Impact Voices | July 15, 2021

Bringing transparency to the growing market for sustainability-linked debt

Lori Shapiro
Guest Author

Lori Shapiro

Sustainability-linked debt is gathering momentum globally. The umbrella term, which includes instruments such as sustainability-linked loans (SLLs) and sustainability-linked bonds (SLBs), is one of the latest additions to the sustainable finance lexicon. And the asset class is growing fast: according to Bloomberg, total sustainability-linked debt issuance exceeded US$130 billion in 2020, an almost 300% increase from 2018 levels.

What distinguishes sustainability-linked debt from other types of sustainable debt instruments, such as green and social bonds or loans, is its approach towards use of proceeds. Sustainability-linked instruments do not require issuance proceeds to be allocated to defined projects. Instead, a borrower can apply the label to any type of loan or bond instrument that associates funding costs with the achievement of predetermined sustainability performance targets (SPTs). Proceeds can then be used for any general corporate purpose.

This additional flexibility in proceed use makes sustainability-linked debt instruments an attractive proposition for issuers without sufficient capital expenditures to issue a dedicated green, social, or sustainability bond or loan, as well as entities which might be at the beginning of their sustainability journeys or lack the capacity to implement effective tracking and reporting practices required for use of proceeds instruments. In addition, sustainability-linked debt holds potential for issuers in the process of transition, or those in hard-to-abate sectors such as industrials or materials. This enables such issuers to highlight their green or social commitments and reinforce their sustainability strategy to investors, lenders and the public. In this way, sustainability-linked debt has the potential to dramatically broaden the appeal of sustainable financin

Staying on target

The credibility of the sustainability-linked debt instrument is largely defined by its SPTs. In practice, SPTs can include any number of measurable goals, but are usually tied to specific key performance indicators (KPIs) that track improvements in an issuer’s sustainability profile. In some cases, an SPT could also be an overall ESG score assigned to the issuer from an external provider. The SPT approach adopted in the market varies largely by instrument type. Most SLLs are linked to more than one SPT – sometimes as many as five – or to an overall ESG score that captures a combination of indicators. On the other hand, SLB KPIs are usually simpler in scope, commonly using just one KPI.

While the flexibility of the asset class lends to its appeal, it also creates a number of challenges. Since the use of proceeds is not explicitly identified upon issuance, there is a distinct risk of “ESG-washing” and funds may ultimately finance projects that do not have a beneficial impact. Furthermore, the novelty of sustainability-linked debt means that the market has not yet developed a standard set of metrics to track issuer performance. KPIs and SPTs are instead unique to every individual entity, limiting comparability across the market. Here, accountability is also a concern, as issuer performance is often self-reported and unaudited.

As a result, the need for transparency and effective sustainability-related disclosure practices is crucial for the continued growth and integrity of the asset class. We view the Sustainability Linked Loan Principles (SLLP), published by the Loan Market Association, the Asia Pacific Loan Market Association and the Loan Syndications and Trading Association in March 2019, and the Sustainability-Linked Bond Principles (SLBP), published by International Capital Market Association in June 2020, as cornerstones of market discipline. These voluntary guidelines provide a standard set of best practices for issuance of sustainability-linked instruments and promote increased transparency, requiring a post-issuance verification of an issuer’s performance against its targets be made publicly available. 

Wider developments across the sustainable finance space, such as the implementation of the EU Green Taxonomy, should also foster standardisation in the sustainability-linked debt market over time. The landmark European disclosure framework, which defines the economic activities that meet the EU’s environmental objectives, contributes to a more harmonious understanding of what can be presented to the market as ‘green’ or sustainable.

Expanding market

The first SLL, issued by Phillips in 2017 to the tune of US$1.2 billion, took the form of a revolving credit facility (RCF). And while most SLLs to date have been RCFs – which are generally seen as being well suited for general corporate use – borrowers are increasingly favouring a term loan format, which we believe leads to greater accountability. 

The concept behind this asset class is now expanding beyond the established SLL and SLB models into other types of instruments. For instance, the first sustainability-improvement derivative (SID) was introduced in August 2019. More recently, in March 2021, Japanese construction company Takamatsu issued the first sustainability-linked green bond (SLGB), combining the use of proceeds model of a green bond with the performance-based structure of an SLB.

The geographic composition of the market is also evolving. So far, Europe has led the way in terms of SLL and SLB issuance. Belgian-based beverage company Anheuser Busch and Italian utility Enel issued the two largest SLLs to date in the first quarter of 2021, while Enel also issued the first two SLBs in September and October of 2019, linked to its target of increasing renewable energy installed capacity. Aside from the EU Green Taxonomy, we believe that Europe’s banks are another major factor favouring adoption – they are often keen to increase the share of sustainability-linked loans within their lending books in order to fulfil corporate targets related to impact financing. 

But growth is now increasingly originating outside the EU, and U.S. issuers are taking note of the possibilities offered by sustainability-linked debt. Michigan-based CMS Energy became the first company to issue an SLL, worth US$1.5 billion, in the U.S. in June 2018. Meanwhile, in February 2021, global private equity investment firm The Carlyle Group issued the largest sustainability-linked credit facility in the U.S. at US$4.1 billion – also notable for being the first-ever tied to a governance KPI of improving board diversity. Other recent issuers of SLBs include United Arab Emirates airline operator Etihad Airways and Brazilian paper and pulp firm Suzano.

In S&P Global Ratings’ view, the sustainability-linked debt market is well placed to continue its impressive growth trajectory, and issuance is anticipated to exceed US$200 billion this year. While greater transparency and refined reporting practices are needed to address the challenges associated with this asset class, we are optimistic that the increasing popularity of sustainability-linked debt will continue to drive sustainable business practices – while introducing a new cohort of issuers to sustainable finance. 

Lori Shapiro is an associate at S&P Global Ratings.