The sustainability-transition opportunity
What should your organisation be paying attention to in order to be aligned with ‘green’, ‘sustainable’ and‘ socially conscious’ business practices as we emerge from the COVID-19 crisis?
The opportunity of a crisis
The transition to a low-carbon, environmentally sustainable and inclusive economy requires a constant interplay between private and public finance, regulators and supervisory boards, technology, and of course people. It is an ongoing, systemic and iterative change to ensure that we live and work within the boundaries of the planet.
The COVID-19 crisis in the first half of 2020 has led to a short-term shock, moving the dial towards a better balance. It has given us some respite from air pollution, led to a crash in oil demand and production and it may hopefully lead to some rebalancing of how we interact with the natural world. This shock has given us space to act, but also means that we now have a fundamental responsibility to ensure that the restart of economic activities after the lockdowns does not lead to a quick return to the old, imbalanced ways, but rather to the development and then application of sustainable solutions in business as well as in our lives as individuals, where we have the power to make choices every day.
The solutions developed to achieve a sustainable recovery will then depend on our corporate and individual commitment to implementing them. This will in turn depend upon market expectations in each specific sector. For example, in the transport sector, understanding if/how COVID-19 affects EV sales differently from traditional car sales will be important to plan for investments in charging networks, and individual purchase decisions.
At the corporate level, there are three broad frameworks to keep in mind. They are not mutually exclusive and indeed there are several elements of overlapping in their application. Those are:
• Alignment with ‘green’ standards for production, services and reporting;
• Alignment of activities and new investments with the Sustainable Development Goals (SDGs); and
• reporting / analytics of the basis of specific environmental, social and governance (ESG) considerations.
Some of these areas of action come under specific multilateral legal-governance contexts at global level such as the United Nation Framework Convention on Climate Change (the UNFCCC) and the downstream work on Paris alignment and the implementation of the Nationally Determined Contributions (the NDCs); the emerging principles underpinning the nexus between SDGs and international environmental law; and the (at present) voluntary and/or emerging global reporting frameworks such as the Task Force on Climate-related Financial Disclosures (TCFD), and the EU taxonomy for green investments. In order to drive the change towards sustainability, all of these will have to be further developed and structured into standards and principles for organisations to adopt as part of their corporate alignment with these objectives. But they also capture elements of individual responsibility, to be enacted for example in goal setting for sustainability, through individual transformational leadership.
Financing the Sustainability Transition
Over the last decade, sustainability has become one of the most important drivers in the development of new products, services and more recently in reporting, and the market for green and sustainable financing solutions market has grown apace. In 2012, this market - which accounts for both debt and capital market instruments including green loans, green bonds, sustainability bonds, social bonds and sustainability linked loans – accounted for just USD10 billion. By 2018, this rose to USD250 billion, on the back of regulatory changes, increasing awareness of the potential costs of climate transition and physical risks, decreasing technology costs and a better understanding of the financial and economic benefits of transitioning to green and overall behavioural changes in the population.
The boundaries of ‘green’ or ‘sustainable’ are quite broad however, and many definitions exist in parallel in the literature and in practice, spanning from inclusive frameworks covering general efforts to green the economy, or determining sustainable use of financing proceeds, to much narrower ones, as those adopted by several ethical banks. One way of understanding green and sustainable finance is to break it down into its components. Green finance can broadly be considered any financing that delivers environmental benefits. This will include mitigation, adaptation and environmental finance. It captures a wide range of actions, including but not limited to:
• Reducing greenhouse gas emissions;
• increasing carbon sinks, through landscape-based practices, afforestation, reforestation, and avoiding forest degradation;
• scaling up clean energy generation, e.g. through renewables;
• reducing energy/carbon intensity through energy efficiency (EE);
• delivering sustainable transportation, e-connectivity;
• green & smart digitalization services in cities;
• supporting resource efficiency (e.g. water, materials), with e.g. the promotion of circular economy practices and cradle-to-grave designs;
• reducing water, air and land pollution;
• adaptation to climate change and climate-resilient practices; providing early warning services;
• improving farming practices to enable farmers to cope with climate change; and
• investing in programmes to boost biodiversity and protect habitats and species.
Two major green finance instruments to finance the sustainability transition are green bonds/sukuks and green loans.
