Navigating sustainable debt instruments: from green and social to transition and sustainability-linked bonds

For all its flaws, 2020 was a significant year for the sustainable bond market. Not only did the number of labelled issuances markedly increase, the breadth of sustainability topics being addressed also expanded following the release of key new market guidelines.

These, most notably, included the Sustainability-Linked Bond Principles (SLBPs) and the Climate Transition Finance (CTF) Handbook, both administered by the International Capital Market Association (ICMA), as well as the Usability Guideline of the upcoming EU Green Bond Standard. Against this backdrop and as we look ahead to 2021, ISS ESG believes these initiatives are opening the door to more sectors for sustainable debt financing and will allow all issuers more flexibility in structuring their commitments and showcasing ambition.

Environmental Finance: Looking back on 2020, what stands out to you in terms of market developments?

Federico PezzolatoFederico Pezzolato, sustainable finance business development manager for EMEA & APAC at ISS Corporate Solutions: The numbers speak for themselves, there has been a notable rise in both social and sustainability bonds. What stands out most prominently in our view, however, was the launch of important new industry guidance and standards: the SLBPs and the CTF Handbook and of course the EU Green Bond Standard moving ever closer to finalisation.

Miguel Cunha, sustainable finance business development manager for Americas at ISS Corporate Solutions: While we were excited to conduct the first ever second party opinion (SPO) based on the SLBPs for Brazilian pulp and paper giant, Suzano, we can also relate to issuers who feel overwhelmed trying to navigate the rapidly evolving sustainable finance market. The prevailing two questions going forward will be, firstly, how issuers can select the best option to finance their individual sustainability strategy and, secondly, how these new labelled bond types can help make the real economy more sustainable.

EF: How do these new guidelines complement the existing option of a use of proceeds issuance?

Viola Lutz, head of investor climate consulting at ISS ESG: Use of proceed (UoP) bonds introduced a great degree of transparency on the activities financed through a transaction and the environmental and social objectives they address. While that is correct with respect to the financed projects, a challenge that has been brought up over the past years is that UoP bonds do not put sufficient emphasis on the overall strategy of a company. A lack of insight on that point means that at times investors have no additional information as to the general direction a company is taking.Viola Lutz

This concern has been mitigated somewhat by the fact that, in practice, most issuers nowadays give ample information on their overall sustainability plans and characteristics; however, the UoP structure following ICMA's Green Bond Principles (GBP) lacks a formal requirement in that respect, since the GBPs encourage only issuers to position the bond issuance in their overreaching strategy.

While it has not yet been fully finalised, the EU Green Bond Standard is addressing this information gap by explicitly asking issuers to provide a rationale for issuance and disclosure on how the financed UoP categories impact their business model.

Mélanie CombleMélanie Comble, head of second party opinion operations at ISS ESG: Both the SLBPs and the CTF Handbook confirm the trend of putting a strong emphasis on issuers' strategies as well. For example, a core focus of SLB issuances is to select environmental, social and governance (ESG) KPIs material to the issuer's business model and set associated targets that are ambitious compared with the past performance of the company, but also with sector peers and international targets such as the Paris Climate Agreement.

The commitment to achieve the targets is tied to the bond's coupon, reinforcing the level of commitment. Interestingly, if a target is both material and ambitious, it naturally implies the implementation of sustainable actions across a significant share of the issuer's operations and business segments. SLB issuances thus have the potential to have broader effects on the way a company conducts business.

In the case of the CTF Handbook, the strategy of an issuer to shift towards being Paris Climate Goal-aligned takes centre stage. Here again, the company's impact across all its operations is impacted and at the core of the transaction.

EF: How can issuers effectively leverage those new guidance documents and financing options?

VL: Crucially, the new issuance options that the SLBPs and the CTF Handbook represent give issuers the opportunity to address a wider scope of their business instead of focusing just on specific activities. Figure 1 shows that, with UoP bonds, an issuer can predominantly raise funding for the greening of its own products, services and activities portfolio or highlight its social dimension. A SLB structure allows an issuer to also address its operations and processes, including upstream and downstream activities via the selection of appropriate KPIs.

Figure 1: Potential focus of use of proceeds and sustainability-linked bonds

Let's take the example of a transport company's climate ambition and how to make that visible via a sustainable debt issuance. A UoP bond can highlight projects such as replacing old vehicles with electric ones in the company's own fleet and thus address emissions from its own operation. A SLB bond could allow a company to set a broader objective, targeting emissions along its value-chain as well by supporting efforts from its contractors to likewise switch to cleaner alternatives.

