ESG and financial instruments

The number of companies arranging loan capital via ESG-linked financial instruments has grown dramatically in a relatively short period; notably since the publication of the Sustainability-Linked Loan Principles in 2019. The combined total of all green and sustainability-linked loans issued to date has passed the US$100 billion mark.

The recent good performance of investment funds invested based on ESG-related criteria during the COVID-19 pandemic has shone a brighter and more favourable light on financial instruments linked to ESG, drawing even more attention to this growing trend.[i]

Companies say they are looking for capital to build resilience across their organisational structure for inevitable future business/systemic shocks such as climate change and sustainability shifts. And they say the prospect of more avenues of capital would be welcome.[ii]

So how can companies with good ESG credentials, but not yet with a specific green or social project to point to, plan an approach to the markets for access to loan capital based on those strong sustainability scores? How does it work for companies that already do so?

The recognition of ESG as a strategic differentiator and risk barometer has been proved in the market, putting further pressure on companies to up their ESG game. Peer group comparison is never far away and a ‘best-in-class’ ESG label is highly desirable.[iii] Obtaining capital while demonstrating competitive advantage – and at favourable rates – is definitely a reputation builder.[iv] With 2030 – the year the UN Sustainable Development Goals – SDGs – are to be delivered – looming and reports that it will take US$ 5- 7 trillion per annum to fund them, the challenge is on for companies to understand sustainability-linked financial instruments and get involved.[v]The capital is available in the market for those able to access it, but what are the benefits, the risks, the terms, and the prospects for market growth and evolution?

Despite the growth of the green bond market, challenges exist. They include a deficit of harmonized global standards, risks of greenwashing, the perception of higher costs for issuers, and the lack of supply for investors.[vii] Corporates have been active in issuing ESG linked bonds. Enel, the Italian oil major, is a good example. It was an early issuer of green bonds and became one of the largest. In 2019, it issued a broader ‘sustainability-linked’ bond.[viii] Other large established companies such as Alphabet, BASF, Orange, PepsiCo and Phillips are active in sustainability-linked bonds and their participation is enabling and funding new, regenerative business models in the circular economy.[ix] Sustainable development is clearly developing as a result, but is this activity focused in just a few areas, and is the opportunity only available for the “large green giants? For companies with strong ESG credentials and no identifiable projects, where is the opportunity to get involved?

For investors, corporate take up of ESG-related instruments can build reputation and demonstrate work towards a more sustainable future. Investors themselves are under pressure to decarbonise their investment portfolios and demonstrate to their asset owners that their products are credible in terms of their ESG credentials. It is clearly important to avoid “greenwashing”, a term coined by the environmentalist Jay Westerveld in 1986.[xiv]

Companies can brand themselves as associated with sustainable practices and products, but the authenticity of these claims must be known and understood. There is, however, visibility for investors through reporting and disclosure. The Loan Market Association (LMA) is responsible for setting a voluntary framework for the majority of the ESG instruments mentioned in this paper. For example, the Green Bond principles govern and offer best practice approach to transparency and disclosure.[xv] Receivers of loan proceeds are obliged to clearly communicate their environmental objectives and follow mandatory reporting on the capital expenditure (use of proceeds). In the case of sustainability-linked loans, third-party ESG ratings oversee transparency and accountability. This has been bolstered by the LMA who issued the Sustainability-Linked Loans Principles in 2019.[xvi] With investors firmly onboard, there is little excuse for companies not to step up.