Sustainable finance has gained significant popularity in recent years, as proponents argue that sustainability-linked transactions are an innovative and efficient way to enhance corporate sustainability through economic incentives. Issued for the first time in 2019, sustainability-linked bonds (SLBs) constitute one instrument among a vast array of products promoting sustainability across the financial market. Not to be confused with “green bonds” or “social bonds,” SLBs are negotiable debt instruments whose terms directly relate to an issuer’s actual performance, with respect to specified sustainability/environmental, social and governance (ESG) outcomes, which are evaluated against predetermined performance objectives and timelines. SLBs are designed to incentivize the issuer’s achievement of material, quantitative, pre-determined, regularly monitored and externally verified ESG objectives.
Drawing from the sustainability-linked loan principles published in 2019 by the Loan Syndications and Trading Association, the Loan Market Association and the Asia Pacific Loan Market Association, the International Capital Market Association (ICMA) published sustainability-linked bond principles (SLBPs) in June 2020 to foster the SLB market by promoting transparency, credibility and uniformity of information through voluntary guidelines recommending structuring features, disclosure and reporting, and providing market participants with information designed to drive increased capital allocation into this market.
For an overview of other sustainable financing products available on the market, please see our May 2020 Blakes Bulletin: New Guidance Documents on Green Loans and Sustainability Linked Loans, May 2018 Blakes Bulletin: Canadian Investors Take Note: Budding Green Loan Market Set to Ramp Up in 2018 and April 2019 Blakes Bulletin: Lending Market Sets Sights on Sustainability Linked Loans.
SUSTAINABILITY-LINKED BONDS AND KEY DIFFERENCE WITH SUSTAINABILITY BONDS
As noted above, SLBs are a forward-looking performance-based instrument which incentivize the achievement of monitored and verifiable objectives (i) measured through predefined key performance indicators (KPIs) and (ii) assessed against predefined sustainability performance targets (SPTs).
Also introduced by the ICMA, the Green Bond Principles, Social Bond Principles and Sustainability Bond Guidelines (collectively, Sustainability Bonds) differ from SLBs in that they require the issuer to use the proceeds for a specific green or social project. In contrast, use of proceeds is not determinant in SLB categorization, though issuers may choose to use a Sustainability Bond-like approach and allocate some or all of the use of proceeds for specific ESG purposes. As a result, SLB proceeds can be used for general corporate purposes, as long as their issuance provides an investment opportunity with transparent sustainability credentials that can be measured through KPIs and SPTs. This key difference can be qualified as providing increased flexibility and a more attractive sustainable financing option for issuers.
SUSTAINABILITY-LINKED BOND PRINCIPLES
SLBPs are a voluntary framework published in June 2020 by the ICMA. They are intended for use by any type of issuer in the market, but this instrument will, at least initially, likely be more attractive to more senior and investment grade issuers who have already established their own ESG objectives and reporting. SLBPs outline best practices for issuers and their advisers in structuring, disclosing and reporting on SLBs. The ICMA claims that SLBPs not only provide issuers with guidance on the five core components involved in launching a credible and ambitious SLB, but also aid investors by promoting accountability of issuers in their sustainability strategy and availability of information necessary to evaluate their SLB investments. They are also designed to assist underwriters of such SLBs by establishing expected approaches to structuring, terms, disclosures and reporting that will facilitate credible transactions. Transparency, accuracy and integrity of information disclosed by issuers to stakeholders are concepts largely emphasized by the SLBPs, as they are fundamental to the legitimacy and credibility of this instrument.
FIVE CORE COMPONENTS OF SUSTAINABILITY-LINKED BONDS
The SLBPs set out five comprehensive core components required for the issuance of SLBs, namely (i) selection of KPIs, (ii) calibration of SPTs, (iii) bond characteristics, (iv) reporting, and (v) verification.
i. Selection of KPIs
As a primary focus, KPIs should be relevant and material to the issuer’s core sustainability and business strategy. They should also be externally verifiable metrics, able to be benchmarked using external rather than internal references. Ideally, issuers should select KPIs already included in their previous annual reports to facilitate investors’ evaluation of their historical performance. KPIs should also be clearly defined and include the applicable scope or perimeter and the calculation methodology.
ii. Calibration of SPTs
One or more SPTs should be established for every KPI, as it can demonstrate the commitment of the issuer to its sustainability initiative(s). SPTs should be ambitious in that they should represent a material improvement in the relevant KPI. They should also be compared to a benchmark or an external reference, be consistent with the issuer’s overall strategic sustainability trajectory and be determined on a predefined timeline, set before or concurrently with the issuance of the bond.
iii. Bond Characteristics
The SLB must include financial and/or structural consequences arising out of the issuer’s failure to observe its SPTs, such as a variation of the coupon, which is expected to be the most common consequence. Such consequences should be based on trigger events, be commensurate and meaningful relative to the issuer’s original bond financial characteristics and be carefully detailed in the bond documentation.
SLBPs provide for detailed reporting obligations which include the publication of up-to-date information on the performance of the selected KPIs, a verification assurance report relative to the SPT outlining the performance against the SPTs and the related impact, as well as any information enabling investors to monitor the level of ambition of the SPTs. The SLBPs provide that reporting should be published regularly—at least annually—and for dates/periods relevant for assessing any SPT performance that could result in a potential adjustment of the SLB’s financial and/or structural characteristics.
Verification of the issuer’s performance level against each SPT for each KPI is expected to be conducted by an external reviewer with relevant expertise at least once a year, and as often as necessary in relation to any dates/periods relevant for assessing the SPT performance that could result in a potential adjustment of the SLB financial and/or structural characteristics, until after the last SPT trigger event of the SLB has been reached. While a second party opinion is only recommended at the time of closing, post-issuance verification is a necessary element of the SLB.
All five components outlined above indicate that the primary objectives of the SLBPs are transparency and accountability from and to market participants.
Clarifying the use and core components of the SLBs through the publication of SLBPs could be a significant driver in the market’s interest for this instrument. It would therefore not be surprising to witness an important rise in SLB prominence, especially amid the COVID-19 shake up of financial markets and the enhanced enthusiasm for sustainability and reputation inducing initiatives.
We will continue to keep you updated on the development of the SLBs and the SLBPs in both the international and domestic securities markets.
For further information, please contact:
Fabien Lanteri-Massa 514-982-4034
Michael Hickey 416-863-4318
Rebecca Dawe 514-982-5047
or any other member of our Capital Markets or Financial Services groups.
Blakes and Blakes Business Class communications are intended for informational purposes only and do not constitute legal advice or an opinion on any issue. We would be pleased to provide additional details or advice about specific situations if desired.
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