Sustainable Financing: EU Taxonomy and Environmentally Sustainable Activities

Sustainable Financing

• Sustainable financing is crucial for achieving net-zero emissions and addressing the SDG financing gap.
• The EU taxonomy is a classification system that establishes a list of environmentally sustainable economic activities, which can help scale up sustainable investment and implement the European Green Deal.

Double Materiality

• Double materiality is a concept in sustainability and environmental accounting that emphasizes the need for businesses to consider both the financial impacts of environmental issues on their operations and the impacts of their operations on the environment and society.
• It encourages a holistic perspective on sustainability, integrating both internal and external impacts into strategic decision-making and financial reporting.

Financing Sustainable Development

• Sustainable financing instruments are essential for achieving the SDGs, particularly in developing countries where the financing gap has grown to $3.9 trillion annually.
• To secure a sustainable loan, entrepreneurs or companies should demonstrate their commitment to sustainability by showcasing positive environmental and social impacts, outlining a sustainability strategy with clear goals, and providing transparent sustainability reporting.

Challenges in Sustainable Financing

• Heterogeneous understanding of sustainability: There is no universally agreed-upon definition or set of criteria, leading to inconsistencies in how sustainability is interpreted and applied across different industries, regions, and stakeholders.
• Limited access to data: Sustainable financing relies heavily on accurate and reliable data, but data availability can be a significant challenge, particularly in emerging markets or for non-traditional ESG factors.
• Lack of standardization of measurement and disclosure: Without standardized metrics and reporting frameworks, it's difficult for investors to compare the sustainability performance of different investments.
• Conflict of interests: There may be conflicts of interest between different stakeholders involved in sustainable financing, which can create challenges in aligning incentives and fostering collaboration towards sustainable outcomes.

Green Bonds

• Green bonds are a type of bond instrument that allocates proceeds solely to "green projects" with environmental objectives, making them a form of impact investment.
• The International Capital Market Association (ICMA) offers voluntary guidelines for green bond issuers through the Green Bond Principles, which aim to provide a framework for defining and evaluating the environmental integrity of projects funded by green bonds.
• The ICMA Green Bond Principles consist of four core components: use of proceeds, process for project evaluation and selection, management of proceeds, and reporting.
• Green bonds are typically only available to companies in "green" sectors or for priori "green" projects, and they offer opportunities for issuers to attract new investors and potentially lower interest costs compared to conventional bonds.

Social Bonds and Sustainability Bonds

• Social bonds are any bond instrument where the proceeds are solely directed towards "social projects" with social objectives, aligning with the four core components of the Social Bond Principles.
• Sustainability bonds are any standard bond instrument where the proceeds are exclusively allocated to a combination of both "green" and "social projects", adhering to the four core components of both the Green Bond Principles and the Social Bond Principles.
• Special purpose debt instruments, such as green bonds and social bonds, offer several opportunities for issuers, including clear allocation of funds, value proposition, ESG sensitivity, and reputation gain.

Challenges in Special Purpose Debt Instruments

• Lack of universal definition/regulation: There is no universally accepted legal definition of green or social bonds, leading to ambiguity in classification.
• Controversial issuers: Even controversial issuers, like those in the oil or gas industry, can issue green bonds, raising questions about their environmental commitment.
• Greenwashing allegations: Doubts about the true green credentials of financed projects increase the risk of greenwashing allegations.

Sustainability-Linked Bonds

• Sustainability-linked bonds (SLBs) represent an innovative approach to aligning financial instruments with environmental, social, and governance (ESG) objectives.
• SLBs tie the bond's characteristics to the issuer's ability to achieve predefined sustainability or ESG targets, with a focus on forward-looking and performance-based instruments.
• SLBs offer flexibility in fund usage, but issuers may incur coupon penalty payments if they fail to meet the predefined sustainability targets.
• The ICMA Sustainability-Linked Bond Principles (SLBP) serve as a crucial framework for issuers of SLBs, offering voluntary guidelines to enhance transparency, integrity, and credibility in the market.### Sustainability-Linked Bond Principles (SLBP)
• The SLBP is a voluntary guideline for issuers, providing recommendations and best practices for structuring sustainability-linked bonds (SLBs)
• The SLBP has five core components:
  • Selection of key performance indicators (KPIs)
  • Calibration of sustainability performance targets (SPTs)
  • Bond characteristics
  • Reporting
  • Verification

Selection of Key Performance Indicators (KPIs)

