updated on 22 October 2019
QuestionWhat are ‘green finance’ and ‘sustainable finance’?
Green finance and sustainable finance seek to improve the environment through the funding and support of green and sustainable projects. With the present backdrop of socio-political protests centred around climate change, this area of finance appears to grasp the current zeitgeist, but in fact this asset class hasn't just appeared overnight. It is an area that has developed over the past 10 years. Initially, there were no fixed market criteria that guided what qualified, for example, as a green bond or green loan.
In 2014 the International Capital Markets Association (ICMA) published the Green Bond Principles (these have since been updated in 2018), which focus on: (1) bonds as opposed to loans; and (2) the use of proceeds.
Since then the market has moved on considerably. The driving factor behind green and sustainable finance is a combination of international initiatives reflecting the wider social shift to tackle climate change.
That said, this asset class is still a relative newcomer to the market given that in the past five years, there has been a huge expansion in the use of green and sustainability-linked financial products. Moody's has stated that sustainability-linked financial products reached $47 billion in the first quarter of 2019.
Green and sustainable finance covers a plethora of different financial products, but the following categories are the most common products currently on the market:
Green finance: green bonds and green loans
Green finance generically refers to green bonds and green loans, but before we delve into these two types of finance, it might help if we begin the discussion by first establishing what we mean by a loan and a bond.
Companies raise money through two main ways, either by raising equity or debt. When a company takes out debt, lawyers in a banking and finance team draft the loan documentation between the company (the borrower) and the bank (the lender). Traditionally, corporate loan facilities were provided by banks, but it is now common for other types of entities to provide loans, such as private equity and pension funds.
A bond is essentially a promise, made by an issuer (akin to a borrower) to repay the debt to the bondholder (akin to a lender), usually with interest.
Green bonds and green loans
While there is no universal definition of green bonds or green loans, they can be summarised as follows:
What is sustainable finance?
In contrast, sustainable finance focuses on environmental, social and governance considerations. However, sustainable finance does include a strong green finance component that aims to support economic growth while reducing pressures on the environment.
In March 2019 the Loan Market Association and other international syndicated lending organisations (Asia Pacific Loan Market Association and the Loan Syndicated and Trading Association) published the Sustainability Linked Loan Principles.
In June 2018 the ICMA published the Sustainability Bond Guidelines and the Social Bond Principles. Often referred to as the "Principles", they have become the leading framework globally for issuance of green, social and sustainability bonds.
Why do we need this type of financing?
Green finance and sustainable finance are needed as these types of financial products encourage and support the development and implementation of green and sustainable investments, which in turn:
Current issues facing this asset class
Lack of clarity
There is no universally accepted legal or commercial definition of what is, for example, a green bond. There are common features as to what constitutes a green bond, but currently the market has not developed contractual safeguards to ensure that a product sold as being green remains green for the duration of the project. The obvious consequence of this is that it is likely to severely undermine the credibility of this asset class.
Lack of regulation
One could argue that there is quasi-regulation for the most advanced financial product within this asset class, green bonds. The Green Bond Principles, as previously mentioned, have more than 100 issuers, investors and underwriters who have signed up to them. These principles might not have the force of law and regulation, but they are strengthening the integrity of the green bond market and they do provide process guidelines that clarify how issuers should disclose and report on the use of green bond proceeds. However, the fact remains that these principles are still completely voluntary.
Is this asset class cheaper for issuers/borrowers?
Not on the face of it. Discounts are not generally offered to a borrower/issuer simply because they promise to use funds in a certain way (though some green loans do include mechanisms whereby interest rates are linked to meeting certain sustainable/green targets). Investors focus principally on likelihood of repayment and they look at various commercial considerations when deciding the interest rate, repayment terms and so on. This asset class currently provides good PR benefits to issuers or borrowers, but it does not guarantee cheaper financing.
Greenwashing is a phrase that can generally apply to the branding of a product as being "green" or "environmentally friendly", even though this is not based on facts or reality. With respect to green and sustainable finance, greenwashing more specifically refers to the practice of making ambiguous, misleading, or false claims about the environmental benefits of the investment and/or the project that the investment is funding. Essentially, greenwashing can make a company appear to be more environmentally friendly than it really is. The best way to avoid or mitigate the risk of greenwashing is to give full and exhaustive disclosure regarding the green project and to follow through on the promises made in such disclosure even though they may not be legally binding. Financing that is truly green and/or sustainable can be backed up with facts and details.
Where does it end?
The World Bank was the first institution to issue a green bond in 2008 and in 2013 the International Finance Corporation became the first institution to issue a green bond over the value of $1 billion. Today this market is worth $500 billion. Some might think this is a big number out of context, but this only accounts for 1% of the global bond market.
This asset class is only just finding its legs. As previously stated, green finance and sustainable finance cover a plethora of different financial products. There are also social bonds, blue loans, blue bonds and more, which illustrates that this asset class is ever expanding.
Watch this space.