06 September 2019
In the first of this two-part series, Hervé P. Duteil explores the question of what transition finance is and identifies three revolutions within it
The past five years
In the past five years or so, the financial community has got to grips with climate change and its associated systemic risks to long-term investment and credit portfolios. Along with this has come scrutiny of a number of industrial sectors deemed to be responsible for a carbon-intensive status quo that needs to change, in particular the fossil fuel industry and its related pipeline infrastructure sector. 'Green' has become the answer.
The financial sector has started developing solutions that promote better production or utilisation of resources, in particular in the form of green bonds and all their subsequent variations, including social, sustainable, Sustainable Development Goal (SDG), development, blue, vaccine, pandemic emergency, gender, forest, and more recently rhino bonds or loans.
Sustainable Finance is not just green or social finance, it is also transition finance
Participants across the financial spectrum and beyond have enthusiastically applauded this innovation – issuers for the added financial or extra-financial benefits on claims of dedicated use of proceeds, investors (both asset owners and managers) for the ease of accessing green-labelled assets for thematic investing, policymakers and regulators for the ability to call on an easy-to-understand tag to re-target capital flows towards more sustainable practices, and banks for the finding of new underwriting opportunities.
But have we succeeded in setting the world on a truly more sustainable trajectory? While we can each decide on our own the answer to this question, we might settle the discussion by agreeing that green bonds and their close cousins have certainly opened up the conversation on these topics, not only within the financial community but also far beyond.
The next five years
We can now argue that the financial community is opening itself up to a broader set of challenges than just those related to climate change, and that Sustainable Finance is looking at solutions that go beyond the ‘green’ economy.
Indeed, the focus on climate change is expanding to biodiversity challenges (including deforestation, land degradation, desertification, plastic pollution, overfished marine areas or species extinction) and inclusive growth for all inhabitants of our singular planet Earth. Incidentally, 2020 marks the end of the United Nations’ Decade on Biodiversity, and the 15th Conference of Parties on Biodiversity in Beijing is expected to release a New Deal for Nature.
In the meantime, financial circles are starting to acknowledge that we will not reach a fully decarbonised world by 2050 solely through green processes, be they wind turbines, solar farms or electric vehicles. Instead, we will need a much larger number of sectors to participate in this transition – sectors that are ‘brown’ today* and will remain brown for a very long time.
Resource efficiency optimisation as well as greenhouse gas (GHG) and particulate emission reduction will continue to be very much needed as long as we remain unable to displace brown activities with green alternatives, at a reasonable cost and without an unsustainable impact on inclusive growth.
In other words, the question now becomes: “How can we extend some (with an emphasis on “some”) of the benefits traditionally associated with green finance to these ‘brown’ sectors?” Such benefits might take the form of a reduced cost of funding, access to a larger pool of investors, communication to the financial community of a sustainability strategy that is core to overall business strategy, or branding and PR, to name just a few.
Stretching the definition of ‘green’ by applying it to a number of activities that are at best marginal in terms of greenness is certainly not the best course. First, doing so is a disservice to intellectual rigour and honesty; second, it undermines the integrity of the green market itself, while possibly diverting capital flows away from their intended positive or beneficial purpose.
Instead, we should not be afraid to call brown 'brown', especially as there is plenty of room for brown in Sustainable Finance. Sustainable Finance is not just green or social finance, it is also transition finance.
The three Sustainable Finance revolutions
We shall now take a step back and reflect upon where we are in the Sustainable Finance journey. We could say that three revolutions are currently taking place in this field that is itself in constant transition.
The first Sustainable Finance revolution: labelling the ‘use-of-proceeds’
Up until now, this article has focused on just one aspect of Sustainable Finance, which made its real debut in the space of so-called ‘labelled’ or ‘thematic’ bonds (or loans): green, social, sustainable, and now transition financing.
We would call this first Sustainable Finance revolution in the investment banking sector** the ‘labelled use-of-proceeds’ financing revolution.
The second Sustainable Finance revolution: linking returns with sustainability performance and impact
A second Sustainable Finance revolution has also begun. The Sustainable Finance community has now started to look beyond the ‘use of proceeds’ concept and some of its perceived limits, especially with regards to reporting. The focus is now shifting towards sustainability impact and performance.