EF: Where does the CTF Handbook fit into all of this?

MCo: The CTF Handbook sets out guidelines for issuers to effectively demonstrate and communicate their transition strategy and shows how to issue financing instruments that will help advance their strategy. The focus is on transition towards aligning with the Paris Agreement and is of particular relevance to issuers that are in difficult to abate sectors. The benefit of the Handbook is that it is flexible in terms of the bond structure you apply it to. As such, it can be used by issuers to showcase their strategy on climate change both in the context of UoP bonds and SLBs as illustrated in Figure 2.

Figure 2: Key considerations for defining applicable market guidelines for sustainable debt issuance

EF: What trends do you see for 2021 based on those new options for issuers?

Miguel CunhaMCu: We are already seeing issuances from a broader set of sectors, such as the cement and paper and packaging industry. This is crucial.

Continuing with the example of the cement industry, it becomes apparent that, according to commonly used Paris Climate Goal scenarios, this industry will be part of the economy in 2050. To achieve the transition to a carbon-neutral world, the negative environmental impacts of such industries must hence be reduced to the lowest level possible. The SLB structure allowed LafargeHolcim, for example, to raise capital tied to a Paris-aligned commitment of reduction of greenhouse gas (GHG) emissions intensity on its entire business model. SLBs are not only expanding the tool kit of issuers for sustainable financing, they are also allowing new sectors to access sustainable investors and funding opportunities. So, in the coming years, we are expecting to see a continued opening of the market to a broader group of issuers and the introduction of KPIs covering a wider range of topics.

FP: It is also important to note that, in 2020, UoP bonds were a critical tool for raising capital to address pressing social issues, all of which came during an unprecedented global health crisis. Social bond issuances surged to $140 billion in 2020, up an astonishing 778% compared with the previous year. UoP bonds will continue to grow and be a crucial part of the market.

EF: What topics are you especially curious about in the future of the sustainability debt market?

MCo: There are a number of emerging topics we are closely following as we enter the new year. Regarding new technologies, we speculate the potential for more issuances related to hydrogen or carbon capture, utilisation and storage as well as efforts relating to increasing the emission efficiency in a broader range of industrial processes such as in the chemicals sector. One potential new KPI we may see in 2021 concerns issuances linked not only to social or environmental indicators, but also to governance metrics.

VL: And, of course, any issuances linked to the CTF Handbook. It is a highly relevant guidance document but as with the Green and Social Bond Principles and the SLBPs, a guideline really comes to life once it is used repeatedly for transactions in the market. Market participants' critical discussion of issuances, their benefits and improvement options has always been very dynamic in the sustainability bond market.

By way of background, ISS Corporate Solutions (ICS) works in collaboration with ISS ESG, the responsible investment arm of Institutional Shareholder Services, as the distributor of SPOs. While the SPOs are sold and distributed by ICS, the analytical work to prepare and issue SPOs is performed by ISS ESG.

Case study one: LafargeHolcim

Why did you decide to issue a sustainability-linked bond?

Leila Sassi, financing and capital markets manager at LafargeHolcim: The issuance of our sustainability-linked bond offered us the great opportunity to link our funding with our sustainability strategy particularly on climate change. Beyond the target we have set by 2030 to decrease our CO2 emissions, we wanted to give additional comfort to investors that we are committed to reach this target by all means.

What was the biggest challenge in the process?

LS: Compared to a traditional bond, the sustainability-linked bond has additional requirements such as a financing framework which follows the guidelines provided by the International Capital Markets Association. Various teams worked together to make it happen, strengthening cross-functional collaboration across the company.

Case study two: Suzano

Why did you decide to issue a sustainability-linked bond?

Cristiano Oliveira, sustainability executive manager at Suzano: We decided to issue a SLB to further integrate sustainability into our business in order to drive environmental performance where we have the ability to effect positive change. Through our issuance, we commit to specific environmental outcomes with skin-in-the game.

What was the biggest challenge in the process?

CO: The biggest challenge lies in the fact that it is a new instrument in the market, and the short period of time that there was to structure it. Suzano was only the second company in the world to issue an SLB, and the first to issue according to ICMA's SLB Principles and with a second party opinion, so there was little in terms of reference. Everything we did was new.

Contact: Dana Riazi Nejad
Email: Dana.RiaziNejad@isscorporatesolutions.com