As the green and sustainability-linked bonds market looks set to hit $1 trillion in 2022, it’s increasingly important to understand the definition and purpose of a growing range of different structures and financial vehicles.
- Sustainable finance is the broadest term used to define GSSS, and can include environmental finance (green), of which climate finance is a subset, as well as social finance.
- Green finance typically does not have to include economic aspects in its definition.
- An important distinction between use-of-proceeds and general purpose financing.
The green, social, sustainable and sustainability-linked (GSSS) bond market is likely to hit $1 trillion in annual financing in 2022. It now accounts for 10% of global debt capital market activity, according to Refinitiv.
Further, the growth of this market suggests it has not been deterred by concerns over the quality of data, evolving reporting standards, advancing regulations, and the resulting resistance from sceptics, as has ESG investing in equity markets.
Types of sustainable financing
The four types of sustainable financing are primarily distinguished by the purpose for which the funds are raised.
Use-of-proceeds (UoP): Green bonds, social bonds and sustainability bonds are all classified as UoP bonds, which means the entire net proceeds from the issuance must be directed towards a defined and pre-determined green, social or sustainable project.
General purpose: Financing via sustainability-linked bonds (and loans), does not define the use of proceeds but is tied to sustainability key performance indicators (KPIs) that point to the improvement of the issuing entity’s sustainability profile.
The International Capital Market Association (ICMA) sets the rules and best practices for the issuance of most global GSSS bonds, called ‘The Principles’. This, in turn, guides the development of sustainability frameworks, a necessary prerequisite to raising financing in this market. ICMA is a not-for-profit association, headquartered in Switzerland, with global market participants and stakeholders comprising its membership.
The European Securities and Markets Authority (ESMA), the market regulator in the EU, also plans to develop its own set of EU-wide labels, like the EU Green Bond Standard, and ESG labels for financial instruments (e.g., sustainability-linked bonds) between 2022 and 2024.
In the meanwhile, the EU has used ICMA principles to create the NextGenerationEU Green Bond framework. This was used in the issuance of the first NextGenerationEU green bond, raising €14.5 billion between October 2021 and January 2022, as part of a plan to raise €250 billion by end-2026.
The principles that define sustainable finance are ever-evolving, the pillars remain constant
The Principles help define the standards for a $2.4 trillion global market (based on assets under management, not annual issuance), and are constantly being updated by ICMA to incorporate new sustainable finance definitions, and add to the list of KPIs.
The Principles serve as voluntary guidelines, and are designed to promote transparency and disclosure, and define best practices to issuers of sustainable finance instruments. Each of the four types of GSSS have their own set of principles.
ICMA’s guidelines also have four core components, also referred to as the ‘four pillars’, which have not changed, and remain essential to the formation of bond frameworks.
Aligning with the four pillars is core to the Principles
As reporting standards and requirements change, leading to changes in taxonomy and regulation, all sustainable finance bonds need to adhere to four core components of disclosure:
- Use of proceeds
- Process for evaluation and selection of projects
- Management of proceeds
- Reporting on progress, with impact assessment, where feasible.
These four pillars inform the development of sustainability frameworks, which in turn become crucial to the issuance of sustainability finance instruments. A sustainability framework can define an entity’s ESG goals and objectives, alignment with standards, and can help develop key performance indicators (KPIs).
Rating sustainability frameworks has now become equally important to raising sustainable finance, as are ESG or sustainability ratings, and indeed credit ratings themselves.
The four types of sustainable financing defined by use of proceeds
Depending on the type of project to be financed (or refinanced), GSSS bonds fall into one of the following categories –
- Green bonds are used for eligible green projects, like renewable energy, energy efficiency, clean transportation, sustainable water management and green buildings. Issuances follow the Green Bond Principles.
- Social bond proceeds are meant for eligible social projects, like affordable housing and infrastructure, access to essential services, and food security. Issued according to Social Bond Principles.
- Sustainability bonds are geared towards green and social projects, in accordance with Sustainability Bond Principles.
- Sustainability-linked bonds are not tied to specific projects, but rather the achievement of verified sustainability goals, established through key performance indicators (KPIs), and are issued according to Sustainability-linked Bond Principles.
As mentioned before, the first three are UoP bonds, and the projects they finance must meet stringent eligibility criteria, which are defined by standards setting bodies like ICMA.
Flat growth outlook for GSSS bodes well for future issuance
Global issuance of GSSS bonds was down 21% year-on-year in the first half of 2022, but Moody’s outlook called for flat growth for the year, after reducing its forecast in May. While attributing the decline to the overall investment mood in the market, it was a lower contraction than that for the broader bond market, suggesting higher demand for sustainable financing.
Green bonds remain the largest category, owing to the size of the projects financed, and to the nature issuers, which includes sovereigns and trading blocs. Social bonds had the biggest first half decline (-45%), after a spike in 2021 from financing pandemic-related programs, while sustainability bonds declined 30% in 1H 2022.
Sustainability-linked bonds accounted for a larger proportion of the total, increasing to 11%, from 7% in the previous year period, as they seem to be preferred by issues who look to tap the growing demand for sustainable finance, but want to maintain a certain amount of flexibility in terms of the use of proceeds.
Sustainability-linked bonds remain a dominant source of sustainable financing in Asia, favoured by companies in hard-to-abate industries including real estate, transportation and utilities.
Increasingly popular with its real estate investment trust (REIT) and property management companies, Singapore’s sustainability-linked issuance dominates its total GSSS debt, and will likely continue to rise in the near future.
A brief pause in the growth in green, social, sustainable and sustainability-linked (GSSS) bond financing in 2022 does not detract from the popularity of the segment, or the outlook for future fundraising.
As investing in equity market sustainability grapples with issues pertaining to data and standardisation, the GSSS market will likely plough ahead, embracing new best practices in sustainability frameworks that enable the rating and marketing of these debt instruments.
