Issuance of green, social and sustainability (GSS) bonds has become mainstream, followed more recently by the use of sustainability-linked instruments. Meanwhile, regulatory and reporting frameworks have multiplied and become more sophisticated to help ensure the validity of the market.

Market momentum and urgency have clearly built in the past year, including a notable uptick in transaction flow – especially in the loan market – since the start of 2021. The COVID-19 pandemic sharpened focus on environmental, social and governance (ESG) issues in 2020, while the beginning of the Joe Biden presidency and path to COP26 in November have put an even stronger wind in the sails in 2021.

The context for markets is one of deepening international commitments to a quicker and more just transition. The challenge is how to continue driving capital toward demonstrated outcomes that facilitate the transition.

Financial instruments are perhaps the most prominent area where developments have accelerated in 2021. When the delayed KangaNews Sustainable Debt Summit 2020 took place in November, global markets were eyeing another record year of GSS bond issuance, driven in particular by a pandemic-induced surge of social bonds.

At the 2021 summit, Andrew Craig, senior director, sustainability at Royal Bank of Canada (RBC) in Toronto, told the audience: “If there is a silver lining to the pandemic, it has been the incredible increase in focus on the ‘S’ in ESG, and the related attention to important topics like diversity, inclusion, privacy, human capital, combating racism and the just transition to a net-zero economy.”

Global issuance of labelled debt products is again setting record pace in 2021, and the social-bond surge has also reached Australia. Perhaps more important for the transition to a low-carbon economy, though, has been the adoption of sustainability-linked loans (SLLs) and the early signs of adoption of the sustainability-linked bond (SLB). The Australian loan market has seen a series of high-profile SLLs in 2021 from issuers across a much wider range of sectors than has used GSS bond funding.

At the 2020 iteration of the KangaNews event, meanwhile, only a handful of SLBs had been issued, primarily in the euro market. By June 2021, SLBs were consistently appearing in Europe from a range of sectors, and issuance had spread to more markets. Wesfarmers printed the first-ever Australian dollar SLB on the day of the conference.

Herry Cho, head of sustainability and sustainable finance at Singapore Exchange, said at the 2021 conference that since the inception of SLBs in September 2019, more than 50 have been issued for a total of more than US$28 billion. The figure still pales in comparison with the more established SLL market, which Cho said now stands at more than US$330 billion – but even that instrument is only a few years old.

The development of the SLL and SLB markets is important given the products’ potential to expand sustainable finance to sectors in which emissions are high or difficult to abate.

Developing norms in the SLB market also suggest that it may be an inherently more transparent instrument for encouraging transition than SLLs. SLLs typically feature step-up and step-down margins only in the range of 2-10 basis points, whereas the standard for SLBs is around 25 basis points with only one-way penalty pricing. Furthermore, SLB KPIs and metrics are typically disclosed – a contrast with the less transparent loan product.

The ambition of KPIs included in sustainability-linked instruments is key to how successful this type of financing will be in supporting companies with hard-to-abate business models in their move toward low-carbon outcomes.

Investors determining the validity of an issuer’s KPIs can consider several factors, according to Kate Bromley, general manager, responsible investment at QIC in Brisbane. Most importantly, she told delegates, it is important to ensure emissions-reduction targets are aligned with the most emissions-intensive part of a business. “Rather than picking low-hanging fruit, we want companies to be looking at the parts of their business where emissions are most difficult to abate. Even if it is not economically viable to abate emissions in a certain area right now, it is important that steps are being taken to decrease them,” Bromley explained at the KangaNews conference.

Incitec Pivot executed its first SLL in 2021, including emissions-reduction targets in its hard-to-abate fertiliser and explosives business. Uri Gordon, general manager, treasury at Incitec Pivot in Melbourne, told delegates environmental targets were front of mind when structuring the SLL. “We were focused on what our stakeholders want to see from us. Being in a hard-to-abate industry, if we are not stepping forward on environmental issues something is amiss. Therefore our first KPI is for greenhouse-gas emissions and our second is for water use,” Gordon explained.

The most difficult emissions for a company to abate are those out of its direct control – scope-three emissions. Anne-Marie Neagle, Melbourne-based partner at King & Wood Mallesons, commented that scope-three emissions are the elephant in the room for many issuers and investors considering sustainability-linked finance.

On the other hand, Ryan Rathborne, associate director and joint head of property at Clean Energy Finance Corporation (CEFC) in Brisbane, said there is significant opportunity for companies to multiply their impact by addressing scope-three emissions, particularly in sectors of the economy where tackling scope-one and scope-two emissions is already advanced.

Real estate is such a sector. Rathborne described a recent CEFC industrial-property investment in which the borrower was able to neutralise its tenants’ emissions by installing behind-the-meter solar, batteries and biodiesel generators. “Addressing scope-three emissions is an opportunity to create pull-through demand and to build momentum for an industry-wide shift,” Rathborne said.

Instilling ambition in SLLs and SLBs is a clear priority for market participants. Another is concentration, both on what is most important and what is in the issuer’s power to address. Gordon said at the conference that Incitec Pivot wanted to keep its SLL focus primarily on environmental objectives that it can control rather than looking too far down its supply chain or at other elements of ESG.

