ICMA: The International Capital Markets Association (ICMA) brings together over 600 members from all sectors of the wholesale and retail debt securities markets in 62 countries to inform its work on regulatory and market practice issues, which impact all aspects of international market functioning.

LMA: Founded in 1996, the Loan Markets Association (LMA) with its 650 member organisations aims to improve liquidity, efficiency and transparency in the primary and secondary syndicated loan markets in Europe, the Middle East and Africa.

to renewable energy and energy efficiency projects, followed by the World Bank’s first green bond in 2008, no one predicted the “extraordinary growth” – as the European Commission put it in 2016 – of the green bonds market: green bonds volume exploded from $2.6 billion in 2012 and nearly $10 billion in 2013 to over $40 billion in 2015.

Fast forward to the first half of 2020 when green bonds issuance reached more than double the 2015 volume, totalling $91.6 billion. While this marked a 26% dip compared to H1 2019 due to the impact of the COVID-19 pandemic, the first six months of this year still delivered a new market milestone for the green bonds market: with over 85 market entrants from 24 countries the total number of GB issuers jumped over the 1,000 mark to 1,056 issuers, with Energy the most popular use of proceeds category at 34% (H1 2019: 32%) followed by Transport 29% (H1 2019: 22%) and Buildings at 25% (H1 2019: 28%).

On the other hand, social bonds, which ICMA defines as “bonds whose proceeds fund new and existing projects with positive social outcomes such as improving food security and access to education, healthcare, and financing” in its Social Bonds Principles, needed some time to gain traction and – until 2020 – had been overshadowed by the green bonds market. Yet, when the COVID-19 pandemic hit nations around the globe the social bonds market soared on the back of sovereigns, multilaterals and banks raising capital for COVID-19 relief: by October this year, total social bond issuance reached roughly $80 billion, nearly three times the amount sold in 2019.

Sustainability bonds – where proceeds are applied to finance or re-finance a combination of green and social projects – saw an almost-threefold increase in volume to $46 billion in 2019, boosted by the release of the Sustainability Bond Guidelines by ICMA in June 2018.

While bonds remain the staple of the sustainable finance market, a number of new products have entered the space. In particular the “greenification” of finance products has gathered speed: individuals and corporations looking to go green can pick and choose between green debt and investments products supporting their ambitions. Green credit cards, offering economic incentives for eco-friendly behaviours and green mortgages rewarding borrowers for energy efficiency improvements in their home are two examples of personal banking products going green.

In the corporate space, senior unsecured bonds remain the most common green bond format, but other bond types are catching up. Green securitisation, green covered bonds, medium-term notes (MTNs), Sukuk and green loans all saw sharp increases in issuance. Green loans, for example, jumped from $3.1 billion in 2017 to $5.1 billion in 2018. What’s more, the growth of this product suite is likely to boost demand for associated derivative instruments as market participants seek to manage environmental, social and governance (ESG) risks inherent in their portfolio and business operations.

So-called sustainability-linked products have gained popularity during the pandemic, too. “Sustainability-linked” is a relatively new concept in the capital markets, with associated ICMA Principles only released in June 2020, but it has been prevalent in the loan market for almost three years. It requires the issuer to link a bond attribute, typically the coupon, with a predetermined sustainability KPI. Depending on the achievement of the KPIs the bond’s characteristics – usually the coupon rate – are adjusted: if the target is not met, the coupon rate will increase, and if the issuer meets the KPI the coupon rate will be lowered. This route is compelling for firms which don’t want to face restrictions around identifying and maintaining a specific green and/or social pool of assets, or indeed lack tangible assets for such a pool.

Sustainability-linked loans are similar in structure to sustainability-linked bonds. Global sustainability-linked loan volumes have been steadily increasing over the past three years, experiencing an exceptional increase of 168% in volume to $122 billion in 2019[7], driven both by borrowers looking to show their commitment to achieving sustainability key performance indicators (KPIs), and lenders (banks), bound by the UN Principles for Responsible Banking to facilitate and support environmentally and socially sustainable economic activity.

