Background and Rationale

In 2021, we saw ever-increasing volumes of ESG bonds and loans in the European leveraged finance market — particularly "sustainability-linked" high-yield bonds and syndicated loans. To put it in some context, in 2021 Reorg EMEA Covenants tracked approximately €49 billion of institutional loan transactions with a margin ratchet linked to ESG-related criteria (43% of the total leveraged loan market in Europe, up from 5% in t e year before), and €25 billion of green, sustainability, and sustainability linked ig yield bond issuances (18% of issuances).

The rise is driven by increasing demand on all sides — from institutional investors in the debt (who are integrating ESG into their overall investment strategies at a rapidly increasing rate) to the private equity sponsors themselves (whose LPs are pushing them more and more to consider ESG in their valuation and asset selection processes). This demand looks set only to grow in line with the changing regulatory environment — it is expected that more investors will start to integrate FSG requirements as they are required to comply with the new EU Disclosure Regulation (which requires financial market participants to publish their sustainability risk policy to explain how they integrate such risk into decision malting processes (irrespective of any stated ESG focus or strategy).

Types of ESG Finance – Key Differences

ESG finance is broadly understood to mean bonds or loans that have an "ESG" objective or are subject to "ESG" metrics – i.e.

  • "Environmental" - promoting conservation of the natural world and seeking to combat measures such as climate change and carbon emissions, resource depletion, deforestation, waste management, biodiversity and pollution.
  • "Social" - relating to the consideration of people and relationships, including matters such as gender/diversity, human rights, community relations and labour standards.
  • "Governance" - involving the standards of running a company and relating to matters such as board composition, bribery and corruption, executive compensation, lobbying and donations.

There is no consensus on the exact scope of what can qualify as an ESG bond or loan. Having said that, there are two main and distinguishable types of ESG bond and loan product, each with the key characteristics as summarised below.

Bonds/Loans Tied to Use of Proceeds

Issuers/borrowers of these bonds or loans use the funds raised to finance or refinance eligible ESG projects. The main types of these bonds or loans are "green" bonds or loans, "social" bonds or loans, and "sustainability" bonds or loans. To date, in the sub-investment grade space, the focus has been primarily on the environmental aspects, with some ESG loans (rather than bonds) starting to introduce social and governance elements.

Green Bonds/Loans

Green bonds were the first ESG financing product to emerge in the debt markets, in 2007. There is no set definition of green bonds, but most issuances of green bonds in Europe are aligned with the ICMA "Green Bond Principles", which are voluntary guidelines that provide issuers with guidelines around transparency, disclosure and reporting, and which help investors assess the "greenness" of a bond. The Green Bond Principles themselves recommend that the label "green bonds" only be used for bonds that are aligned with these principles - and the use of such label means that the issuer has agreed to comply with fairly onerous disclosure, reporting and monitoring obligations.

While the green bond market has grown since 2007, it has done so relatively slowly in the sub-investment grade market. Bond proceeds in the leveraged finance market are most commonly applied for refinancings and acquisition financings, and generally involve very substantial sums (usually from €250 million and upward). Since the equivalent amount of all of the bond proceeds has to be allocated for green purposes under the Green Bond Principles, not all such issuers have been in a position to find a sufficient green pool of projects. The development of the high-yield bond green market thus naturally led to the development of green loans, with the first green loan being issued in 2014. Like green bonds, green loans are governed by a set of principles developed to guide investors in respect of the characteristics of green loans and clarify when a loan may be labelled as "green" – being the "Green Loan Principles" issued by the Loan Market Association, the Asia Pacific Loan Market Association and the Loan Syndications and Trading Association. Unlike green bonds, however, the loan market offers the advantage of less onerous disclosure and reporting requirements, more flexibility in terms of debt size, and lower transaction costs (and as a consequence the green loan market has grown at a faster pace than the green bond market).

The Green Bond Principles and Green Loan Principles each have four (similar) core components:

  1. Use of Proceeds: amount equal to the net proceeds must be exclusively used to finance or refinance, in part or in full, eligible new and/or existing green projects which provide clear environmental benefits and contribute to environmental objectives (such as climate change migration, climate change adaptation, natural resource conservation, biodiversity conservation and pollution control).
  2. Process for Project Evaluation and Selection: an issuer/borrower is required to communicate to investors the process by which it determines how the projects fit within the categories identified in the use of proceeds requirement and the related eligibility criteria.
  3. Management of the Proceeds: proceeds (or amount equal to the net proceeds) must be ringfenced and placed into a sub account or otherwise tracked. For green loans, if the loan is part of a tranched facility, each tranche must be clearly designated and tracked. Green bonds must generally not be fungible with non-green bonds (in practice, trading under separate ISINs).
  4. Reporting: the Green Bond Principles provide that an issuer must make readily available and renew annually information on the list of projects and a brief description of them, amount of proceeds allocated and their expected impact; the Green Loan Principles provide for such information to be provided annually until the green loan is fully drawn (and thereafter to account for material developments only).

