Key Takeaways
- Reaching $960 billion in 2021, sustainable debt issuance continues to climb to impressive heights, but the credibility and legitimacy of sustainable debt instruments is still sometimes murky.
- Because the issuer assigns the "sustainable" label to a transaction, there are several factors that can set transactions or financing frameworks apart as stronger or weaker in our sustainable financing opinion analysis. In use of proceeds transactions and frameworks, these could include risk management and reporting practices, while for sustainability-linked they include KPI relevance and SPT ambition.
- The strengths and weaknesses that we have identified thus far in the market may soon look very different, and we expect the transparency and detail disclosed in documentation to increasingly go beyond minimum requirements as the push toward greater granularity in disclosure, from issuers, investors, and intermediaries, accelerates.
The exponential rise in sustainable debt issuance is helping bridge the gap between current investment levels and the capital needed to finance a more sustainable economy. Total sustainable debt issuance, including use of proceeds green, social, and sustainability bonds, and general corporate purpose sustainability-linked bonds, totaled about $960 billion in 2021, according to preliminary estimates from the Environmental Finance Bond Database, up an impressive 61% from 2020.
However, it has also raised some concerns from market participants surrounding the legitimacy and credibility of instruments with a sustainable label. In particular, investors have expressed fears that sustainable debt instruments, which are labeled as such by their issuers, may not be much different from their vanilla counterparts due to inconsistent instrument labelling, reporting, and data disclosure. These concerns have led to a call for issuers to follow more robust governance and reporting practices when issuing a sustainable debt instrument to drive greater comparability and harmonization across the asset class.
As a sustainable financing opinion (SFO) provider, S&P Global Ratings has been closely following the development and evolution of the sustainable debt market and the associated governance and reporting practices. In our SFO analysis, we evaluate the clarity of issuers' commitments, described in a financing framework or transaction documentation, and the extent to which these commitments are transparent to the relevant parties involved in the financing, including investors, banks, underwriters, and other market participants. Our analysis is usually performed pre-issuance and as a result, we pay special attention to the language used to express future commitments. (The list of third-party principles and standards (collectively the Principles) that are in scope for our SFO analysis can be found in the Sustainable Financing Opinions Analytical Supplement.)
Chart 1
Use Of Proceeds Frameworks And Transactions
Sustainable assets are only one part of the equation
Sustainable debt instruments that finance projects with green or social characteristics are not all necessarily strong from a use of proceeds perspective. In fact, the asset being sustainable is only one part of the equation. Setting up appropriate processes to manage the instrument proceeds and ensuring transparency to market participants are equally important.
The Principles require that an instrument align with four core components to be eligible for a sustainable label. In addition to the proceeds of the instrument being allocated exclusively to projects with clear environmental or social benefits (eligible green or social projects), the Principles also require the issuer to disclose the practices for project selection, how it monitors and manages the funds, and its commitments to reporting on the allocation and impact of the proceeds. For example, even an issuance from a pure-play entity (such as a social housing provider or renewable energy company) is not necessarily aligned with the Principles, despite the underlying projects being unambiguously sustainable.
Furthermore, many financing frameworks and transactions provide the issuer flexibility to finance a wide range of assets. While the specific projects to be financed do not all have to be identified upon issuance, a credible and well-defined prospective project list is essential to ensure funds are allocated in a timely manner. In addition, in our view, some assets offer higher intrinsic sustainability benefits than others. For example, we believe renewable energy projects, such as the development of wind or solar power, offer more systemic environmental benefits than other green projects such as green transport with fossil fuel combustion. For social frameworks or transactions, we view the accessibility and affordability characteristics of projects that fall into the "access to essential services" category to be very important. For example, we would view access to finance projects that explicitly assess and address the affordability of the financing (i.e. the interest rates) to be stronger from a use of proceeds perspective than those that do not. Similarly, specifying how the borrower would use the financing is seen as a stronger practice.
The Principles also encourage issuers to adopt enhanced use of proceeds transparency practices. For example, the Principles recommend that issuers disclose a look-back period (defined as the number of previous years that the issuer will look back to for refinanced eligible projects), which provides investors greater clarity on the age of the assets being refinanced. Most of the look-back periods included in frameworks or issuance documents we have assessed so far were no more than three years long.
