Despite the global disruption from the COVID-19 pandemic, the transition to a clean energy economy continues. Trillions of dollars in play over the next decade will accelerate the economic recovery, and investors are showing interest in new performance-based sustainability-linked debt products (SLDs), with North America following Europe’s lead.

Learning from my experience in helping strategize and structure several major recent deals using these new instruments, SLDs will speed up this transition because they appeal to investors who want certainty and results, while offering borrowers greater flexibility than green bonds.

Businesses that embrace environmental, social, and governance (ESG) goals in a meaningful and transparent way will thrive, by avoiding potential litigation and fostering positive public opinion. Emerging SLD products tied to performance should enhance credibility. Also, as more financial institutions and corporate entities jump on the bandwagon, they’ll have broader implications than just on the loan markets.

Standardization for Investors

New principles for sustainability-linked bonds from the International Capital Market Association (ICMA), and for sustainability-linked loans from the Loan Syndications and Trading Association and their partners, offer standardization for investors interested in progress toward ESG goals. These principles can be applied to all types of issuers and any type of financial capital market instruments, ICMA says.

Such sustainability-linked financial products offer:

  • Flexibility, so the proceeds can be used for a wide range of corporate purposes, as opposed to green bonds and sustainability bonds, whose proceeds must be spent only to finance or refinance the ESG projects themselves;
  • Incentives, in the form of lower interest rates, so long as the borrower meets sustainability performance targets that are “material, quantitative, pre-determined, ambitious, regularly monitored, and externally verified...within a predefined timeline”; and
  • Reputation enhancements, including disclosures that enhance credibility and support for higher ESG ratings.

While these new principles are voluntary by market participants and applied on a deal-by-deal basis, ICMA says the idea is to go well beyond “business as usual.”

The EU has gone further toward regulation, as it has in other areas such as online privacy. Effective July 12, Europe finalized its Taxonomy Regulation, which adjusts the criteria by which economic activities are judged to be environmentally sustainable.

Related rules govern transparency and disclosure, and ensure that low-carbon climate initiatives won’t harm other ESG objectives. Multinationals operating there must meet these elements of the “European Green New Deal,” even if they’re voluntary in the U.S. for now.

The major players are forging ahead: Last year saw more sustainable debt issued globally than ever before, reaching 3.5% of all debt issued. According to BloombergNEF, $465 billion was raised globally in 2019, up 78% from $261.4 billion in 2018.

Most were still in green bonds, earmarked for projects such as renewable generation or marine habitat conservation, or sustainability bonds which add social goals. But sustainability-linked products with more flexible applications—while tied to overall ESG performance—jumped by 168%, to $122 billion. Just two years after their first appearance in the market, SLDs made up more than a quarter of the total in 2019.

Investors such as BlackRock are listening, as are our clients, including Toyota, Starbucks, Pepsi, Nestle, Verizon, Southern Power, and Hannon Armstrong.

Citibank announced on July 29 a new five-year sustainable progress strategy which includes a $250 billion “Environmental Finance Goal” for global climate solutions, building on its previous $100 billion goal announced in 2015 and completed last year, four years ahead of schedule.

Qualifying activities include renewable energy, clean technology, water quality and conservation, sustainable transportation, green buildings, energy efficiency, circular economy, and sustainable agriculture and land use. Citi said it will “continue to develop financing structures and seek opportunities to scale positive impact in these areas.”

Why SLDs Are So Popular?

SLDs offer a modest price advantage, but flexibility is their most significant draw: a standard corporate revolving credit facility can be linked to sustainability, so there’s no need for the borrower to apply the proceeds toward a specific green activity.

Jet Blue, for example, set up a $550 million senior secured revolving credit facility to help it align its business strategies with sustainability goals such as operating carbon neutral on all domestic flights by offsetting the emissions from its jet fuel.

Yet for all their flexibility, SLDs incentivize achieving outcomes, not just activities. So investors interested in sustainability may be more attracted to the promise of results. Metrics such as target CO2 emissions are familiar. But the cost of financing for a wind farm could be tied to gender equity at its developer, for example.

Finally, there’s reputation. Last month, Wells Fargo, Goldman Sachs, JPMorgan Chase, and Bank of America launched the Center for Climate-Aligned Finance. This is just one recent example of how boardrooms are prioritizing climate-related investments and broader ESG issues. Existing public disclosures, such as annual reports, can help provide verification.

As businesses develop a pandemic recovery strategy, many are prioritizing sustainability. “If there’s one lesson to be learned from the COVID-19 pandemic it is that our economic and physical health and resilience, our environment and our social stability are inextricably linked,” as Citi’s Asia Pacific chief executive officer Peter Babej said July 30.