In recent years, the size of the sustainable debt market has increased dramatically, in parallel with rising investor demand for environmentally-oriented debt products. However, 2022 saw the first decline in the sustainable debt market after years of strong growth. This decline is largely due to the decline in the overall market coupled with heightened volatility and inflation rates.

According to Bloomberg, green, social, sustainability and sustainability-linked bonds raised a total of $863 billion in 2022, a 19% drop from the record $1.1 trillion issued in 2021. Sustainability-linked bonds – the most scrutinized segment of the market for environmental, social and governance-related debt – dropped 21% to $86 billion. Meanwhile, green bonds, which were propped up by a surge in sales from China, saw the smallest bond decline – dropping 11% to about $480 billion. Sustainability-linked loans dropped only 1% to about $474 billion, while green loans dropped 30% to about $118 billion. Increased interest and participation in the sustainable debt market has also generated concern among investors and ESG activists that many of the products being offered do not incorporate ambitious and material sustainability goals.

Despite the decline in 2022, many expect sustainable debt issuances in 2023 to recover to at least 2021 levels if the general global debt market stabilizes, but with it, tighter guidelines and increased scrutiny from investors, market observers and regulators.

Green Bonds and Green Loans

Green bonds generally look like regular bonds other than requiring a specified use of proceeds. The indenture and notes for green bonds often do not include any identifying features regarding their “green” nature. However, in the offering document, the use of proceeds reflects the application of the funds to exclusively finance (or refinance) eligible green projects meeting certain environmental or sustainability criteria.

In addition, the offering document typically describes the categories of eligible projects for which the funds may be used and includes commitments from the issuer to describe on its website or in other reports how the funds have been allocated. For example, some issuers include a report that includes qualitative and quantitative environmental performance indicators such as greenhouse gas (“GHG”) emissions avoided.

Similarly, the defining feature of green loans is the requirement to dedicate loan proceeds to finance or refinance specified eligible green projects providing clear environmental benefits

that can be assessed, quantified, measured and reported by the borrower. Pursuant to the Loan Syndications and Trading Association (“LSTA”) guidelines, borrowers should clearly communicate to lenders the process for selection of eligible projects (including environmental and sustainability objectives), track and manage loan proceeds to ensure appropriate allocation towards the specified project, and provide up-to-date reporting with respect to use of loan proceeds.

Green bonds and green loans provide a valuable financing option for issuers looking to expend capital on “green” projects, but the restrictions on use of proceeds also make these instruments less accessible for many other issuers of debt who require flexibility to apply proceeds to a variety of corporate purposes. For many issuers who are not in a position to dedicate the entirety of the proceeds of a debt financing towards a green project, sustainability-linked bonds and loans (discussed below) provide an appealing alternative.

Sustainability-Linked Bonds and Loans

Unlike green bonds, sustainability-linked bonds do not require that proceeds be dedicated to a specific purpose. Instead, sustainability-linked bonds contain one or more specific key performance indicators (“KPIs”) and related sustainability performance targets (“SPTs”) that are applicable to the issuer’s operations as a whole. In the event the issuer fails to satisfy the applicable SPT, the bond interest rate increases by a predetermined amount. The intent is to incentivize the issuer to achieve ambitious and meaningful sustainability-related goals, including environmental and social initiatives.

For example, a company may have a SPT based on a specified reduction of greenhouse gas emissions by a specific date. The indenture for the bonds would provide that if the issuer does not deliver a written confirmation of its achievement of the SPT by the specified date, which is typically confirmed by an external verifier with expertise in the industry, the interest rate on the bonds will increase by an agreed number of basis points (e.g., 25 basis points).

The offering document for sustainability-linked bonds would describe the KPI and the issuer’s efforts to achieve the SPT, and issuers often include a sustainability-linked bond framework on their website. This provides the issuer’s sustainability objectives and quantitative data behind the applicable KPI.

