscribed by up to 200%.

Social Bonds

Social Bonds operate like Green Bonds, though their proceeds go toward projects that have a social impact rather than a purely environmental one.

Pros: They’ve grown spectacularly since the COVID-19 outbreak, largely because the virus has helped define (if broadly) a vast – and urgent – social purpose. “The pandemic has demonstrated how Social Bonds can be used,” says Pacifico. “We’ve seen a substantial increase in Social Bonds with proceeds directed toward the healthcare industry.”

Cons: In the rush to issue pandemic bonds, there’s real concern that – with fewer standards and a more subjective purpose in place – they won’t actually have the social impact they purport to. “There’s a lot of debate about that right now,” Pacifico adds. “Are you issuing a pandemic bond that’s not actually a Social Bond?”

Sustainability-Linked Bonds (SLBs)

Whereas Green and Social Bonds earmark proceeds for specific projects and assets, an SLB issuer can use proceeds for broader corporate purposes. SLBs simply provide incentives to fulfill the commitments. “Where certain predefined ESG-focused targets are not met within an established timeframe,” Ng explains, “the issuer will be hit with an increase in the coupon rate or some other unfavorable change in terms.”

Pros: By enabling issuers to use proceeds for broader corporate purposes – beyond the purchase of substantial green assets – SLBs widen the pool of organizations that can participate in sustainable finance, expanding the number (and diversity) of investors. The freedom provided by SLBs also allows issuers to pursue more comprehensive, holistic ESG strategies. The ICMA’s working group on SLBs released a set of SLB Principles in June 2020.

Cons: Most funds dedicated to Green Bonds will not be able to purchase SLBs, given that the proceeds of an SLB issuance need not be earmarked to acquire/finance green assets or invest in green projects. SLBs are also public by nature, meaning, as Ng puts it, “issuers can open themselves up to ‘green washing’ accusations if they set the bar too low with their key performance indicators.” SLBs are exciting, but still new – only a few have been issued to date, and widespread adoption may take time. Finally, the European Central Bank (ECB) only very recently – on September 22, 2020 – announced that, starting January 1, 2021, SLBs will be eligible as central bank collateral, as well as potentially eligible as assets for the purposes of its Asset Purchase Programmes and the Pandemic Emergency Purchase Programme (subject to compliance with program-specific eligibility criteria).

Sustainability-Linked Loans (SLLs)

A Sustainability-Linked Loan, as Robert Lewis, a partner in Sidley’s Chicago office, explains, is a loan or similar facility that, like an SLB, includes an economic incentive for the borrower to achieve certain defined sustainability performance targets. For example, “increasing the percentage of power generated by a utility from renewable sources, or increasing the certified-sustainable space operated by a real estate company,” Lewis says.

Pros: The initial providers of SLLs in the U.S. market have been syndicates of banks with whom the applicable borrower has a long-term relationship. Like public investors in SLBs, the banks may have internal incentives to provide sustainable finance products, like SLLs, that align with the borrower’s objectives. At the same time, Lewis says that “whereas historically, sustainability is seen as the purview of a single team or business area, tying loan pricing to ESG outcomes sends a powerful message of alignment across a company’s core businesses.”

Cons: For some organizations, especially in today’s environment, the absence of objectively determinable, historical benchmarks evidenced by a borrower’s public commitment to ESG might make SLLs less achievable. Loans also may not provide the capital levels that many companies are seeking.

Transition Bonds

Transition Bonds are issued by companies in industries with high greenhouse gas emissions to raise capital, with the goal of reducing such emissions and becoming “greener.” The aim is the decarbonization of economic activities.

Pros: Transition Bonds allow “brown” companies to enter the sustainable finance space, without as much fear of green washing. After all, it’s often these companies whose shift toward sustainability will have a significant impact. “A super green company building another wind-powered farm is great and should be able to easily raise capital, but a huge multinational carbon producer moving toward green – using a Transition Bond – can have an important impact,” Pacifico says.

Cons: Like SLBs, dedicated Green Bond funds won’t be able to purchase Transition Bonds.

