16 February 2022

Sustainability-linked financing for a credible net-zero transition

How can issuers, including within carbon-intensive sectors, use sustainability-linked markets to help finance their climate transition? Viola Lutz, Federico Pezzolato and Marie-Bénédicte Beaudoin discuss the issues at stake

Environmental Finance: What role can sustainable finance play as companies plan to transition towards net zero?

Viola Lutz: COP26 has helped trigger enormous interest from corporates and financial institutions alike in net zero, as well as creating the context for ambitious net-zero strategies. In this regard, sustainable finance can create a framework for much more transparency around the net-zero process. By using sustainable finance, issuers – particularly those in carbon-intensive sectors – are signalling their commitment to a rigorous, transparent process, because they will automatically subject themselves to greater levels of scrutiny than would otherwise be the case.

Viola Lutz

There are minimum requirements around the information that needs to be disclosed, and it is established market practice that issuers subject themselves to a second-party opinion [SPO] to provide an external view. Of course, there are different types of SPOs, some are more detailed than others, and some provide more of a critical assessment.

ISS ESG's objective is to offer an independent assessment of the credibility of what the issuer is presenting in terms of its climate transition – for example, how a long-term net-zero pledge, usually going out to 2050, combines with short- and medium-term targets used for a sustainability-linked bond.

This shows the specific practical steps a company plans to undertake to get there.

EF: What are the processes that companies need to undertake to link net-zero strategies with sustainability linked financing?

Federico Pezzolato: At the core, of course, is the identification of the right KPIs [key performance indicators]. These need to be material, relevant to the operations of the issuer, and display the appropriate level of ambition in terms of target setting. Therefore, greenhouse gas [GHG] KPIs may be more material to companies in certain sectors, depending on the industry and emissions profile.The company also has to identify and clearly state the existing technologies, production processes and corporate plans that it will implement to achieve its targets.

Federico Pezzolato

The Climate Transition Finance Handbook from ICMA [the International Capital Markets Association] is an important benchmark. You can debate whether you need to explicitly reference it, but we would strongly recommend that an issuer's sustainable finance framework covers the content of the handbook.

This requires the issuer to disclose on four main elements: its climate transition strategy and governance; its business model environmental materiality; the 'science-based' nature of the strategy, including targets and pathways; and how it plans to implement the transition.

There are some misconceptions in the market regarding the usability of the handbook.To many, it seems more appropriate as a guidance document, compared with ICMA's Green Bond or Sustainability Linked Bond Principles. For example, the latter requires an issuer to identify a material KPI, set an ambitious target, and have externally verified reporting; the actual strategy itself is somewhat in the background and of course the focus is not on climate. However, the Climate Finance Transition Handbook requires for indicators to be disclosed regarding the trajectory and the mission of the company to deliver the expected targets.

EF: What is the appropriate boundary for a net-zero target and the associated KPIs?

Marie-Bénédicte Beaudoin: Firstly, net-zero targets are usually long-term targets to be achieved by 2050 or, in very ambitious cases, 2040. So, the net-zero ambition itself needs to be underpinned with a medium-term target, usually set to be achieved sometime between 2026 and 2035. Those medium- term targets usually form the basis for the KPI linked to the transaction.

Secondly, I would strongly recommend that any issuer who wants to go out with a KPI linked to a net-zero pledge thinks very carefully about boundaries. In a net-zero context, the key element is the emission scope. It will, to some extent, depend on the industry involved, but it should capture all main greenhouse gases, not just carbon dioxide, and all material emissions from Scopes 1, 2 and 3.

To understand what material Scope 3 emissions are for an industry, reference points such as the Science Based Targets initiative [SBTi] and Climate Action 100+ can be used. Some issuers will set different KPIs for Scope 1 and 2 and Scope 3 emissions; that is fine in principle, but if coupon payments are linked to the achievement of emissions targets, they should focus on the material emissions of the company.

EF: How do you judge the credibility of strategies and targets?

Marie-Bénédicte Beaudoin

MBB: It is highly recommended that there is an external reference point to judge the ambition of the target set. It could be the SBTi, the Transition Pathway Initiative, or a third-party consultant: it is important for an issuer to not only issue a statement, but to explain which external party has looked into the detail of its target. In terms of assessing strategies, it is a difficult topic. That will be a huge area of development in the year to come.There are external reference points for industries, such as from industry bodies, investor coalitions etc. From the company point of view, it should qualitatively describe its activities, and best practice would be to quantify the contribution per activity to the reduction target: so, for example, that the substitution of raw materials will contribute 10% to the achievement of the Scope 3 emissions target.