Furthermore, when evaluating the eligible projects, we assess whether they contribute to an environmental or social objective. However, we believe best practice is when the issuer itself discloses the intended objective. ICMA and the EU Taxonomy each identify several environmental objectives to which eligible projects may contribute. Advanced frameworks and transactions also disclose the relevant benefit within a specific objective such as a project contributing to climate change mitigation by reducing greenhouse gas emissions, or reducing social inequality by increasing access to affordable housing. Finally, while aligning the eligible project categories to the sustainable development goals (SDGs) is common, we believe specifying specific SDG targets helps provide additional clarity on the environmental or social objective the projects aim to achieve.
But while all market-based sustainable debt standards require that 100% of the proceeds of a sustainable finance instrument be allocated exclusively to green or social projects, in some of the transaction evaluations (TEs) we have conducted, the issuer chose to assign a sustainable label despite the transactions proceeds not being exclusively allocated to eligible green or social projects. While we can still evaluate the environmental benefit of the portion of proceeds going to environmental projects under our TE methodology, given the leakage of funds to finance "non-green" assets, we would expect the use of proceeds, and other governance and reporting practices of such issuances, to be significantly weaker than those of instruments which are strictly financing sustainable assets.
Magnifying assets' intrinsic benefits through the project selection process
Core to sustainable debt issuance is the process followed to select eligible projects for financing, as well as to manage any environmental or social risks associated with those projects. In our view, strong sustainable debt instruments and frameworks incorporate clear eligibility criteria, including taxonomies or thresholds from international initiatives, into the selection process for all projects. We believe the use of internationally recognized taxonomies or thresholds allows market participants to better identify projects with material environmental or social contributions. Several taxonomies already exist at the regional and international levels that we have seen incorporated into more advanced frameworks or transaction documentation (e.g., the Climate Bond Initiative's Climate Bonds Standard, EU Taxonomy, China Green Bond Catalogue, and Mongolian Green Taxonomy). For social projects, where in many cases regional or international taxonomies do not exist, incorporating official definitions or guidelines for selected target populations (vulnerable, underserved, excluded, etc.) into the project selection process strengthens the project eligibility. That said, we believe this area of the project selection process is still lacking for many issuers, as acquiring the necessary information to verify thresholds can be challenging and some taxonomies are commonly viewed as too restrictive.
The Unique Case Of Structured Finance Transactions
Green and social securitization transactions are unique in that asset eligibility is usually determined at origination, rather than at issuance. For social securitizations, for example, the criteria for determining whether a project is eligible are typically tied to a borrower's characteristics such as employment status, age, income, or credit history, which can change over the tenor of the instrument. Most information needed to determine ongoing alignment with eligible projects post-origination is unavailable to the issuer. For example, an unemployed borrower could obtain full-time employment over the life of the loan, but the lender generally would not be informed of it. As a result, for securitizations, we can assess alignment with the Principles when eligibility criteria are applied by the issuer at the point of loan origination (or time of need for the borrower when the social benefit is ultimately achieved), rather than at issuance. We view disclosure of a look-back period, which indicates the maximum period between when the loan was originated and when the eligible portfolio is selected, as stronger practice. That said, if social or environmental eligibility is confirmed only at origination, the framework or transaction is unlikely to achieve a stronger score, under our methodology.
Another important part of the project selection process is identifying and managing the most material environmental and social risks associated with the financed projects. According to the Principles, the environmental and social risk identification process should be done at the project level and be incorporated in, or go beyond, the issuer's normal credit and legal risk evaluation processes. In addition, risks should be identified and managed regardless of project type, including social risks for green projects (e.g. solar energy) and environmental risks for social projects (e.g. affordable housing). In our view, advanced issuers go a step further and describe how they manage exposure to a project's environmental and social risks.
Further, we find that information disclosed by issuers on key decision-makers involved in the project selection process, such as internal bodies, committees, and relevant teams, provides an additional layer of transparency into project governance. While this disclosure is usually relatively strong in frameworks, we have found it to be vaguer in transaction documentation. For example, for refinancing transactions performed through special-purpose vehicles (SPVs) where the project pool is already pre-defined, the project selection process is usually implied but not explicitly described. Finally, we view the inclusion of decision-makers with sustainability backgrounds to be a strength.
