ESG, Insights/30 Mar 2023
Sustainability-Linked Instruments – Helping in the Transition to Sustainable Economy?
Many of us have heard companies and banks talking about sustainability-linked instruments. But what actually are these instruments and what is their contribution to sustainable development? Are there any risks involved and what are the main benefits of such instruments?
Sustainability-linked instruments tied in with performance
A sustainability-linked instrument, i.e. a loan or a bond, is an instrument where the pricing of the instrument is tied to the sustainability performance of the borrower. The borrower agrees together with the lenders or bond arrangers on certain key performance indicators (KPIs) that are monitored throughout the life of the loan or bond.
If the borrower fails to reach the targets set for the KPIs, the pricing of the instrument goes up, meaning that it will become more expensive for it. Furthermore, the loan’s margin decreases if the targets will be reached. Most of the KPIs are currently related to the environmental aspects, most often to climate, with greenhouse gas emissions being the most popular KPI in the sustainability-linked instruments.
The sustainability-linked instruments market has overgone a huge growth in the last couple of years and, nowadays, almost all financing received by large companies include a sustainability link. The main reason for the sustainability-linked instruments becoming popular instruments is that they are flexible and easy-to-approach instruments that the companies can also use to partly accomplish their sustainability strategy and to improve their sustainability-related communication.
There are many advantages on using sustainability-linked instruments, such as, they are not heavily regulated, and the borrower is not required to have a specific green project. However, not all the companies are able to use these instruments. To be able to determine ambitious and demanding targets, the company needs to have its sustainability strategy already in place.
The legal framework for these instruments
Even though the sustainability-linked instruments market has been growing during the last year, there are still not so many regulations in place for the sustainable finance and, therefore, these instruments are not standardised, which can lead to problems with greenwashing. For example, one cannot know if the company is really setting competitive targets or targets that it would reach in any case. The Sustainability-Linked Loan Principles and Sustainability-Linked Bond Principles established by different associations, such as Loan Market Association and International Capital Markets Association, currently set the base for these instruments, but they are not binding regulations.
In addition, there are no exact definitions of different ESG criteria and these, as well as different ESG ratings, can vary a lot between the providers in question. Therefore, there is some room for green or sustainability washing and other questions on the benefits of these instruments in terms of sustainable development. However, the market participants see quite unanimously that no additional regulations are needed, and the market works well with the market-driven guidelines.
On the contrary, it is seen as an advantage that the sustainability-linked instruments are easy to approach, which means that no direct regulations are needed, and the market-driven standardisation will be sufficient in the future as well. In addition, the upcoming EU Taxonomy and CSRD will in a way help with the determination of the KPIs and will make the disclosures and data behind them more credible.
It is acknowledged that there is a certain risk of greenwashing involved in the sustainability-linked instruments. For the lenders and investors, it is very important to avoid reputational risks caused by greenwashing as this can also affect the company’s share value in addition to its reputation.
Therefore, to avoid the risks of greenwashing, the lenders and investors should be careful with ensuring that the KPIs and sustainability performance targets included in the sustainability-linked instruments are demanding enough and relevant for the company’s business and that they are in line with their overall sustainability strategy.
Furthermore, such instruments that state that they are sustainability-linked instruments, but do not yet include the targets and indicators, should be avoided. This has also been reflected in the updated Sustainability-Linked Loan Principles that were published in the beginning of March 2023.
Contribution to the sustainable development
Even though the actual direct contribution to the sustainable development remains low with the sustainability-linked instruments, it is a good step into the right direction and indirectly makes an impact as the companies become more interested in the sustainability strategy.
As such, sustainability-linked instruments are not seen as contributors to the sustainable development on their own, as companies need to have their sustainability strategy in place already before this, and borrowing funds with a sustainability-linked instrument is only one part of implementing such strategy.
Another great benefit of this is that the process of raising funds with a sustainability-linked instrument might bring the finance department to the same table with the sustainability department for the first time and engage more and more people inside the company to be interested in the company’s sustainability journey.
The sustainability link will more likely be the norm than the exception
It is certain that the growth of the market for sustainability-linked instruments will continue. In the future, it might be that the sustainability link will become mainstream in the credit facilities and a credit facility without a sustainability link will be an exception.
Given that many companies have already included a sustainability link in their credit facilities, it would be bizarre if, in connection with the refinancing of such facilities, the companies will suddenly go back and remove the sustainability links.
It is also possible that the sustainability link will expand to different financial products in addition to loan agreements and bonds. It is also foreseen that sustainability-linked instruments might not be special instruments under “sustainable finance” in the future, but rather integrated in the corporate finance, which means that all financings would be sustainability-linked as default.
If you have any questions about the subject or would like to discuss the matter in more detail, please contact the undersigned or your regular Borenius contact.