When the European Bank for Reconstruction and Development (EBRD) issued an A$280m ($203m) green transition bond in January 2021, the private placement was the latest in a series of fundraising for cutting the carbon emissions of ‘dirty’ industrial sectors where decarbonisation is most challenging, such as steel and cement, chemicals and mining.
Central and eastern Europe, the EBRD’s region, has some of the highest carbon emission rates in the world, due partly to its carbon-heavy industries. Such a dependence on these industries means a transition to a zero-carbon economy will take time.
If the financial markets are to fulfil their potential in helping to meet the Paris Agreement’s aim of containing the rise in global temperatures to well below 2 degrees Celsius compared to pre-industrial levels, then the sustainable funding markets would be well advised to focus on the importance of transitioning dirty assets. As these sectors will be the hardest, and costliest, to decarbonise, finance needs to be deployed with specific incentives for them to cut carbon.
Many banks’ ESG policies have a tendency to focus mainly on pure ‘green’ assets, such as wind farms and renewable energy
Currently, many banks and asset managers’ environmental, societal and governance (ESG) policies have a tendency to focus mainly on pure ‘green’ assets, such as wind farms and renewable energy. However, a more flexible approach is desirable if they are to play their full part in mobilising the up-to-$5tn-a-year deemed necessary for investing in the transition. Otherwise, there’s a danger that assets in so-called ‘hard to abate’ sectors become stranded and that carbon-heavy companies cannot raise funds for decarbonising their manufacturing processes.
Rising sustainability-linked financing
The sustainable finance market must therefore recognise the importance of flexibility. In the securitisation market, for example, should an asset be worthy of an ESG label even if it is not pure green? Should transitioning assets that are moving in the right direction be included? Currently there is no consensus.
Across financial markets, interest in transition, or sustainability-linked, finance is picking up against a backdrop of soaring interest in green, social and sustainability finance more generally. The issuance of sustainability-linked debt instruments — including sustainability-linked bonds (SLBs) and sustainability-linked loans (SLLs) — is on the rise worldwide. S&P Global Ratings expects SLL and SLB issuance to surpass $200bn this year. That compares with more than $130bn in 2020, according to Bloomberg, and nearly triple that of 2018 levels.
The principle behind these sustainability-linked financings is that they are linked to the issuer’s or the borrower’s ESG improvement targets, such as cutting greenhouse gas emissions or paying staff an appropriate wage. Key performance indicators (KPIs) are then set for monitoring progress towards those targets. If the KPIs are met, the cost of the bond or loan falls.
The debate within securitisation
Returning to the securitisation market, a July 2020 European Banking Authority survey on sustainable securitisation illustrates the case for flexibility to foster growth. Responding to the survey, the Association for Financial Markets in Europe stated: “We acknowledge that the market will only grow if room is made for, and there is engagement with, transition assets, as currently there is limited availability of sustainable underlying collateral.”
It went on to note: “Many transitioning assets satisfy the criteria to be considered as green under the EU taxonomy, which envisages that a project or economic activity can be green where the underlying activity results in a significant improvement in environmental performance.”
In other words, many property mortgages and auto loans that back many securitisations are not yet green. But if transitioning assets are accepted as falling within a broad definition of ESG-compliant, provided that the relevant issuer or originator commits to making those assets less carbon-intensive during the life of the securitisation, then there would be incentives and funding for reducing carbon emissions.
Take commercial and residential real estate for example — an area responsible for about 40% of the UK’s carbon emissions, according to the UK Green Building Council. Targets and KPIs could be set for retrofitting buildings to reduce emissions. Making existing real estate stock more carbon-efficient is key to reducing those emissions.
Regulation’s defining role
When the EU taxonomy regulation’s first set of disclosures come into force on January 1, 2022, they should bring greater clarity to the debate over what is considered green. Indeed, the taxonomy has been developed specifically to define which economic activities are economically sustainable. Although they will not extend beyond the EU’s 27 member states, it will have a broad influence overseas.
More specifically, the European Commission recognised the importance of transition assets in its strategy for financing the transition to a sustainable economy in July 2021. It has promised to report on extending the taxonomy framework to recognise transition activities by the end of 2021.
This approach should, in time, encourage a less purist approach to financing ESG assets by clearly including those that are significantly improving their environmental performance. If this more flexible approach is accepted across financial markets, the sectors that will find it most difficult to make the transition to net-zero carbon emissions will be better able to access the capital markets, and financing generally, and will receive the funding they need in order to make that transition. This, in turn, will help to combat global warming and improve society as a whole.
Isabel Tinsley is a senior associate at law firm Allen & Overy.