Interestingly, while the ‘use-of-proceeds’ concept started in the bond space and extended to the loan market, the reverse holds true for ‘non-use-of-proceeds’ Sustainable Finance.
The idea probably originated in 2016 with sustainable supply chain financing, where the discount factor applied to supplier invoices is linked to sustainability performance verified over time.
The concept was further extended to longer-term financing (mostly revolving credit facilities) in the form of sustainability-linked loans (SLLs), where the interest rate moves up or down in line with the achievement of sustainability performance targets (e.g. ESG score, GHG emissions intensity, water intensity, waste intensity or gender ratios).
In fact, the concept of a variable coupon tied to sustainability performance was embedded in a swap derivative for the first time in August 2019.
Note that this second Sustainable Finance revolution was initially driven by sustainability-focused bank lenders (as opposed to bond investors for the first one) who were willing to give up a portion of their performance or return, as an incentive for borrowers to steer our world in the right direction; to strengthen the resilience of their corporate model; or to hedge loan portfolios against systemic risks such as the emergence of carbon taxes or higher capital adequacy ratios for credit extended to carbon-intensive sectors.
The third Sustainable Finance revolution: linking cost of risk (and funding) with sustainability performance and impact
The third Sustainable Finance revolution is about linking sustainability impact and performance to the cost of risk (and funding).
The subtle difference between this and the second revolution is that while in the former, bank lenders are accepting a lower return in exchange for sustainability improvement, in the third, investors are starting to ask for a higher compensation in exchange for an increased (credit or operational) risk stemming from poor sustainability performance.
Credit rating agencies finally seem to be fully waking up to this reality and are gradually showing signs of a much more formalised integration of environmental, social and governance (ESG) risk assessment into credit ratings; a move which will ultimately affect security and loan pricing.
While this has already been discussed for some time, especially by long-term asset owners such as pension funds, the documented fact that sound sustainability management improves long-term risk-adjusted returns will eventually make its way into letters or numbers, from credit ratings to capital adequacy ratios – ultimately all reflected in funding costs and security prices.
Just yesterday (5 September 2019), the concept used in sustainability-linked loans (SLLs) was applied for the first time to a bond issued by ENEL, in order to raise funds from the capital markets (as opposed to banks’ balance sheets) for general corporate purposes.
In this first ever SDG-linked bond, the coupon is indexed to a sustainability target that will be assessed half way through the life of the security***. If the stated objective is not achieved by then, the bond coupon will step up by 25 basis points. However, if the objective is met or over exceeded, investors will not receive a lower coupon. Note that this labelled bond has no dedicated use of proceeds, unlike the labelled bonds developed during the first revolution described earlier.
There is nothing to prevent a borrower from one day issuing a sustainability-linked bond with a symmetrical step-up, step-down sustainability-linked coupon. We might for example imagine ‘two-degree-aligned bonds’ to fund the entire balance sheet of companies that are verified to be in compliance with a two-degree pathway scenario within their sector, while incorporating such a reward/penalty mechanism to keep some of the issuer’s and investors’ skin in the game, thereby explicitly linking ESG and financial/credit risks.
Finance in transition
From climate change to biodiversity or inclusive growth, from green to brown, from sustainable loans to transition bonds, from labelled use-of-proceeds to sustainability/impact-linked financings, one thing is sure: transition is everywhere, including in the finance space itself.
That is the nature of life, after all, and we should finance it – in a way that remains just for all.
More to discuss
In the second and final article, to be published next week, we will focus more specifically on the concept of transition finance, explore its limits and propose a non-prescriptive framework to start thinking about transition bonds (and loans).
Hervé P. Duteil is Chief Sustainability Officer for BNP Paribas in the Americas
* Sectors whose economic growth largely depends on environmentally detrimental forms of activity
** We are referring here to Sustainable Financing as opposed to Sustainable Investing, which began much earlier.
*** In this five-year senior unsecured US Dollar benchmark-sized security, the coupon is indexed to ENEL’s percentage of renewable energy installed capacity out of its totaled installed capacity. Currently at 46%, if this amounts to less than 55% as of 31 December 2021, ENEL will pay investors an additional 25 basis points on top of the original coupon for the remaining life of the bond. The ratio will be audited by Ernst & Young as part of ENEL’s annual audit review.
Read the second part of this article Sustainable finance: it's all about transition! Part two here