Proceed management practices through instrument life are key
In our SFO analysis, we evaluate whether there are proper management practices to ensure proceeds are dedicated to sustainability projects over the life of the sustainable finance instrument. A key piece of our analysis looks at the temporary management of unallocated (bond) or undisbursed (loan) proceeds. From our experience, frameworks are often vague in how such proceeds are managed. For example, many issuers commit to managing unallocated proceeds in line with their normal liquidity practices. We view such commitments to be untransparent, as they do not specify whether proceeds will be held in liquid investments, such as cash or cash equivalents, or rather used for other purposes such as short- or long-term debt repayment. Based on the Principles and ICMA's Guidance Handbook, debt repayment (not associated with the eligible projects) could be a temporary use of funds if there is a clear commitment to allocate an amount equal to the net proceeds to eligible projects over the instrument's life. However, in our view, using proceeds for debt paydown is not best practice as it increases the risk that the funds will not be available when needed to finance the eligible projects and blurs the line between use of proceeds and general corporate purpose instruments. In addition, while ICMA and LMA Principles allow the use of unallocated proceeds for debt repayment, other international initiatives, such as Climate Bond Initiative's Climate Bonds Standard, do not, which further supports our view.
A strong proceed management practice, in our view, is placing unallocated proceeds into dedicated sub-accounts or sub-portfolios with strict cash management covenants that prevent the leakage of funds, a practice heavily utilized by project finance entities and SPVs, such as securitization issuers. We also view holding unallocated proceeds in cash or cash equivalents or liquid securities, with a preference for ESG investments, to be a strength, in addition to a commitment to allocate proceeds in a specified timeframe, in line with market best practice of 24 months.
We also look at how the issuer ensures financed projects remain eligible for the life of the sustainable finance instrument. In our second party opinion (SPO) methodology, if a financed project is divested, stops being operational, or loses its status as an eligible asset (such as due to a green certificate for a green building project expiring), providing information on how to replace those projects with new eligible ones as soon as possible is a requirement.
Given the structure of structured finance transactions, where continuous access to information on the green or social characteristics of the financed assets is extremely challenging, we recognize the limitations for assets to be replaced over the life of the debt instrument. Nevertheless, tracking and disclosure of material changes of the eligible portfolio is still expected (e.g. loan prepayments, cancellations, defaults).
Reporting and disclosure practices underpin the integrity of the use of proceeds market
The last fundamental component of sustainable finance frameworks and transaction documents is the commitment to post-issuance reporting. Reporting on use of proceed instruments can be broken up into two main types: allocation reporting (reporting on how proceeds have been allocated across the eligible project types) and impact reporting (reporting on the environmental or social benefit produced by the sustainable finance instrument). We believe these reporting practices provide transparency to market participants that proceeds are going exclusively toward sustainable projects and that the projects financed are providing an environmental or social benefit.
According to the Principles, issuers are expected to conduct post-issuance allocation and impact reporting until proceeds are fully allocated (bonds) or the instrument is fully drawn (loan). That said, in our view, issuers that commit to reporting for the life of the instrument, especially in cases where the asset becomes operational only after the funds have been disbursed, demonstrate stronger reporting practices.
When comparing issuers' reporting practices, we have found allocation reporting to be widespread and relatively more advanced than impact reporting. Allocation reporting, which usually includes the amount of proceeds outstanding, the types of projects/project categories financed, the project location, and the balance of unallocated proceeds, is often integrated into issuers' financial statements or annual reports. These reports are produced regularly and usually verified by an external third-party auditor, which we see as a significant development in the market.
On the other hand, we see more significant variation in the quality of impact reporting, especially the types of impact metrics issuers choose to disclose and the granularity (individual project versus project category disclosure) and lifecycle (full life or economic lifecycle disclosure) of those metrics. In our view, disclosing these metrics supports stronger reporting practices as it helps investors understand how environmental and social benefits will be measured.
Zooming In On Impact Metrics
ICMA's Principles expect issuers to report on the expected environmental impacts at least annually. More advanced issuers report on a combination of expected/forward-looking impact (projected impact of the eligible projects) and actual/achieved impact, which allows the market to follow the evolution of projects' sustainable benefits. We have seen significant developments in disclosure of comparable, quantifiable, and science-based environmental performance metrics.
