Sustainability-Linked Financial Instruments and the Role of the Second-Party Opinion

Posted on November 4, 2022

Ian Holroyd
Ian Holroyd
Writer, Corporate Solutions
Lindsay Brent
Lindsay Brent
Director, Debt Capital Markets and Sustainable Finance

Ever since the global business community began taking concrete steps towards environmental and social responsibility, innovation in the capital markets has driven enhanced corporate sustainability performance. Financial instruments such as green, social, blue, sustainable, and transition bonds and loans, have gained traction. Known as use of proceeds instruments, they directly fund projects that could impact a company’s environmental, social, and corporate governance (ESG) targets. Alternatively, sustainability-linked bonds and loans offer issuers the ability to raise capital as a means to support their overall sustainability strategy.

Explaining the Rise of SLBs and SLLs   

The rising popularity of sustainability-linked bonds (SLBs) and sustainability-linked loans (SLLs) can be attributed to several factors. First, they can be used to fund general corporate purposes, offering the flexibility to apply proceeds to any business activities. Second, sustainability-linked instruments tie their financial characteristics (i.e., bond coupon rate or loan terms) to predetermined ESG performance objectives, thereby incentivizing the corporate issuer/borrower to improve their sustainability performance. Third, when a company dives into the sustainable finance market, they are essentially communicating their sustainability ambitions to the investment community. How that is received depends on how relevant their goals are for their sector, and if their targets are ambitious enough.

Incentivizing a Shift in Market Behavior

The thing that makes SLBs and SLLs most exciting, however, is that they incentivize a shift in behavior, whether it's lowering greenhouse gas emissions, decreasing wastewater usage, or improving diversity in senior management positions. And by hitting those measurable, benchmarkable, and publicly disclosed targets, not only does the community and the environment benefit from those activities, the company is also pushed to do better. 

The issuer’s sustainability performance, linked to the financial impact of the bond or loan, is measured by key performance indicators (KPIs), with one or more sustainability performance target (SPT). The KPIs and associated targets are selected by the issuer, or, in the case of SLLs, the lender and borrower agree to certain targets. The goals should be meaningful and ambitious though, not simply low-hanging fruit, to guarantee the issuance’s success. 

Validation Through an Independent Perspective: The Second-Party Opinion

To support the credibility of SLBs and SLLs, an independent perspective on the strength and validity of the issuance is essential. A second-party opinion (SPO) provides a detailed evaluation of the bond or loan’s alignment with the International Capital Markets Association’s (ICMA) Sustainability-Linked Bond Principles (SLBPs) and the Loan Market Association’s (LMA) Sustainability-Linked Loan Principles (SLLPs). It will also evaluate the issuer’s overall sustainability strategy and the expected impact of the sustainability performance target’s contribution to the UN’s Sustainable Development Goals (SDGs). Having a second-party opinion provides an extra layer of comfort to investors and lenders, that what is being brought to market will live up to expectations.

Put Your KPIs and SPTs to the Test 

Investors and lenders are becoming more discerning when it comes to the KPIs and SPTs they find acceptable. Issuers must demonstrate that KPIs and SPTs will have material impact on their company’s environmental or social objectives. A second-party opinion can assure investors that goals and targets are ambitious enough. Without an SPO, capital raising efforts might fall short if the investment community starts asking hard questions about the strength of an issuer’s targets or the work done to ensure they are relevant. 

Also, in this rising interest rate environment where cost of capital is getting more expensive, a company might have leverage to seek better terms on their linked bond or loan if a second-party opinion verifies alignment. Clear, ambitious, and meaningful targets endorsed by a trusted second-party opinion provider maximizes the potential of favorable outcomes for bond issuers and lenders alike.  

Communicate Your ESG Performance    

With sustainability-linked instruments, a company is essentially putting their money where their mouth is. While the capital raised by an SLB or SLL is not earmarked for any specific sustainability project, it is designed to push the envelope when it comes to sustainability targets. Companies that issue a linked-bond or loan are making a very public statement about their sustainability ambitions and their intent to follow through on environmental or social commitments. They can boast about progress in their annual report as they work toward meeting their ESG targets. 

Second-party opinions can be a valuable communications and marketing tool, signaling to potential investors that your issuance is credible and can be trusted to meet market standards. If an issuance goes above and beyond with particularly ambitious targets, the opinion can make note of this as well, further legitimizing a company’s sustainability efforts, while influencing future market expectations. 

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