To Regulate or Not to Regulate? When It Comes to Sustainable Finance, That’s the Question

Even as frameworks, standards, and guidelines begin to take shape – at the ICMA, from the EU, the SEC, and various industry groups – business leaders considering sustainable finance still don’t have a consistent regulatory framework to help them understand what rules they’ll be playing by.

The task of creating a consistent framework is made more complicated by the vast differences in various industries’ operations.

“What’s appropriate for a financial services company may not work for a REIT, or a utility company,” says Lewis. “Ultimately, we might have to utilize different metrics for particular industries.”

For the most part, the market still has the last word. Whether that’s a feature or a bug is up for debate.

“On the one hand, it lets issuers and investors find the right standards amongst themselves,” says Bartholomew Sheehan, a partner in Sidley’s New York office. “On the other hand, it’s a vacuum that leaves a lot open to interpretation, which can then lead to green washing.”

That said, if the EU’s latest regulations – namely, the Taxonomy Regulation and the Sustainable Finance Disclosure Regulation (SFDR) – are any indication, the government’s role in the space may be evolving.

“Even with the ICMA principles and the Green Bond Initiative, there was still a debate around what a green asset actually is,” Pacifico says. “The taxonomy helps on that front by saying if you satisfy these specific criteria, the asset can be labeled as green.”

“Compelling issuers to make specific disclosures will make investors’ lives easier and begin to move the whole market in the same direction – and that would greatly expand the market for sustainable finance products.”

It’s worth noting that while neither of the new regulations creates a green labeling regime per se, their requirements do enable environmentally conscious investors to determine the level of sustainable investments in various products that might call themselves green. This relieves pressure from investors to set the criteria on their own. But it also reduces their flexibility – “the standard to be classified as ‘green’ under the Taxonomy Regulation is very high, which might be part of the reason why we’ve seen other products developing alongside Green Bonds,” Pacifico says.

As for disclosures, the SFDR imposes obligations on financial market participants – both at the entity- and product-level – highlighting their sustainability considerations and potential adverse impacts, and offers disclosure frameworks for sustainable investment products. In addition, the Taxonomy Regulation will require a large issuer/investee company – that is subject to the EU Non-Financial Reporting Directive (NFRD) – to include in its non-financial statement (or consolidated non-financial statement information) how and to what extent that issuer’s activities are associated with economic activities that qualify as environmentally sustainable under the Taxonomy Regulation. At the same time, the NFRD itself is in the process of being reviewed so that it better aligns with the obligations imposed on financial market participants under the SFDR and Taxonomy Regulation.

Though still in early days, Ng sees these regulations as a positive step.

“Compelling issuers to make specific disclosures will make investors’ lives easier and begin to move the whole market in the same direction – and that would greatly expand the market for sustainable finance products.”

There’s a publicity angle to the disclosure as well, and the way the market reacts might, at the end of the day, lessen the need for further regulation. Specifically, disclosing a portfolio’s impact will force investors to focus on products that will actually deliver results on sustainability.

“Ultimately, the issuer whose product doesn’t help investors show impact will find it harder to raise finance in the capital markets,” Pacifico says. “We’re very far from that stage, but that’s the aim: to facilitate capital raising for entities that are committed to sustainability.”

Current regulations also tend to be more focused on the environment. Yet products like Social Bonds may follow a similar progression as their green counterparts: first, the market weeds out the bonds that don’t meet investors’ standards; then industry groups and multilateral organizations create frameworks and guidelines; finally, regulators step in and take a position.

Taken together, the Taxonomy Regulation and SFDR give the EU a step up on the U.S. in the burgeoning green financial markets. With the EU’s stimulus package explicitly focused on pushing the European economy in a more sustainable direction – 30% of planned stimulus spending is earmarked in support of climate objectives – and with market indexes indicating that sustainable fund valuations have endured 2020’s gyrations with less volatility than the broader market, green finance would appear poised for a significant breakthrough.

And while both investors and business leaders in the U.S. have called on regulators like the SEC to adopt a comparable, consistent, and clear ESG framework, as of yet there are no domestic legal standards in place. Some of this is political: for instance, a rule adopted by the SEC in August aimed at modernizing descriptions of business disclosures was shot down by some commissioners because it wasn’t prescriptive enough.

