Over the last couple of years, public expectations for businesses, investor sentiment and regulations in financial markets have changed dramatically. Private households as well as professional investors now often prefer to make an impact while investing their money. They demand good returns and want to do good at the same time.
Banks and institutional investors meet the demand by offering sustainable investment products, focusing on less harmful industries, environmental technology and, in general, on investments in companies that are committed to transition into, for example, a low-carbon environment or improved access to healthcare.
DNV is a world-leading risk management and assurance firm offering third-party opinions on the sustainability of companies in general as well as specific financial instruments and projects. Markus Zeitzen, Nordic Head of Sustainability & Finance says: “We expect that by 2023 all banks and investors in Europe will integrate ESG (Environmental, Social and Governance) perspectives into their investment or credit decisions and processes. In essence, as a reaction to this, all companies, their strategies, operations and their financing will have to be aligned: ‘Are they green? Are they socially responsible? Is their governance strong enough?’”
New regulation and initiatives like the EU Green Deal or the EU Taxonomy oblige investors and banks to report on their activities in relation to ESG. Investments and financings will have to be classified according to the degree of alignment with these regulations. When financing a business with a loan or bond, companies will have to demonstrate their ESG alignment and ambitions for the future, so that banks can extend loans and investors can buy their bonds.
Criteria not always sufficient
But who sets the criteria for whether a loan is sustainable? One widely recognized standard on Green Loans and Social Loans is issued by the Loan Market Association (LMA), but some observers feel these principles are somewhat vague. “The criteria aren’t very quantified, and they are subject to interpretation,” says Victor Carstenius, analyst at EKN. “The EU Taxonomy will probably play a bigger role in our sustainability assessments in the future.”
At The Swedish Export Credit Corporation (SEK), Senior Sustainability Analyst Helena Engnér Aili agrees: “The LMA principles are not always sufficient to determine the specific environmental or social impact of a project, which calls for more detail. We always look at the local context of a specific project, and local ambitions.”
SEK is active on the green bond market and issues green bonds for funding used to refinance export credits to sustainable projects. The Swedish government has assigned the country’s export credit system the task of contributing to the climate transition, while at the same time promoting Swedish exports. Therefore, EKN and SEK have developed their own set of guidelines, taking in what the EU Taxonomy and other standard setters have to say, as well as industry-specific benchmarks.
“To financiers and project owners, the EKN/SEK framework offers additional assurance that a project meets high sustainability standards,” Aili says, “but it is a learning process for everyone involved and we challenge each other in arriving at a common viewpoint.”
The market for green loans has been growing rapidly over the last 2–3 years. According to Swedish bank SEB, the sustainable debt financing market reached USD 980 billion in 2021 (until August). The market is at record levels compared to previous years and poised to reach well over USD 1 trillion this year.
“The strongest growth is in the sustainability-linked segment, where issuers commit to improvements of their ESG performance over the tenor of the financing and commit to additional payments to investors, if these improvements cannot be demonstrated,” says Lin Jacobsen Hammer, Sustainability Manager at DNV.
Sustainability-linked bonds and loans are geared towards companies that commit to change their operations in general to become more sustainable, whereas Green and Social Bonds and Loans are tied to specific projects or project portfolios that have a verifiable, positive impact on the environment or social conditions.
The “Greenium” effect
To be sure, the booming interest in sustainable finance does have its benefits for the borrowers, says Zeitzen at DNV and points to a so-called “Greenium effect”, or a real advantage in terms of a reduction in financing cost for the issuer, evidenced by many studies. “This Greenium is driven mainly by strong investor demand for sustainable finance instruments – a traditional bond would be seen as in good demand if the issue would be oversubscribed 1.5–2 times. It is not rare to see investor interest of more than 6–10 times of the issue volume in sustainable finance”, he says and adds. “This would tend to reduce the yield investors are willing to accept, and it certainly increases the chance of a successful offering.”
This entails that offering a sustainability-labelled bond will certainly support a wider outreach to investors that would otherwise not be interested.
The phenomenal growth in sustainable loans obviously goes hand in hand with more stringent demands on sustainability verification to authenticate the quality of the bonds. DNV’s Hammer notes that, “the most important trend is that verification is going from voluntary to mandatory, due to requirements from the different stakeholders and changes in regulatory requirements. Companies also need to take more responsibility for their entire supply chain, which requires new focus on how the company sets requirements in line with their strategic sustainability focus, implement and secure reporting on these.”
With the growth of sustainability-linked instruments, issuers, advisors and investors are faced with a proliferation of possible KPIs that issuers might commit to. Many issuers have more than 8-10 potential KPIs and need to focus. These KPIs can differ across companies and industries and investors need to be able to trust the relevance, baseline and ambition of these KPIs in the specific industry and company setting to make an informed decision.
Need for insight
When reporting on sustainability efforts, companies and investors need to be able to rely on the data and information presented. This makes it even more important that the non-financial data is correct and verified, just as we are used to in relation to financial data and reports. “This creates a need for industry specific and technical insight into the business which means it becomes even more important who the verifiers are in order to get the right trust in the verification,” concludes Hammer.
Finally, what can the export credit system do to stimulate and further incentivise sustainable investment? “Ideally, EKN would like to offer more favourable conditions for sustainable loans. But we have a limited room to manoeuvre within the existing OECD and EU rules that govern government-backed export credits. We must follow the minimum OECD premiums and cannot offer tenors that deviate from the rules for example. But there are discussions and initiatives, which EKN supports, to change the OECD rules and have more favourable conditions for sustainable loans,” says Carstenius.
Nevertheless, the share of green financing in EKN’s portfolio is continuously rising. Renewable energy production, for example, currently comprises about 7 percent, primarily offshore windfarms in the North Sea and solar projects in Angola. Including electrification (transmission and cables), the share is 10 percent.
At SEK, Export & Project Finance Director David Lindström concludes that Swedish industry and exports are well positioned to meet the demands for investment in transition technology: “The financing capabilities of SEK and EKN, and cleantech from world-leading suppliers form an unbeatable combination.”
Common sustainability standards
Standards for how to assess the ESG or sustainability qualities of financing instruments have been developed by the financing industry and not-for profit organizations, structuring the due diligence mechanisms and eligibility criteria. The most prevalent standards are:
- ICMA (The International Capital Market Association) – for traded debt instruments
- LMA (Loan Market Association), for loans
- CBI (The Climate Bond Initiative), covering both bonds and loans
ICMA and LMA, as the most used standards, describe how a framework against which loans and bonds are issued should be structured, and help issuers to both highlight their ESG qualities and commit to either a certain use of proceeds or to relevant, company-wide strategies and targets that demonstrate long-term commitment to ambitious sustainability improvements in their own products, their operations or their entire supply chain. These are voluntary standards that as a best practice have reached market-wide acceptance.
Such standards can only work in conjunction with a strong set of accepted rules for eligible activities. These can be found in the UN Sustainable Development Goals (SDGs) or in the various taxonomies that are under development (EU Taxonomy, Chinese Taxonomy, ASEAN Taxonomy, CBI Taxonomy). Such taxonomies serve as the “bar” an issuer has to clear at the time of issue, detailing in the Technical Screening Criteria e.g. the accepted (“taxonomy aligned”) level of emission in the production of electricity.