Both the Green Bond Principles and the Green Loan Principles recommend issuers/borrowers get a third party to verify that their bonds or loans are compliant (referred to as the "second party opinion" or "SPO").

A distinguishing feature of green bonds is that generally the application of the use of proceeds is not an undertaking in the indenture, unlike in green loans where the borrower will have an obligation to apply the proceeds for a specifically identified purpose. Equally, the reporting covenant in the indenture will not require a green bond issuer to comply with the ongoing reporting described above. Therefore, investors would have no contractual recourse against a green bond issuer that is no longer complying with the Green Bond Principles.

Green bond frameworks have been developed to be increasingly flexible, including allowing issuers to use the proceeds of the bonds for refinancings or other purposes while allocating an equivalent amount of the proceeds to green projects (past, present or future). Nevertheless, green bond issuers face some unique challenges, which also explains the recent rise in popularity of sustainability linked bonds (discussed below). For example, an issuer that issued green bonds and allocated an equivalent amount of proceeds to a specific green project may want to access the markets again by "tapping" the existing bonds in a fungible manner (i.e. issuing more bonds with the same ISINs which benefits the liquidity of both the existing and the additional bonds). Unless the issuer is able to find additional eligible green projects to which an equivalent amount of proceeds can be allocated, the additional bond will not be fungible with the existing bonds and, therefore, will be less attractive to investors.

Social/Sustainability Bonds/Loans

In recent years, there has been increased focus by both investors and companies on socially responsible lending and investing, and new categories of ESG bonds and loans have developed as a result — notably, "social" bonds or loans (which require that the proceeds be used for new or existing projects with positive social outcomes) and more recently, "sustainability" bonds or loans (which are designed with a hybrid set of objectives, bridging both green and social issues).

The Spanish Instituto de Credit° delivered the first formal "social" bond offering in January 2015, to help finance SMEs in economically depressed regions of Spain, which generate lower GDP per capital than the national average. ICMA in response published in 2017 the "Social Bond Principles" and "Sustainability Bond Guidelines", and, in turn, most recently in 2021 the Loan Market Association, the Asia Pacific Loan Market Association and the Loan Syndications and Trading Association together published the "Social Loan Principles".

Both the "Social Bond Principles", "Sustainability Bond Guidelines" and the "Social Loan Principles", cover the four components covered by the "Green Loan Principles" (as set out above), with the difference being the use of proceeds i.e. that a "social" bond or loan must be used to finance or refinance a social purpose or project (such as financing the building of affordable housing, employment generation, or increased access to education or healthcare), and that a "sustainability" loan or bond must be used to finance or refinance a combination of both eligible green and social projects.

The growth in "social" and "sustainable" finance has most recently been further fuelled by the recovery from the global COVID-19 pandemic – "social" bonds and loans in particular remain largely the remit of supranational and sovereign entities, and have grown as governments seek to stimulate economies and create jobs while committing to ambitious environmental targets. Nevertheless, to date there has not been any notable issuance of "social" and "sustainable" bonds in t e leveraged finance market.

Sustainability Linked Bonds/Loans

What Are They?

Sustainability linked bonds or loans, by contrast to the "use of proceeds" bonds or loans described above, do not require the issuer/borrower to apply the proceeds for specific eligible ESG projects – the proceeds can be applied for any general corporate purpose. Instead, the focus of the sustainability linked bond or loan is to encourage the relevant issuer or borrower to improve their ESG performance by the setting of certain targets (which, if met, provide the issuer or borrower with financial benefit, usually a change to their margin ratchet as set out below).

The fact that the issuance of the relevant bonds or loans is not limited by the nature of the project it is intended to finance and the flexibility of the sustainability linked structure has led to a huge surge in sustainability linked bonds and loans in the European leveraged finance market, as companies from industries not typically considered "green" or those without specific eligible green or social projects are now able to access ESG related finance.

In contrast with green bonds and loans, sustainability linked bonds and loans have also been used in connection with notable leveraged buy-outs, with sponsors incorporating ESG into their M&A investment thesis by linking their LBO financing to specific ESG-related key performance indicators.

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