How companies that are unable to issue green bonds can still participate in sustainable finance.
By Paul A. Davies, Aaron E. Franklin, and Kristina S. Wyatt
If the 2010s were the decade in which green bonds took hold, the 2020s will be the decade in which sustainable finance hits the broader marketplace. The green bond market has hit its stride, with issuances reaching well over US$200 billion in 2019. Attaining that figure is quite an accomplishment, considering that the first green bond appeared in 2007. While the green bond market will likely continue to grow, sustainable finance is expected to extend well beyond the strictures of traditional green bonds to embrace sustainability priorities beyond environmentalism and products other than bonds.
Why Sustainable Finance Supply Does Not Meet Demand
Demand for sustainable finance products continues to outpace supply, with the Climate Bonds Initiative reporting that the majority of green bonds are oversubscribed, some tenfold. This imbalance can be explained partially by three key hurdles companies face in accessing the green bond market:
- Green bonds require allocation of an amount equal to the net proceeds of the offering to expenditures on “eligible green projects” (projects with environmental benefits that give the bond its color). Many issuers cannot identify sufficient expenditures to justify a bond large enough to interest investors, which often will only invest in issuances exceeding US$250 million. This difficulty is known as the minimum issuance size concern, and exists despite flexibility in the green bond market to allocate net proceeds to prior spending or refinancing of debt related to prior spending.
- Notwithstanding the environmental credentials of the projects to which the proceeds would be allocated, green bond investors will sometimes push back against a green bond by an issuer from an industry with a net impact that investors do not consider to be consistent with their sustainable investment mandate. This difficulty is known as the issuer-industry concern.
- Market participants are uncertain about applying a “green” or “sustainable” label. In some ways, the green bond market is global, with prominent standards such as the Green Bond Principles commanding wide adherence. But in other ways, the green bond market is fragmented, with no definitive norms for what constitutes a green-enough business activity to support a green bond. The market is left to rely largely on investor reaction to determine which bonds are properly labeled. In some cases, companies are hesitant to move beyond well-established precedents, which eliminates many potential issuers. This difficulty is known as the regulatory-uncertainty concern.
New Products Allow Greater Access to Broader Sustainable Finance Market
As the market matures, new products are emerging that pave the way for companies that would not ordinarily be able to participate in the green bond market to access the broader sustainable finance market.
Sustainability-Linked Revolving Credit Facilities. These facilities allow borrowers to participate in sustainable finance without requiring allocation of the borrowings to particular expenditures. What makes these facilities sustainable is that the interest rate payable by the borrower can adjust based on its sustainability performance. Therefore, minimum issuance sizes are no longer an impediment. These facilities are typically offered by a syndicate of relationship banks, which avoids the issuer-industry concern in many cases.
Sustainability-Linked Bonds. These bonds are similar to sustainability-linked revolving credit facilities, but they are issued in bond format and distributed to a broad, unrelated investor base. The first example was Enel’s September 2019 issuance, which featured a potential 25-basis-point interest rate increase if the company’s renewable energy power generation capacity was less than 55% of its total capacity by the end of 2021. Sustainability-linked bonds help avoid each of the key hurdles mentioned above.
Transition Bonds. These bonds are structured similarly to a green bond in that they are based on allocation of an amount equal to the proceeds of the bond to certain eligible expenditures. Transition bonds differ in that they are open to issuers that may not be able to issue green bonds due to the issuer-industry concern. For example, certain green bond investors had expressed misgivings about a green bond from a beef producer due to the greenhouse gas emissions and deforestation associated with cattle ranching. Despite these concerns, in July 2019, a South American beef producer issued a well-received sustainable transition bond in which an amount equal to the proceeds of the bond would be allocated to purchase of cattle from farmers and suppliers meeting anti-deforestation and other positive environmental criteria. The emergence of a product self-consciously avoiding the “green” label may also support companies in overcoming the regulatory-uncertainty concern. By making the more limited “transition” claim, companies are less exposed to greenwashing criticisms.
Green Stripes. Another means of avoiding the minimum issuance size concern could be characterized as green striping, in which an amount less than the full net proceeds of the bond is allocated to eligible green projects. Whereas green bond investors insist on the full net proceeds being allocated to eligible green projects, green striped bonds specify upfront that a lower percentage will be so allocated. Such a product may be attractive to investors without a “green bond only” mandate, that are otherwise interested in a company’s risk/return profile. An example might be a sub-investment grade bond issuer with a total debt capitalization of only US$500 million, only 20% of which could be allocated to green assets. This issuer could issue a 60% green striped bond, complying with all applicable norms of the green bond market as to the 60%, and investors would account for the green quality of their investment accordingly.
“Separable” Green Bonds. A European central bank announced in December 2019 a plan to issue zero-interest, zero-coupon bonds solely reflecting green commitments related to a green bond framework. These “separable” green bonds would be in nominal amounts mirroring a concurrent issuance of conventional bonds (a “host bond”), but with separate security codes allowing them to trade independently of the host bond. The purpose of this structure is to avoid a stand-alone issuance of green bonds that would be less liquid than (and in turn negatively affect the liquidity of) the existing sovereign bond market. Investors interested in both the economic returns of a bond and the green commitments can pair the two components and hold the equivalent of a green bond. Investors interested in one, but not the other, can buy and sell at a market-determined price. This may allow investors to acquire the green commitment when they would not otherwise be interested in the economic profile of a sovereign issuer, for instance if they invest in high-yield bonds. Intriguingly, any positive value of such separable securities would reveal a “greenium” — a price that investors would be willing to pay purely for green commitments.
Why More Companies in Sustainable Finance Is a Good Thing
The value of a company’s participation in sustainable finance extends beyond supporting green expenditures or creating interest-rate incentives for a company’s achievement of green outcomes. A company’s participation in this market sends a powerful signal to stakeholders — including investors, employees, regulators, and communities — of the company’s strategic approach to the risks and opportunities of climate change and other sustainable development challenges. Issuing a green bond or one of the above-described emerging products indicates to investors that the company is willing to engage on sustainability. The process of participating in sustainable finance also helps to create the institutional structures within a business that are necessary for it to take even more substantial steps in the future.
Perhaps just as importantly, a diversity of options for a company to participate in sustainable finance helps to remove some of the pressure on the boundaries of what can plausibly be called a green bond. Rather than trying to apply green bond principles in situations that are a poor fit, each company can find the sustainable finance product most appropriate to its impact and balance sheet. More options not only means more market participants, but also a more credible market.
As regulators and industry groups work in the coming years to harmonize international approaches to sustainable finance and address the regulatory-uncertainty concern, they would be well advised to also consider how new regulations help, or hinder, the diversification of products described above.
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