Green corporate financing – an expanding toolkit

Green bonds have gone from being a fringe phenomenon to a central means of corporate financing. However, they're often not enough to make a company's entire financing range sustainable, which means that participants in the financial markets are increasingly including new solutions in their portfolios.

Rock guitarist Paul Kantner is reported to have remarked that San Francisco is 49 square miles "surrounded by reality". In fact, the city on the West Coast of the United States is only 46 square miles in size, but Kantner's statement was not meant to be taken literally in terms of the mathematics. What the Jefferson Airplane frontman was trying to say was that San Francisco was a rather surreal community that had little to do with the rest of the country – and presumably the world.

It’s why many considered it typical when the city announced in 2001 that it was issuing a bond to finance a massive expansion of solar panels. The Los Angeles Times sardonically noted that this sun-soaked plan had been put forward by a city best known for its abundant fog banks.

But 20 years later, it should be noted that people in those 46 square miles in California didn't have their heads in the clouds but were instead ahead of the curve. In actual fact, San Francisco issued the first Green Bond in history.

Growing market for sustainable finance

Since then, many cities, countries and companies have followed suit, and the market for green bonds had grown to 700 billion US dollars by 2020.

However, the Green Bond is only the first in an ever-lengthening list of financing instruments that are not just about raising capital but are also intended to promote socially relevant issues. As ESG is increasingly taking centre stage, this type of financing is becoming increasingly important for companies.

In response, banks have added a whole range of products to their portfolios, designed to enable completely sustainable credit procurement. There are green bonds, social bonds, sustainability bonds, sustainability-linked bonds, as well as loans issued according to ESG criteria and promissory note loans. But what exactly is the difference between all these instruments that, at first glance, seem so similar?

Green Bonds – as the classic type of sustainable financing, they are usually simple, fixed-rate bonds or an asset-backed security, ranking on an equal footing with other ‘regular’ bonds. They are often referred to as Climate Bonds, as they're typically used to promote climate change initiatives.

The International Capital Market Association (ICMA), the industry association representing capital market participants, has stipulated in its Green Bond Principles that the money from these bonds should go towards projects that help protect the environment. These principles aren’t mandatory but are considered an important guideline for issuers and investors to follow.

Companies mainly use green bonds to finance renewable energy projects, such as solar plants. Building renovations or more environmentally friendly transport options for employees are also measures that comply with the Green Bond Principles.

Social Bonds – in contrast to their green counterparts, social bonds were long considered rather unimportant. In 2019, for example, only US$19 billion worth of social bonds were issued. However, last year the market absolutely exploded, with bonds worth US$141 billion being issued.

According to guidelines set out by ICMA, social bonds are primarily used to enable projects intended to help disadvantaged groups. The effects of the coronavirus pandemic, which hit people already living in precarious conditions hard, may therefore have been responsible for this increase.

An example of this is the EU’s SURE Programme, which offers support to mitigate unemployment risks in an emergency and is financed with the help of social bonds. Traditionally, social bonds have been more of a financial instrument for the public sector, even though in theory there's nothing preventing companies from issuing them. However, sustainability-linked bonds have now become established instruments on the corporate bond market (see below).

The French food company Danone, for example, issued one of the few corporate social bonds in 2017. Danone intends to invest the €300 million raised primarily in research and development for medical nutrition as well as sustainable production practices.

Sustainability Bonds – a hybrid of social and green bonds, according to ICMA specifications, sustainability bonds can be used for projects that have an impact in both areas. Increasingly popular, in 2020, the issue volume was US$79 billion, about twice as much as in the preceding year.

These bonds are often issued by large financial services providers, including JP Morgan, Goldman Sachs and Bank of America, who use the money to finance projects in areas such as renewable energies or social housing.

The largest sustainability bond to date was issued in 2002 by Google's parent company Alphabet. According to the company, the US$5.75 billion bond was significantly oversubscribed, and the money is intended to flow into the company's energy efficiency measures as well as the construction of smart office buildings, among other investments.

Sustainability-Linked Bonds – the financial and structural terms of sustainability-linked bonds can vary according to whether the issuer achieves certain overarching corporate sustainability goals. These are determined in advance alongside the KPIs that will be used to evaluate whether the respective goals have been met. Using external agencies to track these KPIs offers an additional layer of transparency to bond subscribers.

Sustainability-linked bonds contain no use of proceeds clause, which means that companies are not obliged to use the money only for ESG projects. They can also use the capital to cover general business expenses. However, if they fail to achieve the targets they've set for themselves, the interest rate on the bond, for example, will rise.

The first sustainability-linked bond was issued in 2019 by the Italian energy company ENEL. The company committed to producing 55 per cent of its electricity from renewable energy sources by 31 December 2021. If they fail to meet that target, the interest rate will increase by 25 basis points.

Transition Bonds – for companies in more environmentally damaging sectors, such as energy or some manufacturing industries, accessing sustainable financing instruments can be a challenge, especially for those in the midst of a transformation process that makes it impossible for them to achieve ambitious ESG goals in the short term.

In these cases, transition bonds can be a solution that can support companies as they seek to transform their business models. Issuers must be prepared to disclose their strategies for change and ideally commit to having them monitored by external auditors. They can be linked to the use of proceeds principle as well as to the free use of capital.

Although critics have long considered the lack of international standards for transition bonds as an opportunity for greenwashing, ICMA has created a first set of rules to guarantee their effectiveness. Amongst other things, they insist that transformation plans issued by a company be measurable, evidence-based and linked to milestone targets.

To date, transition bonds have played a rather minor role in corporate financing. The Climate Bonds Initiative, for example, counted just eleven such bonds in 2020, including those issued by the Hong Kong coal-fired power plant Castle Peak Power and the Italian natural gas group Snam.

Loans – not every company likes using the bond market for financing, which is why ESG-linked loans are also becoming increasingly popular. In principle, they function in exactly the same way as sustainability-linked bonds, with companies committing to meeting certain sustainability criteria in return for money from banks.

Often the interest rate of the loan is tied to a sustainability rating awarded by an external agency. This was the approach taken by REWE Group for a €750 million loan they secured in April 2021. A pioneer in this area in Germany is Henkel, which concluded an ESG-linked loan at the end of 2018.

Promissory note loans – promissory note loans link interest rates to a company's ESG performance. Whilst promissory note loans are similar to bonds, they are structured differently in that they are not a security in the conventional sense.

The first company to use a promissory note loan was the German machine manufacturer Dürr back in 2019, linking the interest rate to an agency's sustainability rating, and securing €200 million.

With a growing range of corporate finance solutions designed to support businesses as they move ahead with their ESG journeys, understanding your objectives and circumstances is particularly important to ensure you choose the right one. That way, you can move ahead with your ESG strategy with confidence.