• KPIs should be relevant, core, and material to the issuer's overall business
• KPIs should be measurable or quantifiable on a consistent methodological basis, externally verifiable, and benchmarkable
• Examples of KPIs: metrics related to carbon emissions reduction, renewable energy capacity, or diversity and inclusion initiatives

Calibration of Sustainability Performance Targets (SPTs)

• Involves defining the target or calibrating the target value of the selected KPI(s)
• SPTs express the level of ambition of the issuer and should represent a material improvement in the KPI
• The targets should be challenging yet achievable within the defined timeframe

Bond Characteristics

• Outlines the financial consequences if the selected KPI(s) do not reach the predefined SPT(s)
• Examples: coupon step-up, where the coupon rate increases if sustainability targets are not met, or coupon step-downs for surpassing targets or adjustments to principal amounts

Reporting

• Issuers are required to transparently report on the KPI and SPT, typically on an annual basis
• Reports should provide updates on the issuer's overall environmental, social, and governance (ESG) strategy, including progress towards meeting sustainability targets

Verification

• Issuers should seek independent and external verification of their sustainability performance, both before (recommended) and after issuance (necessary)
• Verification helps ensure the accuracy and reliability of reported data, enhancing transparency and credibility in the SLB market

Challenges of Sustainability-Linked Bonds (SLBs)

• No restrictions on the use of proceeds
• Level of ambition and defined penalty
• Low incentives for achieving sustainability targets
• Rolling basis and target failure
• Lack of legally-binding standards
• Credibility and greenwashing allegations
• Uncertainties and measurement problems

Opportunities of Sustainability-Linked Bonds (SLBs)

• Signaling ESG commitment
• Measuring ESG metrics
• Diversifying investor base
• Potentially lower financing costs
• Reputation gain

Transition Bonds

• Directed towards decarbonizing operations and projects, particularly targeting hard-to-abate sectors
• Intention is for "brown" issuers to transition from brown to green, supported by clear ambitions and strategies for the future
• Focus on short- to medium-term transition finance and do not label assets producing high emissions in the long term as transition assets

ICMA Climate Transition Finance Handbook

• Provides guidance for issuers
• Contains four key elements:
  • Issuer's climate transition strategy and governance
  • Business model environmental materiality
  • Climate transition strategy to be 'science-based' including targets and pathways
  • Implementation transparency### Green Buildings
• Green buildings are not only energy efficient, but also provide healthier and more productive spaces through better natural lighting, ventilation, and materials.
• They provide better health, comfort, and productivity for occupants.
• Initial incremental costs of about 2% can result in life-cycle savings of over ten times the initial investment.
• Location is often given too little attention as a sustainability criterion.

Sustainability in Real Estate

• Sustainable real estate initially requires higher construction investments, but can lead to higher returns and reduced resource consumption and energy costs.
• Improved rentability has the greatest impact on commercial space.
• Companies that rent green space make a positive contribution to their ESG profile.

ESG Ratings

• ESG ratings assess corporate sustainability risks, focusing on financially material ESG risks impacting financial performance.
• There are two approaches: Financial Risk-Based and Ethical-Ecological.
• Financial Risk-Based Approach dominates the ESG rating landscape due to its relevance to financial performance and investment risk management.

Comparison of ESG Ratings

• Different ESG criteria selection, methodologies, and weightings can lead to different judgments.
• Handling of non-transparency also affects ESG ratings.

Sustainable Financing

• Fields of action for lenders regarding sustainable financing include exclusion and pricing in sustainability risks.
• Risk-oriented ESG ratings or risk-oriented key figures can be used to determine risk-adjusted pricing.

Climate Change Risks

• Companies need to assess and integrate climate-related risks and opportunities into their strategic planning and risk management processes.
• Climate change affects revenues, expenditures, asset valuations, and capital structure.
• Two out of three companies are already affected by increased raw material costs, and one in two companies are affected by increased production costs.

Disagreement about Climate Risks

• There is a disagreement between the board of directors, risk management, and sustainability management on the relevance of climate risks.
• Management boards tend to rate climate risks as low, while risk management assesses potential damage from climate risks as high.

Challenges in Assessing Climate Risks

• Many companies lack data and expertise to assess climate risks.
• Lack of available historical data on climate risks is a significant challenge.
• More than one in three companies do not assess climate risks at all.

Examples for Climate Risk Assessment

• Climate modeling and scenario analysis can be used to assess climate risks.
• Stress tests, simulation analysis, sensitivity analysis, and risk matrix can also be used.