To further promote the development of such loans and underpin their integrity, the LMA recently published the LMA Sustainability Linked Loan Principles:  

Furthermore, ESG is starting to feature in other corporate liquidity products, too. Crises such as the current COVID-19 pandemic have shown that the provision of short-term relief is a sustainable, ESG-conscious action to undertake. Moreover, sustainability-minded corporate treasurers with large cash positions consider themselves accountable for placing this in a way that promotes societal good.

Of course, most companies adopt a relatively conservative cash investment policy, restricting them from buying longer-dated, tradeable instruments such as bonds. Their universe of investable products are typically deposits and money market funds, and in some cases commercial paper. ESG solutions are available across all three of these:

• Deposits: At NatWest Markets, for example, we launched ESG Deposits in 2019 as part of our ESG Product Framework. This instrument works similarly to the pledge of a typical green bond: for every £ of ESG deposits we raise, we commit to investing a £ in an ESG impactful asset. This will typically be debt issued by a development finance institution or other agency. To determine the ESG-worthiness of the asset we rely on the ESG Prime classification of ISS ESG, a long-standing rating agency in this space.
• Money market funds: ESG investments have been spreading from equity to credit funds and, in recent years, to money market funds.ESG-labelled money market funds tend to consider several socially responsible investment (SRI) strategies:

1. Exclusion of issuers active in environmentally or socially harmful industries
2. Overweight positions in companies with stronger ESG scores
3. Flagship holdings in ESG-labelled commercial paper 

• Commercial paper: Recent years have seen a steady rise in sustainability-labelled commercial paper issuances, which fall within three categories:

1. Use of proceeds: Green use of proceeds commercial paper is effectively a green bond with a short tenor. The issuer pledges to invest the proceeds raised in environmentally positive projects in a manner set out in their Green Finance Framework. Such a framework, in turn, is effectively an expanded Green Bond Framework, that explicitly allows the company to issue all forms of green-labelled liabilities, not just bonds.
2. Sustainability target: Sustainability target commercial papers associate the issuance of commercial papers with the attainment of a particular corporate sustainability goal. The company promises to provide a verified report once this goal has been reached, after which it will no longer be able to issue a sustainability-labelled commercial paper.
3. ESG rating: ESG-rated commercial papers promote the strong ESG rating of the issuing entity. Should an issuer not meet a predefined ESG score and sector-relative ranking, they are required to inform the note holders.

Chart: The sustainable finance product universe

As this expansion continues, ESG investors will need to remain vigilant about the credibility and transparency of new products and labels being introduced. As with green bonds, when conducting their due diligence ESG investors ought to focus on the following 4A’s, which we introduced at NatWest Markets last year:

1. Level of Ambition: is this business as usual or is this an issuer seeking to be an industry leader in embracing the carbon transition?
2. Alignment with the issuer’s overall strategy: is it a “side show” project or truly congruent with a company’s overall operations? And are they setting the right incentives?
3. “Additiveness” of the projects: what portion of proceeds is being used for new initiatives?
4. Analysis offered on projects: what measurable environmental impact is expected?

Our next article will focus on how to structure sustainable debt products in order for corporates to successfully embark on their sustainability journey.

Corporate clients who would like to discuss this topic further should contact:

Varun Sarda, Head of ESG Advisory

Notes

[1] Green bonds: New study shows extraordinary growth and signals potential in financing Europe's climate and environment goals

[2] EM Compass Note 25 Green Bonds (PDF)

[3] Green Bonds H1 2020 Update: $91.6bn Green Bonds & Loans:1,000 green issuers milestone reached: Outlook for 2020 remains positive | Climate Bonds Initiative

[4] ICMA: Social Bond Principles (SBP)

[5] Euromoney: Will social bonds survive Covid?

[6], [7] Bloomberg NEF: Sustainable Debt Sees Record Issuance At $465Bn in 2019, Up 78% From 2018