Sustainable finance in Europe may provide insight into future developments in U.S. markets, including more issuance of sustainability-linked bonds and increased focus by regulators, banks, and institutional investors on climate risk.
The share of sustainable bonds in global debt issuance has doubled so far this year, up from an average of 5% in 2020 to 10% in the first quarter of 2021. This growth confirms that ethical and responsible considerations are increasingly integrated into corporate finance strategies.
The rise of SLB bonds
Sustainable linked bonds, or SLBs, are debt securities that provide a financial incentive for the issuer to commit to a more sustainable business model. Unlike green bonds or social bonds, where the funds raised finance a particular project, SLBs automatically pay an increased coupon at a predetermined date if the issuer fails to meet the sustainability targets, such as reduced carbon emissions, set when the bonds were issued. These quantified sustainability targets are established through key performance indicators, or KPIs, that are defined in the prospectus.
SLB issuance has grown over the past few months in Europe, mainly through private placements that do not require a prospectus, but this may change as SLB issuance is extending to regulated markets. The French Financial Markets Authority (AMF) recently approved a bond prospectus allowing SLBs to be admitted on Euronext Paris for the first time. Within the $500 billion sustainable debt issued globally in 2020, SLB issues accounted for around 25% to 30%, with green bonds (40% to 45%) and social bonds (30%) making up the remainder, according to Eikon Refinitiv.
The $150 billion of SLBs issued in 2020 is a sizable amount, but it was concentrated in fewer than 150 issuers. Since the beginning of this year, SLB issuance rose by 48% compared with the last quarter of 2020. The market welcomed a number of high-profile new European issuers, including Rexel, Berlin Hyp, and Natura &Co. SLBs enable many different issuers from a wide variety of industries to participate.
Regulatory and investor pressures drive adoption of new social and sustainability metrics
The past 12 months have seen rapid changes in the policy and regulatory environments that have been designed to help the financial world increase its social and environmental responsibility. More tolerant of inflation, the new monetary strategy that the U.S. Federal Reserve unveiled in August 2020 intends to tackle inequality through a more inclusive employment mandate.
There is wide agreement that the Biden administration will use regulatory powers to push banks to pay more attention to sustainability and social issues. In an Executive Order on Climate-Related Financial Risk dated May 20, 2021, President Joe Biden stated, “The failure of financial institutions to appropriately and adequately account for and measure these physical and transition risks threatens the competitiveness of U.S. companies and markets, the life savings and pensions of U.S. workers and families, and the ability of U.S. financial institutions to serve communities.”
This sends a clear signal to expect more regulatory oversight and an increased emphasis on sustainability. Where the regulators lead, U.S. banks will follow. Meanwhile, the 87 other central banks that met last year at the Jackson Hole Economic Policy Symposium reaffirmed that fighting climate change is among their priorities. Central banks view global warming as a threat to financial stability.
The “greening” of balance sheets
In the future, the link between monetary policy, credit distribution, and sustainability issues is likely to strengthen. Several banks have anticipated this development and intend to “green” their balance sheets, reserving enhanced allocations for sustainable financing. This is clearly visible in continental Europe, notably in Italy, France, Sweden and Belgium. More than 40% of the syndicated loan volumes signed in Europe between October 2020 and March 2021 included ESG criteria, as well as 20% by number of transactions.
Sustainable linked loans, or SLLs — which are general-purpose loans that integrate compliance with environmental, social and corporate governance, or ESG, objectives adapted to the borrower’s situation — are driving this trend and are currently well ahead of green loans and social loans in terms of volume outstanding. Driving financing towards SLLs is one way that banks can demonstrate their dedication to helping the world meet climate goals.
In the first quarter, French banks completed the first climate stress test that the French regulator now requires them to undertake. A similar test will be extended to all European banks in 2022 under the guidance of the ECB and the Bank of England.
In the U.S., Biden’s Executive Order requires a report within the next six months discussing, among other things, incorporating financial risk due to climate change into regulatory considerations and assessing climate-related financial risk.
The effect on investors and banks
On the investor side, the disclosure regulation of the European Commission’s Sustainable Finance Action Plan from November 2019 requires asset management companies to present how they take into account the risks associated with climate change and the loss of biodiversity. It also requires them to communicate on how they consider the negative impacts on the environment of their investment policy. In a survey of institutional investors published by the European Corporate Governance Institute, 51% believed climate risk reporting was as important as traditional financial reporting, and almost one‐third believed it to be more important.
Against this backdrop of growing pressure on both banks and institutional investors, negotiations between lenders and borrowers on the targets included in sustainable linked loans and bonds are getting tougher. U.S. issuers and investors should watch Europe for potential developments.