Green bonds and green sukuks
Generally, a green bond is considered any type of bond instrument that is used exclusively to finance or refinance eligible green projects, but the detail is important. There are several different types of green bonds: “use of proceeds” bond (or asset-backed bonds); “use of proceeds” revenue bonds; project bonds; securitisation bonds; and covered bonds. The most common is the “use of proceeds” bond, where proceeds are designated for green projects, but the repayments are backed by the issuer’s balance sheet. Green bond issuers can range from multilateral institutions like the World Bank or other development finance institutions to private companies or banks, and local, state or national governments. At present, most issuers are located in the Global North, but emerging economies are making headway. Indonesia, for example, was the first country in the world to issue a sovereign green sukuk. A green sukuk is a Shari’ah compliant investment in environmental assets, similar to a Bond and used in Islamic finance.
The risk of greenwashing is present for green bonds and loans alike, and it can lead to undermining the development of the market for green finance as a whole. To mitigate this risk, various criteria aiming to ensure integrity are emerging. Most importantly, the International Capital Market Association (ICMA) has defined a set of principles, the Green Bond Principles (GBP), which details four key components that bonds must comply with in order to classify as green. They are voluntary process guidelines that recommend transparency and disclosure and promote integrity in the development of the Green Bond market by clarifying the approach for issuance of a Green Bond. The four principles are:
1) Most importantly, is how the bond’s proceeds are used. This aims to ensure that finance goes toward green projects that are appropriately described and provide clear, tangible environmental benefits. The GBP provide a non-exhaustive list of categories within which green projects can fall.
2) That borrowers communicate transparently to their lenders their environmental sustainability objectives, processes to determine alignment with green project categories, and any related eligibility criteria.
3) That proceeds are credited to a dedicated account or appropriately tracked by the borrower so as to uphold transparency and integrity.
4) Issuers report regularly on the use of their proceeds.
A similar concept applies to green loans. A green loan is, broadly speaking, any type of loan instrument made exclusively to finance or refinance eligible green projects. There are four types of green loans: green bilateral loans between a company and a bank; green syndicated loans, which involved a group of banks; green revolving credit facility, based on ESG criteria; and green project finance which is for the purpose of financing specific projects, such as a wind farm. This sub-market of green finance has also grown rapidly, from an issuance of just USD37 billion in 2014, to USD 167.3 billion in 2018, and the market is expected to continue growing.
The Green Loan Principles (GLP) were established by the Loan Market Association (LMA) and applies the four principles of the GBP. In all cases, external verification and certification (i.e. seeking second-party opinion) can uphold higher standards as well as offer transparency and visibility to all parties in the transaction.
Similarly, sustainability-linked loans and bonds are held against the sustainability linked loan principles and the sustainability linked bond principles by the ICMA and LMA respectively. Categorization of eligible activities can include climate and environmentally related action (as described above a part of green finance standards), but it is generally wider, to also include activities that are consistent and aligned with the realization and impact creation along the 17 SDGs, as outlined in the UN 2030 Agenda for Sustainable Development.
Sustainable finance and ‘traditional’ green finance instruments could also differ in terms of how they hold the client to account. Typically, while green bonds and loans can be defined on the basis of use of proceeds, sustainability linked loans and bonds are not necessarily just determined by on how borrowers use the proceeds. Instead, they could also be designed to incentivise the borrower to improve its performance against predetermined ESG criteria by fixing the respective interest rates according to the sustainability performance of the borrower. This pledge is made more significant by ensuring that the design of a ‘green’, ‘SDG-linked’ or ESG framework for an organization including content of strategic or specific relevance by sector or industry, and it will have to use consistent and comparable analytics that allow tracking across time and corporate boundaries. This is an important stance proposed by regulators, such as the London Stock Exchange, the Singapore Monetary Authority or the Indonesian Otoritas Jasa Leungan.
Applying general standards and principles adapted to sectors can help us to move further and deeper than the traditional corporate social responsibility practices, by creating specific sectoral blueprints to mainstream green and sustainable strategies and operations across teams and sectors. This is a starting point from which to expand further with organization-specific benchmarks and indicators, which increases their relevance at corporate level and can help to shape the competitive advantage of a business versus another.
The current crisis is providing us with an opportunity to re-imagine a world that is sustainable and in balance. We have the tools at hand, thanks to work done over the last decade, to turn this opportunity into reality. We must not fail at this, and achieve the sustainability transition, so that we can leave a planet worth living on to future generations.