01 December 2021
If sustainable finance trends 'across the pond' are any indication, sustainability-linked bonds (SLBs) will soon bloom on Canadian soil. As momentum builds for these flexible, attractive, and timely instruments – in light of the wave of 'Net Zero' pledges emanating from Canadian corporates – what must issuers and investors do to benefit from this soon-to-bud market of ESG-friendly finance vehicles?
Getting your SLB bearings
It's no surprise that SLBs are popping up in corporate finance conversations in Canadian boardrooms lately due to their burgeoning popularity in other influential markets. For example, in 2021, SLB issuances reached US$31 billion in Europe, up 3.6 times from 2020 and up 6.2 times from 2019 when they first appeared in the marketplace. The trend has expanded to other markets, with global issuance reaching nearly US$57 billion, surpassing total 2020 SLB issuance earlier this year, and up over five times total 2020 issuance.
And there is a strong likelihood that they will soon blossom in Canada, since sustainability-linked loans (SLLs) have taken off in Canuck territory already, totaling US$5 billion in 2021, up from US$2 billion in issuance in 20201. Typically, corporate issuers test the waters with SLLs before they venture into SLB issuances.
What's more, with so many Canadian companies embracing ESG practices and committing to Net Zero emissions by 2050, there is likely to be a surge of companies seeking sustainable financing to turn their long-term pledges into near-term, tangible action to drive the integration of sustainability into their businesses.
For these reasons, many corporate treasury departments are studying the differences between SLBs and other forms of sustainable finance, such as pure sustainability bonds (SBs) or green bonds (GBs). The primary difference, of course, is that SBs and GBs are issued so that the proceeds can be directed to specific green projects, such as the installation of renewable energy infrastructure or waste management technologies. In fact, GB proceeds can only be allocated to eligible green projects aligned with ICMA's Green Bond Principles (2021)2, the international guidelines for green bond financing.
In contrast, the proceeds of SLBs can be directed to general corporate purposes. Their pricing will depend on whether the issuer attains pre-established key performance targets (i.e., GHG emissions reduction, renewable energy capacity build out, and diversity and inclusion representation) when assessed at a specific date throughout the life of the bond, or at bond maturity. ICMA published Sustainability-Linked Bond Guidelines in June 2020 to provide guidance to issuers on the requirements for an SLB3.
Thus, SLBs provide considerable flexibility for the issuer to select among various innovative pathways to satisfy their business' key ESG performance objectives. By linking a company's cost of capital to sustainability KPIs, a strong organizational incentive is created to meet ESG targets and accelerate positive impact, alongside the possibility of a pricing benefit for a company.
SLB innovation has allowed a greater range of organizations and sectors to get involved in the market as companies look to play a role in societal and organizational sustainability issues, such as reducing global greenhouse gas emissions. SLBs also create a marketing opportunity for organizations to share their ESG strategy and story and demonstrate their progress along their 'sustainability journey.' These instruments can also help to diversify the investor base, by attracting the growing community of ESG-oriented and like-minded investors.
Ready to wade into SLB markets?
Companies that are embracing ESG and sustainability principles today are laying the thoughtful groundwork to access sustainable financing. This is an important step for an SLB to be successful in the market and to meet the corporation's stated sustainability objectives. Once a company defines its ESG strategy, which typically starts with identifying its most material environmental and social focus areas, the issuer can then measure its performance against meaningful sustainability targets such as its GHG emissions objectives, and report progress using well-established standards. This sets up the right foundation to dive into the market, as prospective investors will expect to see clear, credible pathways to achieve stated ambitions through tangible initiatives and capital investments.
Many organizations in the Canadian market have become early adopters of ESG as they have spent years, even decades establishing the architecture for their sustainability strategy. For organizations new to ESG, materiality testing and target setting will build the necessary infrastructure for sustainability-linked instruments. Today, those companies that have developed a robust ESG program can access a range of sustainable finance options that complement their business ambitions. In fact, we now see an interesting intersection of corporate ESG teams and finance departments coming together to explore opportunities to strengthen their company's ESG strategy through financing activities.
Another important consideration, in anticipation of an expected proliferation of SLBs, is that investors will become increasingly selective among a multiplying array of issuances. In turn, the investment community may prioritize those SLBs that are underpinned with clear ESG strategy and ambitious performance targets.
Competition may mean that a company's everyday mitigation measures will not be enough to attract investors who seek aggressive innovation among issuers. That said, investors will not blindly follow bold claims and 'fluffy' activities, so companies must be transparent in how they integrate ESG considerations in their strategy. It will be important for issuers to demonstrate the impact on their performance from their sustainable financing activities. Furthermore, stakeholders will endeavor to see how ESG is driving business model innovation against a backdrop of emerging policy and technology levers.
We will see in the months ahead how the global investment community responds to the wide range of narratives presented by sustainable finance issuers. Similarly, we are yet to witness how SLBs will trade in secondary markets alongside conventional bonds as SLBs reach their performance assessment dates, and the markets react when issuer targets are met or missed.
The many unknowns in this evolving market also place new pressures on investors who must bolster their capabilities to identify, analyze and assess a multiplying landscape of SLB issuers and satisfy their own mandates and deliver appropriate returns. To do so, asset managers will need to become savvy at scrutinizing ESG strategies, evaluating ambitious targets and, ultimately, judge a fast-moving landscape of historic and projected ESG and financial performance measures.
Although such challenges may seem overwhelming at this moment in time, they represent meaningful opportunities for both companies and investors to unite environmental and social, business and financial priorities to accelerate the positive impact corporations are making on important societal issues. Financial markets participants are no strangers to disruptive change that sparks fresh innovation and positive outcomes, and the arrival of SLBs to the Canadian market is a significant and dynamic move, with powerful impacts for our economy, society, and planet.
1. BNEF. As at August 31, 2021.
2. ICMA Green Bond Principles (June 2021)
3. ICMA Sustainability Linked Bond Principles (June 2020)