That said, commitments to disclose the underlying methodology used to calculate these metrics contribute to transparency in the market yet are often still vague or lacking. Additionally, we view social impact disclosure to be relatively weaker, with many metrics calculated by simply counting (beneficiaries, hospital beds, affordable housing units, etc.) rather than measuring improvements in social outcomes. Significantly fewer issuers have also committed to the advanced practice of having their impact reporting externally verified, which we view to be a shortcoming in the market.
Chart 2
Sustainability-Linked Frameworks And Transactions
Sustainability challenges are well understood, but are they well measured?
Issuers of sustainability-linked instruments are generally well informed of the sustainability challenges to which they, and the sector in which they operate, are most exposed. Various resources exist that outline sector-specific material factors including S&P Global Ratings' Key Sustainability Factors articles, Sustainability Accounting Standards Board (SASB) standards, and industry association reports. That said, we have seen significant variation in how these sustainability challenges are translated into relevant KPIs.
In our view, strong KPIs are well defined with a clear scope and calculation methodology. In addition, they are also directly linked to the sustainability challenge the issuer identified and expressed in sustainability outcomes. More advanced issuers incorporate recognized international standards in the calculation methodology to facilitate external benchmarking. On the other hand, less advanced KPIs are those that use proxies to measure sustainability efforts (for example financial or business development KPIs such as the proportion of sales from a green or social product). Even though such KPIs may be comparable to peers, the link to the issuer's sustainability efforts is somewhat indirect. Similarly, KPIs expressed in capacity factors rather than output metrics or in relative instead of absolute terms face similar challenges. Issuers using group-level KPIs might encounter challenges justifying the definition of the KPIs and targets, as well as the level of control of the KPIs. As such, a clear rationale of why these KPIs are the best fit for the issuer is important when determining alignment with the Principles. For issuers that select more the one KPI, we believe each KPI must be considered for its own merits, including relevance to the issuer's strategy, materiality to the industry, and characteristics.
Benchmarking SPT ambition
In addition to a well-defined KPI is the importance of a clear and ambitious, yet realistically achievable, sustainability performance target (SPT). The issuer's benchmarking approach is key to assessing the target's level of ambition. Common benchmarks include the issuer's historical performance, peer performance, or industry trajectories including reference to science-based scenarios such as those provided by Science-Based Targets initiative. Market-based standards require that issuers apply at least one type of benchmarking approach when setting their targets, although we view a combination of benchmarking approaches to be stronger practice. That said, peer and industry benchmarking has shown to be a demonstrable challenge for many issuers, largely due to a lack of standardization across KPI calculation methodologies and companies facing challenges identifying comparable peer groups. Many of the SPTs we have seen have been tailored to a company's internal data and methodologies, which in our view limits comparability from one set of SPTs to another. This is particularly the case for metrics where there is no common calculation standard, such as scope 3 emissions (1).
Strengthening the SPT's ambition and clarity, in our view, is a specified timeline for target achievement and target observation date(s). We also see the use of externally verified historical performance data for benchmarking purposes, as well as the rationale for the selected baseline, to be strengths. Specifically, we believe SPTs should consider performance improvement already achieved before issuance or framework development to be considered ambitious. When issuers have more than one KPI, we believe that each set of SPTs should be assessed individually as ambition may vary.
The First-Mover Challenge
Sustainability-linked instruments are still quite new. As a result, many of the issuers tapping the sustainability-linked market are the first to do so in their industry or sector. We are starting to see these issuers set increasingly innovative KPIs rather than common choices such as scope 1 and 2 greenhouse gas emissions (2) (currently the most commonly used KPI for sustainability-linked instruments) and instead are better tailored to address the most relevant industry challenges faced by their sector. That said, because they're idiosyncratic there are additional challenges in benchmarking the associated targets to peers or industry standards, and in our view weakens the transparency surrounding SPT ambition. Nonetheless, we expect that as the market for sustainability-linked instruments grows, such challenges associated with the asset class will be better addressed, fostering credibility across the market.
