Sustainability-linked bonds (SLB) issuers are under fire for funding heavily polluting investments, but the fault may lie with the wider issuing standards.
- Issuers of SLBs are being accused of using the proceeds to finance activities that are not sustainable, such as fossil fuel projects.
- According to SLB principles, bond proceeds can be used for general corporate needs.
- This exposes a flaw in the issuance criteria, their treatment by the financial services community with regard to discounted interest rates, and their inclusion in sustainable funds.
Issuance rules give SLB issuers wide berth on use of proceeds
Rules governing the issuance of SLBs are set by the International Capital Market Association (ICMA). In June 2022, it released additional details clarifying the setting of key performance indicators (KPIs) and their materiality. It clearly states that SLB proceeds are intended for general corporate purposes. Explaining the credibility of their sustainability or transition strategy, and how it relates to the SLB, is left up to the issuer.
In this regard, SLBs are different from green, social or sustainable (GSS) bonds, which are “use of proceeds” bonds. Their proceeds must be used for defined green, social or sustainable projects. A framework explaining the alignment of a GSS bond with green or sustainable bond principles is also recommended by ICMA.
KPI materiality needs to align with sustainability strategy
Issuers can combine their SLB frameworks with those they develop for GSS issuance, but this is not a requirement. ICMA also leaves adequate room for interpretation when it comes to KPI selection. While SLB principles require KPIs to be material, ICMA states that “the notion of materiality is multi-faceted”.
It allows for setting KPIs based on ESG issues, or their impact on the environment or society, with the measurement of the scale or magnitude of the issue being the salient feature. The above seems to suggest that many of the SLB issuance criteria are subject to interpretation.
SLBs have been widely viewed by the financial services industry as an instrument to finance the transition to sustainability by companies in hard-to-abate sectors. While the rise in their issuance suggests further support for transition finance, their use by banks to raise funds, especially those heavily involved in financing fossil fuel projects, has sparked concerns.
SLBs viewed as excuse to fund fossil fuels
According to industry sources, SLB KPIs based on Scope 1 and 2 are considered insufficient by market participants. This is because they account for a small volume of overall emissions. Scope 3 emissions account for 75% of a company’s overall emissions, on average, therefore KPIs to cut those emissions would be considered more relevant.
This is especially true for banks, as they generate very few direct emissions in daily operations. An EU report on the exposure of financial institutions to fossil fuel assets found that assessing environmental risks associated with a bank’s portfolio is more relevant when including Scope 3 emissions, especially with regard to financing the fossil fuel sector.
One bank that has drawn scrutiny in this regard is HSBC (LON:HSBA). The UK Advertising Standards Authority recently upheld complaints about the bank’s adverts providing misleading information about its financing of high-polluting sectors.
Investigative media reports have also alleged that HSBC has raised sustainable financing to fund fossil fuel expansion. Specifically, it claims that part of the sustainable finance funds raised by the bank were directed to heavily polluting industries. In response, HSBC has said it is following industry standards in issuing sustainable bonds.
Greenwash concerns grow with rising ESG assets demand and SLB issuance
SLB issuance has grown in size in 2022 despite a contraction in the wider bond market. SLBs now account for a larger portion of the overall GSSS bond universe as well. While this has been viewed as a favourable development for helping finance the transition, especially for hard-to-abate sectors, it has also raised concerns over the misuse of SLBs.
These concerns are typically over greenwashing claims. The latitude in setting sustainability KPIs is one reason for this concern. The chief executive of Climate Bonds Initiative, a global climate action non-profit, stated that he thought the SLB market was flawed, citing the KPIs set by banks as an example.
The demand for green and sustainable investments continues to rise at a rapid pace. Asset managers expect to increase ESG-related assets under management by 84% by 2026, compared to 2021 levels. When asset managers deliberately misstate the green or sustainability claims of their products, it may constitute greenwash.
It is less clear whether there is a gap between investor expectations and those set by an asset manager. This disconnect is receiving a lot of attention, which could be resolved by better standards setting, improved transparency and educating investors on investment risks, according to Morningstar.
The Climate Bonds Initiative says that $5 trillion in annual green financing issuance is needed by 2025 to meet global net zero commitments. It advocates rapid deployment of sustainable finance to do so, in particular the issuance of more green bonds, and calls for accelerated development of policy to support this.
In the near term, SLBs will continue to dominate green and sustainable issuance. Reducing friction between issuers and the marketplace may require ICMA to tighten up its SLB principles.