For more than a decade, governments and businesses progressively issued conventional green and sustainable fixed income securities to address social and environmental issues. According to the Climate Bond Initiative, their issuance is on track to reach $1 trillion in issuance by 2023. However, there is growing scepticism regarding the market's integrity. Is it making a meaningful contribution to reducing sustainability and climate risks? Unfortunately, green labels do not seem to be an effective signal for identifying sustainable improvers. For instance, green bonds issuance has not necessarily translated into comparatively low or falling carbon emissions at the firm level. Moreover, the situation gets even more challenging regarding the sustainability transition to net-zero, as financing green does not always imply alignment with a credible transition pathway. Because of the current climate crisis, I suggest that a transition finance approach is necessary, and National Development Banks can employ transition financing products to better coordinate global financial flows to meet Paris Agreement goals in the next few years.
Increasing regulatory scrutiny of green assets
What are the advantages of conducting an integrity check on long-term debt markets? It is expected that new regulations will drastically alter how long-term debt is issued, which will impact the cost of capital across all economic sectors. Such changes can be understood as part of the sustainability-related transition risks. NDCs and financial regulators are becoming more aware of the threat of greenwashing. Authorities in the United Kingdom and Switzerland, for example, are supporting legislation to ensure that investors are not misled about the supposed sustainability of products and financial services. One of the expected changes is the new way to determine investment product labels, which will not be defined by non-governmental organisations but by regulators based on specific sustainability characteristics by jurisdiction. Authorities such as the Swiss Financial Market Supervisory Authority attempt to prevent and combat greenwashing by evaluating sustainable-related information at the asset level and the institutional readiness of organisations to manage such assets. Most recently, the U.S. Securities and Exchange Commission highlighted that misleading by omission of material information should not be tolerated in sustainable debt issuance statements.
Transition financing and market integrity
Transition financing should be a priority if we can agree on Mark Carney's three key climate change solutions: policy, transition plans and disclosure. While green financing refers to the flow of capital to sustainable development initiatives, it does not consider the transition to a more sustainable society. An alternative is the new concept of climate transition financing, but it limited to decarbonization objectives. As a result, green investing does not correspond to achieving a net-zero economy since we risk overlooking transition sustainability-related risks and opportunities. For this reason, capital providers and counterparties should adopt a transition finance approach, which refers to the provision and use of financial products and services to support the transformation of corporations, sovereigns and individuals aligned with a sustainability transition.
How to improve the integrity of the market and motivate issuers to follow a sustainability transition? One recent innovation that National Development Banks (NDBs) should consider are the sustainability-linked bonds. The International Capital Markets Association (ICMA) defines sustainability-linked bonds as any type of bond instrument whose financial or structural features fluctuate depending on whether the issuer meets set sustainability targets. Therefore, if the issuer meets certain pre-determined targets, a discount or penalty might be applied to the bond's margin payable. The global market for sustainability-linked financial instruments, such as sustainability-linked loans (SLLs) and sustainability-linked bonds (SLBs), is expanding. S&P Global Ratings and SEB anticipate that issuance of SLL and SLB will exceed $200 billion this year.
Despite its growing adoption, this new asset class falls short of transparency and disclosure of metrics and targets. However, market participants, including issuers and investors, are not entirely responsible for this current situation. There is widespread agreement that more development is required to strengthen the criteria for sustainability-related metrics that take material factors into account. While the new International Sustainability Standards Board (ISSB) is expected to address this issue rapidly, there is still a lack of understanding about more advanced debates such as the dynamic nature of materiality and the idea of double materiality. The former relates to the fact that the factors affecting enterprise value will change over time, whilst the latter refers to sustainability-related effects on organisation value and the entity's environmental impacts.
National Development Banks’ role in the sustainability transition
As a result of the post-pandemic world, which has a much more challenging environment for mobilising funds, it has become imperative to increase the role of national development banks. In order to build a sustainable economy, funds should be invested in green technology and renewable energy and the transformation of conventional industries such as steel and cement. This will require a coordinated policy agenda and various instruments, including innovation agencies, procurement, and long-term patient financing enabled by NDBs. We can only ensure genuinely inclusive and sustainable solutions with bold public policies that align private capital with a credible transition.
NDBs should begin developing transition financing frameworks to establish the rules for issuing innovative fixed-income instruments without the risk of greenwashing. To this end, the guidelines should specify how NDBs will contribute to their countries' Paris Agreement targets by defining the financial instruments employed and their connection with the various stages of a rigorous transition plan. Additionally, it is critical to define the sustainability accounting standards they will follow and report on the impact of the funds received. Finally, the NDBs should include an external reviewer to ensure the use of funds is transparent and credible.
The Bank of China's first "sustainability re-linked bond" issue was a recent development in the sustainable debt market. Interestingly, the coupon contains a step-down clause, indicating that bondholders will lose money if debt debtors surpass their sustainability targets. This historic transaction totals $300 million, with the proceeds being employed to finance or refinance the bank's qualified sustainability linked loans (SLLs). The notes incorporate a novel mechanism in which the coupon will be changed by the underlying SLLs' sustainability performance targets via a re-linking mechanism. The remarkable aspect of this issue is that it integrates both bond and loan markets and ties the cost of capital to the sustainability performance targets of the SLLs' prospective borrowers.
Final remarks
NDBs must take the lead in the climate transition by establishing and implementing financing frameworks that successfully close the gap between the funds required to achieve global net zero emissions and the actual investments made. These frameworks should be consistent with their country's Paris Agreement targets, considering the distinct stages and transition pathways within each region. This methodology enables NBDs to construct a more structured engagement strategy with private financial institutions that are critical to blended finance projects, as well as a replicable and standardised country-specific reporting system for tracking capital flows.
