By José Luis Reséndiz
Latin America Analyst
Ahead of COP26, decision-makers are setting ambitious targets to tackle climate change, which has led to an increasing interest in sustainable financial instruments to incentivise a transition towards a net-zero economy. One of the most recent innovations to address climate change goals has occurred in debt capital markets by creating sustainability-linked financial (SLFs) instruments.
SLFs connect the sustainability performance of companies with their cost of capital. The key to the success of these instruments relies on incentivising borrowers to be more ambitious in achieving their environmental, social and governance (ESG) targets. The way to do this is by lowering their funding costs, based on pre-established sustainability performance targets (SPTs), while enabling lenders to invest in sustainable and innovative projects.
Before creating SLFs, green loans and bonds were the most recognised sustainable financing instruments in the market. However, most companies could not take advantage of them because their use-of-proceeds was limited to specific environmental projects. Instead, SLFs do not specify how an issuer should spend the money. Alternatively, they reward the borrower when they improve on pre-determined metrics, such as reducing emissions, or penalise them with higher coupon rates if they fail meeting those targets. That flexibility enables firms to use the funds to build long-term strategies to achieve environmental and social commitments, while improving other business aspects.
From the perspective of the issuer, there are at least four incentives to link the cost of capital to sustainability performance:
- Transparency. SLF products encourage transparency about the sustainability performance of the companies and prevent greenwashing practices.
- Credibility. Embedding environmental or social commitments to financial indicators, such as the interest rate, increase the credibility of the issuers’ obligations.
- Long-term projects. SPTs should be ambitious to achieve international goals, which offers the opportunity to issue securities with maturities longer than five years aligned with the Paris Agreement goals.
- Flexibility. Sustainability-linked financing instruments are more flexible than the use-of-proceeds bonds since the money is not assigned to low-carbon projects but corporate sustainability performance.
Establishing and measuring the environmental performance of companies is a challenge. The recently published SLLP Guidance highlights that borrowers can develop key performance indicators (KPIs) based on science-based targets. Therefore, a critical challenge is to have criteria as ambitious as international scientific agreements, such as the Paris Agreement and SDGs.
The market for sustainability-linked instruments in the United States and Latin America is expected to grow significantly. The new administration in the United States and the recent spike in activity on the regulatory side in Latin America are expected to increase demand for sustainability-linked financing for carbon-intensive sectors. As climate-related KPIS criteria and regulation become more standardised and aligned to a credible transition towards a net-zero economy, investments in SLFs will grow in quantity and relevance.