“In my view, it’s inevitable that once we take politics out of this issue, ESG disclosures will be expressly mandated by SEC rules and regulations,” says Kim. “Very few institutional investors are continuing to assert that it’s not material, or that having 50 different frameworks is the best way to go.”

If and when the SEC does take up such a disclosure framework, Kim adds, it shouldn’t be a heavy lift. “A lot of hard work has already gone into the various disclosure frameworks, whether it’s the Global Reporting Initiative or the Sustainability Accounting Standards Board or an EU framework,” he says. “The SEC should borrow from the best that’s out there. There’s no prize for originality.”

As such, there’s no reason the U.S. should lose hope when it comes to sustainable finance. “The EU may be stealing the march on the U.S. for now,” Ng says. “But the U.S. has a real opportunity to get in the game.”

How to Avoid Green Washing – and Other Key Considerations

In the absence of consistent, objective standards or comprehensive regulations, accusations of “green washing” – using financial products to create the appearance of embracing sustainability without actually taking meaningful action – will continue to persist. These accusations not only impact the reputation of the specific entities under scrutiny. They threaten the viability of the entire sustainable finance market.

“There can be a bandwagon effect,” says Lewis. “A couple deals where the evaluative metrics are really just window dressing can set an unfortunate precedent. It has the risk of undermining the value that honest and substantive attention to ESG metrics has on companies.”

Lewis says the best way to avoid the suspicion of green washing is to embrace accountability – with products like Sustainability-Linked Loans that include both the carrot and the stick.

“There are certain deals where, if a company improves on a metric, it has a pricing decrease – there’s the carrot. If they get worse, it increases – that’s the stick,” he says. “Having both tells investors that the company is meaningfully involved in this.”

Good reporting and transparency, in this respect, are crucial – especially if issuers want repeat investors. For some industries, this may not be so difficult: building an energy-efficient property from the ground up is relatively cut and dried in terms of measurement. Social Bonds, on the other hand, may be more complicated.

“An investor in America may have a different view of what is a social investment compared to investors in Europe or China,” says Pacifico. “It entails a lot of subjectivity.”

The Keys to Effective Reporting

“At minimum it involves an annual report of some kind, depending on the product and entity,” says Sheehan. “Oftentimes this ends up landing on a website, with an assertion by management detailing the use of proceeds and a report from an independent accountant regarding that assertion.”

Various frameworks exist to help companies in this respect (many of which are noted in the sections above). But the real question, as Sheehan puts it, is how granular the report will be. Reporting and quantifying impact can be quite straightforward in some circumstances – but quite complicated in others, involving, for example, possible quantification of relevant expected impact metrics.

“If a new building is certified LEED platinum that’s a very clear impact,” he says. “But if a utility puts scrubbers on a smokestack, it’s harder to make the quantitative link to a reduction in CO2 emissions. It’s a continual dance to find that balance between what investors really need and what the issuer can actually do.”

The lack of a uniform framework poses challenges for investors, too. As Kim says, “Companies can choose what they want to talk about (or not talk about), so there’s not much comparability between reports.”

In these respects, a company’s history makes a significant difference. Most sustainable finance products – with the exception, perhaps, of Transition Bonds – are being adopted by borrowers with a documented history of observing, maintaining, and reporting on ESG metrics.

“If you don’t have that history,” Lewis adds, “start now. Figure out what matters to your stakeholders, what feels right for your business – then define some ESG goals and start to measure and produce reporting.”

And remember the purpose of sustainable finance: to meet the UN’s Development Goals, to reduce the economic costs of climate change, to meet the challenges posed by COVID-19. It’s an important reminder that these financings aren’t just one-off projects that companies can initiate then forget about. The risks and potential scrutiny are too great.

Instead, business leaders should think of sustainable finance within a broader, general ESG strategy. “At that point,” Pacifico says, “it becomes a marketing tool as well. You can start telling a story when using these products.”

This article has been prepared for informational purposes only and does not constitute legal advice. This information is not intended to create, and the receipt of it does not constitute, a lawyer-client relationship. Readers should not act upon this without seeking advice from professional advisers. The content therein does not reflect the views of the firm.
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