Approximately 85% of the KPIs used for sustainability-linked bonds relate to environmental targets, with the most common KPI based on greenhouse gas emission reductions, followed by renewable energy, waste reduction and water consumption. Others that are less frequently applied involve community involvement, gender, biodiversity, employee training initiatives, patient outreach and service quality.

Sustainability-linked loans are similarly structured; in lieu of dedicated use of proceeds provisions, sustainability-linked loans include pricing adjustments if predetermined SPTs are not achieved by the borrower by the target date.

Typically, for both sustainability-linked bonds and sustainability-linked loans, failure to achieve an agreed SPT does not trigger a default under the related debt instrument; the pricing adjustment is generally the sole consequence for the issuer.

For both sustainability-linked bonds and sustainability-linked loans, selection of the applicable key performance indicators and calibration of the related sustainability performance targets is crucial to the credibility of the instrument. The International Capital Market Association (“ICMA”) and the LSTA have promulgated similar guidelines for sustainability-linked bonds and sustainability-linked loans which specify that KPIs should be material to the issuer’s core sustainability and business strategy, measurable, externally verifiable and able to be benchmarked using an external reference. The related SPTs should be ambitious, representing a material improvement over a “business as usual” trajectory, and failure to meet the specified SPTs should result in a meaningful financial or structural impact under the related debt instrument. Both the ICMA and the LSTA recommend publication of up-to-date and accessible information with respect to the issuer’s progress towards achieving its SPTs. And finally, independent and external verification by an auditor or environmental consultant is recommended.

Greenwashing Concerns

In 2022, regulators and participants in the debt market continued to increase emphasis on addressing “greenwashing” in the sustainable debt market. Greenwashing occurs when a company purports to be environmentally conscious for marketing purposes but actually is not making any notable sustainability efforts. Many critics have noted that KPIs selected by sustainability-linked debt issuers often appear to be lacking in ambition, too easily achievable, or not sufficiently material, and the consequences for failing to achieve the specified SPT often appear to be minor. In December 2022, the European Banking Authority (“EBA”) published its second roadmap outlining the objectives and timeline for delivering mandates and tasks in the area of sustainable finance and ESG risks. The roadmap explains the EBA’s sequenced and comprehensive approach over the next three years to integrate ESG risk considerations in the banking framework and support the EU’s efforts to achieve a more sustainable economy. Further, in March 2022, several leading financial institutions active in the global syndicated loan markets, including the Loan Market Association and the European Leveraged Finance Association, introduced tighter guidelines for sustainability-linked loan instruments, with the goal of discouraging easily attainable sustainability targets and providing a roadmap to implementation of sustainability principles in loan documents. Within the leveraged loan market, where selection of sustainability criteria and publication of relevant information have traditionally been opaque, there has been increasing focus by ESG-oriented investors on providing more transparent and meaningful reporting.

In the past year, regulators also have focused on implementing new rules and disclosure standards aimed to enhance transparency and consistency on sustainability-related issues and mitigate the risk of misrepresentation in financial markets. In 2022, the European Financial Reporting Advisory Group, the U.S. Securities and Exchange Commission and the newly formed International Sustainability Standards Board drafted proposals for disclosure standards relating to various sustainability and/or climate-related issues. The final drafts of these standards are scheduled to be adopted in 2023. Disclosure requirements under the Sustainable Finance Disclosure Regulation for financial market participants will also become effective in 2023. The EU Taxonomy came into force in 2020 but its first reporting provisions began applying in 2022.

In 2022, Eco-Business recorded eighteen cases of brands called out for greenwashing. That number increased from eleven in 2021 and eight in 2020. Further, 2022 was the first-year companies like H&M and Dutch airline KLM found themselves in legal turmoil due to exaggerating or falsifying their sustainability credentials.

For now, there remains significant variability and discretion in selection of relevant ESG criteria in the sustainable debt market, but market trends suggest that 2023 will see additional scrutiny of sustainable debt instruments by investors, market observers and regulators, and an increase in standard setting and harmonization in the market.

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