Green bonds and loans
A bond is a type of security where an investor lends money to a company or a government for a set period of time in exchange for regular interest payments. Bonds are labelled ‘green’ when they contain clear additional statements about the company’s commitment to allocating all proceeds from the issuance of bonds to climate and environmental projects (green projects). The impulse for creating one of the first green bonds was a group of Swedish pension funds that sought to invest in projects that help the climate. In November 2008, the World Bank issued a green bond, raising funds from fixed-income investors to support lending for eligible climate-focused projects. More than a decade later green bonds remain a highly publicised, sustainable financial instrument which increase the flow of finance to green projects.
However, in many EU countries, like Poland, except for general bonds regulations, green bonds are not regulated by ‘hard’ law. Instead, market practice is used by international organisations to create ‘soft’ law regulations. The most renowned standard in Poland used for green bonds is the Green Bond Principles created by the International Capital Markets Association (ICMA) based on its observations of the bond market.
How do green bonds work in practice? Each bond has a maturity date, meaning that it must be redeemed (repurchased by the issuer from the bondholder) on its maturity date. To assure that all proceeds from green bonds will be spent on green projects, the issuer accepts the obligation to use the proceeds to finance green projects specified in the terms and conditions of the bonds. If the issuer breaches this obligation, it must redeem the bonds earlier. In addition, under Polish law, if the issuer specifies the purpose of an issue of bonds and allocates the funds received for purposes other than those specified in the terms and conditions it may face criminal charges.
The most important document customarily prepared by the issuer besides the bonds’ terms and conditions is a green bond framework. In a green bond framework, the issuer describes green projects financed or refinanced with green bond proceeds. The framework also includes specific safeguards to ensure that bond proceeds are spent on a specific purpose. For example, green bond proceeds should be credited to a sub-account, moved to a sub-portfolio or otherwise tracked by the issuer in an appropriate manner, and attested to by the issuer in a formal internal process. Issuers should also make and keep readily available up-to-date information on the use of proceeds, which should be renewed annually until full allocation and on a timely basis in case of material developments. The issuer’s annual report on the bonds should include a list of the projects to which green bond proceeds have been allocated, as well as a brief description of the projects, the amounts allocated, and their expected impact. The bonds’ terms and conditions will refer to provisions of the green bond framework.
External advisors play a key role in assuring that green bonds are indeed green and proceeds are properly allocated. The ICMA recommends that, prior to issuance, issuers appoint external reviewers to assess the alignment of the green bond, green bond programme or green bond framework with green bond principles. Also an auditor is usually appointed to verify the internal tracking method and the allocation of funds from the green bond proceeds.
In addition to green bonds, there are also climate bonds, blue bonds, transition bonds, social bonds and sustainability bonds (and many more to come in the future). The main difference is the purpose financed with the bonds’ proceeds, though the mechanics are usually the same.
In this respect, green loans are similar to green bonds. Breach of the obligation to spend loan proceeds on the purpose specified in the loan documentation triggers early repayment. The most common standard for green loans used in Poland is the Green Loan Principles prepared by, among others, the Loan Market Association.
Sustainability-linked bonds and loans
What if a company wants to finance its day-to-day business and not a specific green project? The solution is sustainability-linked bonds and loans. Compared to green bonds and loans, sustainability-linked bonds and loans place more emphasis on the impact of a company's overall activity on the environment, rather than on a specific project.
The ICMA, the author of the most popular standard for sustainability-linked bonds (the Sustainability-Linked Bonds Principles) says: “Sustainability-linked bonds (SLBs) are any type of bond instrument for which the financial and/or structural characteristics can vary depending on whether the issuer achieves predefined sustainability/ESG objectives. In that sense, issuers are thereby committing explicitly to future improvements in sustainability outcomes within a predefined timeline. SLBs are a forward-looking performance-based instrument.”
First, the company must identify the areas of its activity which are the most detrimental to the environment (for example, CO2 emissions). To measure the company’s performance, key performance indicators (KPI) are set and periodically assessed against predefined ambitious goals (the sustainability performance targets, or SPTs). For example, the company decides to cut its CO2 emissions by 20% every year for five years. As a borrower, it must periodically prepare and disclose to investors up-to-date information on the performance of the selected KPIs.
How does this affect the bond or loan? Not meeting SPTs constitutes a trigger event leading to a change of the bond’s or loan’s financial and/or structural characteristics. In simple terms, based on the observation of the Polish market, the issuer’s/borrower’s failure to meet SPTs on a predefined day results in a higher margin for the predefined period of time, which means that the issuer/borrower must pay higher interest to the bondholders/creditors.
Unlike green bonds, for sustainability-linked bonds it is necessary to appoint an auditor who checks the issuer’s performance of each SPT for each KPI. The issuer is free to decide whether it will appoint an external reviewer to perform a pre-issuance review similar to the review performed in the case of green bonds.
The mechanics of a sustainability-linked loan is similar to the mechanics of sustainability-linked bonds. The most popular standard for sustainability-linked loans is the Sustainability-Linked Loans Principles prepared by, among others, the Loan Market Association.
Being eco-friendly is no longer only about saving water or choosing public transport over your car, but also about how you invest your money. There are plenty of instruments to choose from. Since we are only at the starting point of our journey towards a green economy, new sustainable finance instruments are still emerging. For example, a Polish oil company modified the concept of sustainability-linked bonds and issued bonds with interest based on the issuer’s ESG-rating performance. Investors have money, and money is power. Let’s use this power to make the economy green and change the world we live in.