One point that is important to make is that 2°C as a benchmark is not sufficient anymore. That is something that became very clear as a result of COP26. For a long time, the 2°C narrative was dominant, but 2021 marked the year that the narrative fully shifted to the importance of the 1.5°C threshold.

There is sometimes a misconception that the SPO is simply a validation of what has been done by the issuer, its advisors, banks, etc. On the contrary: we see analysing the case presented by the issuer, and perhaps asking some difficult questions, as a very important part of our role. There have been times where, during the SPO process, the issuer has quite dramatically changed the scope or ambition of its targets, which resulted in going to the market with a much more robust framework. Also, what we deliver is an opinion: our aim is to provide differentiated and granular information to investors. It is not simply a stamp of approval or disapproval.

EF: What about residual emissions? And can unproven technologies be incorporated in sustainable finance strategies?

MBB: I think the market is still collectively working this out. But the key point is that, whatever an issuer decides, there needs to be 100% transparency: the chances are, whatever you are doing at the moment will not be the answer in five years. The best practice transition plan, at this point, would say that "this is the X percent of our emissions that we currently, as a company, consider residual because, quite frankly, we do not yet know how we will tackle them." For almost every company, however, there is so much they can do to reduce their non-residual emissions that they will be able to action plenty for the next five to 10 years.

As for unproven technologies, some are key for ultimately reaching net zero in the long-term and hence should certainly be discussed, especially related to research and development investments. But, to be very clear: medium-term targets need to be based on realistic action plans, so unproven technologies should not really play a role in those as you cannot quantify what share of emission reductions you expect them to contribute if they are still unproven.

EF: What are the key criteria that investors in these instruments have for companies with net-zero goals? What are their concerns?

VL: Investors are certainly on a journey, but at the moment there are three elements that most investors are looking at.The first is the long-term pledge, the overall net-zero commitment. Secondly, backed by a specific medium-term target? Does this target cover all the relevant scopes? Lastly, is there a decarbonisation strategy linked to that?

And, as simple as it sounds, is that before we even reach any of these topics, a key question remains as to whether the company is reporting emissions. Where sustainable finance plays a wonderful role in the transition towards net-zero is on some of these really basic issues. If a company wants to issue a sustainability-linked financing instrument, it needs to have reported its emissions for three years and it needs to have those figures audited. Some companies are going through that process for the first time when issuing such financing. It's worth noting that, out of the more than 28,000 companies that ISS covers, only about 5,200 report emissions and, of those, only a little over 1,400 have reported good Scope 3 data. 

Four takeaways to set credible net-zero targets:

EF: How do you see the market evolving for sustainability-linked financing from companies with net-zero targets?

VL: For investors, I think what we're seeing now is the journey that happened a couple of years ago with Paris-aligned investment approaches. These evolved from larger investors to smaller players looking into them, and then the approach was applied to indices, and then in turn to ETF products. I think that a similar journey can be expected for net-zero investment.

A key element will also be the growing demand from investors for substantiating transition plans. I would also note that the fact we have high-emitting industries moving is an absolutely key trend. Setting net-zero targets is a bold move for such companies, if you think of the magnitude of the challenge, given how many technological unknowns remain, and how dependent they are on uncertain policy environments. So, I expect this to be applauded but, at the same time, their transition plans will be scrutinised.

Finally, I also think that we are likely to be in a more dynamic target-setting environment than many companies and investors assume. We've seen this in the COP process. Countries submitted their nationally determined contributions, which were assessed as insufficient to hit the climate targets. So, rather than come back in several years with new targets, as was originally planned, an agreement was reached to come back within the next year.

I think a similar dynamic might happen with investors and companies because, so far, the world has a consistent track record of missing climate targets. That means that, with a finite carbon budget, the emission reduction curve needs to get steeper and steeper. If I were a company or an investor, I would question whether the emission reduction trajectory that you're setting yourself now would be the one that is required in the future. The best-prepared companies and investors will be those that have the tools and the internal processes in place to continuously adapt to a changing environment.

Viola Lutz is head of climate solutions at ISS ESG, based in Zurich, Marie-Bénédicte Beaudoin is head of SPO operations at ISS ESG, based in Paris, and Federico Pezzolato is sustainable finance business manager at ISS Corporate Solutions, based in London.

To learn more about ISS' Sustainable Finance Solutions or to see example case studies, contact: SPO@isscorporatesolutions.com

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. 

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