Michael Momdjian, general manager, treasury, tax and insurance at Sydney Airport – Australia’s first syndicated SLL and SLB issuer – agreed, saying the targets in sustainability-linked instruments should focus on initiatives that reduce emissions and are within an issuer’s operational control. “Our target to be net-zero by 2030 covers our scope-one and scope-two emissions, though we are also active in identifying and implementing initiatives that curtail scope-three emissions,” Momdjian said. “For example, we acquired on-site jet-fuel infrastructure last year driven in part by an ambition to facilitate the use of sustainable aviation fuels. However, improving our performance under our sustainability-linked instruments is focused on initiatives that we are in direct control of.”

If sustainability-linked finance is to retain credibility and maximise impact, market users agree it must also maintain flexibility rather than being commoditised. What is ambitious for an airport is clearly different from a fertiliser producer, a building company or an energy gentailer. It is possible that peer-group comparisons will become possible as sustainable finance expands. In the meantime, Neagle said target shopping – where a borrower seeks out targets it can easily achieve – and greenwashing are issues the industry at large will need to be on guard against.

Cho said the best way for companies to avoid accusations of greenwashing in their sustainability-linked instruments is to ensure KPIs are linked to overall corporate strategies, and that these strategies should be aimed at achieving targets in line with the Paris Agreement and UN Sustainable Development Goals.

Cho explained: “KPIs should not be cherry picked. My advice is to look at what goes to the heart of the transition your company needs to undergo, and select what is material, measurable and, ideally, quantifiable. Ambition level ideally should be benchmarked to external standards. This calibration is the first and second of the Sustainability-Linked Loan Principles and Sustainability-Linked Bond Principles.”

A clear path to cut through greenwashing suspicions can be found in reporting and disclosure. A plethora of frameworks and benchmarks for measuring progress on sustainability now exist in financial markets. In many jurisdictions it is becoming the norm for large corporate institutions to include these in regular financial reporting.

Momdjian said at the KangaNews event that the disclosure Sydney Airport is already providing to the market as a listed company helps when it comes to administering sustainability-linked instruments. The company also outsources measurement of sustainability performance to a third-party provider, further reducing the resource burden of reporting while also adding independence to the assessment.

“We have to provide additional supporting information at times to validate specific outcomes and of course we seek clarification in understanding why certain ESG risk subscores have changed for better or worse. But this is all part and parcel of getting comfortable with an externally derived rating outcome,” Momdjian added.

Strong standards in corporate sustainability reporting could also lay the groundwork should Australia ever adopt a more comprehensive regulatory regime for climate and environmental risk. Several countries – including New Zealand but not Australia – have mandated or heavily recommended companies report using the Taskforce for Climate-related Financial Disclosures (TCFD) and large jurisdictions such as the EU and US are increasing expectations for corporate-sustainability reporting.

Stakeholder engagement is encouraging corporations to make progress down the road of enhanced reporting regardless of regulatory impetus (see box).

Andrea Barrack, global head of sustainability and corporate citizenship at TD Bank in Toronto, said at the KangaNews event: “Over the past couple of years, the percentage of shareholder proposals related to climate and other ESG issues has been rising and the percentage of shareholders voting in favour of these proposals is pushing companies to act. But in my experience it is not just investors: other stakeholders are also now raising their expectations for how companies demonstrate their positive influence on society and the environment.”

There are still challenges, of course. One issue that has been building in sustainable finance for a number of years is the lack of consistency – and therefore comparability – among corporate reporting on sustainability objectives.

RBC’s Craig told delegates at the online event that consolidation is afoot. “The ESG reporting ecosystem continues to expand, driven by greater investor demand for decision-useful environmental and social data. The ecosystem is very busy, but we have heard welcome news that major players in ESG disclosure have declared their intent to collaborate and release a shared vision on a comprehensive sustainability reporting system.”

One such proposal is from the International Financial Reporting Standards Foundation (IFRS Foundation). It is considering the establishment of a new sustainability standards board to promote collaboration among established ESG frameworks, and to develop a global standard for ESG metrics, frameworks and disclosure requirements to meet investor needs.

Sue Lloyd, London-based vice chair at the International Accounting Standards Board – which is overseen by the IFRS Foundation – told the conference audience that the impetus for the new standards board has come from investors, which she said are increasingly providing feedback that they need better information to understand the effect of sustainability considerations on company value.

Lloyd said that, in creating a new sustainability standards board, the IFRS Foundation has the advantage of not starting from scratch and that therefore the platform should be established more quickly than would otherwise be the case.

“Rather than start with a blank page, we are being encouraged to build on the work that has already been done in this field – for example by the TCFD. Our starting point is to work with existing initiatives and from these build the basis for what we are calling the climate prototype. This is intended to be the basis for the first standard the new board publishes,” Lloyd explained.

Meanwhile, a reporting gap also still exists between process and achieving sustainability targets, according to London-based Rory Sullivan, chief executive at Chronos Sustainability and lead technical adviser at Transition Pathway Initiative. “We are increasingly seeing companies building sustainability into decision-making and management capability. Progress is being made but we are not yet seeing it translate into substantive performance change that would be aligned with the goals of a net-zero economy,” he said.

Sullivan identified two major disconnects in the corporate community’s response to climate change. “First, a large number of companies still provide little or no information on their approach to climate change. Second, while many companies have built good capacity to deal with climate change, most are not yet setting demanding medium- and long-term targets.”