Defining the structural or financial sustainability "link"
Market-based standards require a clear link between the set performance commitments and the financing structure of the sustainability-linked instrument. Frameworks allow for issuers to exercise greater flexibility in disclosing this information and generally include a relatively high-level description of the potential structural or financial variation. We believe that a commitment to disclose the specific mechanism in the transaction documentation is in line with standard market practice. Similarly, disclosure of fallback mechanisms for SPTs cannot be calculated as well as potential exceptional events that could affect achievement of the SPT add an additional layer of transparency, although this is still not widely adopted.
This lack of disclosure on instrument characteristics, particularly in framework documentation does not affect our opinion for SPOs. Nonetheless, we understand that an area of growing interest is whether companies are truly incentivized to become more sustainable especially if the incentives to perform or disincentives to fail are relatively immaterial.
Regularly monitored and externally verified sustainability performance
Regular monitoring of the issuer's performance against its SPTs is required by key market-based standards. Beyond these minimum disclosure requirements, the Principles also include recommendations for stronger transparency practices including disclosure of the main factors driving the issuer's performance and of any reassessments of KPIs, SPTs, or baselines. Although still relatively uncommon, ICMA's Principles also recommend issuers illustrate the positive impacts of the sustainability performance improvement. Finally, in contrast to use of proceeds instruments, to qualify as a sustainability-linked instrument the Principles require the issuer to seek a post-issuance verification of performance against the targets set for each KPI. Obtaining an SPO does not fulfill this requirement, as these opinions constitute pre-issuance external reviews.
Looking Ahead
As the sustainable debt market continues to grow, innovate, and evolve, the challenges and opportunities facing sustainable debt issuers will also morph and change. Existing principles will likely be updated to account for these changes while new standards and regulations may emerge. As a result, the strengths and weaknesses that we have identified thus far in the market may look very different over time. Specifically, we expect the level of detail disclosed in the documentation to become more advanced, increasingly going beyond the minimum requirements outlined in sustainable debt principles and standards. Transparency efforts have already increased significantly, and we believe the push toward greater granularity in disclosure, from issuers, investors, and intermediaries will continue to accelerate. Some issuers have started adding short frameworks to their transaction documents to summarize how the transaction tackles the key components and requirements of market-based standards. In our view, we are at the start of a virtuous cycle: as depth and liquidity in the sustainable debt market improves so will market participants' understanding of what's most material, begetting more growth and driving even better harmonization and standardization. We believe that more efficient, transparent, and liquid sustainable debt markets will help drive progress on the key environmental and social risks facing society over the coming decades.
Related Research
- Sustainable Covered Bonds: A Primer, Nov. 17, 2021
- Social RMBS: Is The Pursuit Of Housing Equality A Risky Business?, Sept. 1, 2021
- Sustainable Financing Opinions Analytical Approach, Aug. 25, 2021
- Sustainable Financing Opinions Analytical Supplement, Aug. 25, 2021
- The Fear Of Greenwashing May Be Greater Than The Reality Across The Global Financial Markets, Aug. 23, 2021
- Credit FAQ: Green Mortgages And Green RMBS: What Are The Challenges?, June 28, 2021
- How Sustainability-Linked Debt Has Become A New Asset Class, April 28, 2021
- Sustainable Debt Markets Surge As Social And Transition Financing Take Root, Jan. 27, 2021
This report does not constitute a rating action.
(1)Scope 3 emissions are a consequence of the activities of the company, but occur from sources not owned or controlled by the company. Some examples of scope 3 activities are extraction and production of purchased materials, transportation of purchased fuels, and use of sold products and services (GHG Protocol).
(2)Scope 1: Direct greenhouse gas emissions occurring from sources that are owned or controlled by the company, for example, emissions from combustion in owned or controlled boilers, furnaces, vehicles, etc., or emissions from chemical production in owned or controlled process equipment. Scope 2: Scope 2 accounts for greenhouse gas emissions from the generation of purchased electricity consumed by the company. Purchased electricity is defined as electricity that is purchased or otherwise brought into the organizational boundary of the company. Scope 2 emissions physically occur at the facility where electricity is generated.
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| Secondary Contacts: | Michael T Ferguson, CFA, CPA, New York + 1 (212) 438 7670; michael.ferguson@spglobal.com |
| Florence Devevey, Paris + 33 1 40 75 25 01; florence.devevey@spglobal.com |
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