Sustainable finance – a means to incentivise good outcomes
Sustainable finance has grown in popularity in recent years, driven by societal change, banks focussing on their licence to operate and increasing regulatory pressure.
Although New Zealand has lagged behind other markets, it too has seen rapid growth in recent years which shows no signs of slowing. As New Zealand looks to the future to meet its emission reduction goals and as a number of entities look ahead to address climate risks and meet climate reporting requirements, it is expected that sustainable finance will play an increasingly important role in supporting these objectives and in promoting environmental, social and governance outcomes.
In this article, Partner Kate Lane and Senior Associate Marie Kissick discuss the various instruments used for sustainable finance and predict future trends.
Green bonds are used to finance or refinance projects with clear environmental benefits
A green bond is a bond instrument where the proceeds are used to finance or refinance projects with clear environmental benefits. Green bonds are the most well-established of the sustainable finance instruments, with the market for green bonds first emerging in 2007. The market is well established in New Zealand with Auckland Council being the first local issuer in 2018 (using the proceeds to refinance its electric train fleet). Other issuers include Westpac (to finance or re-finance sustainable New Zealand projects), Argosy Property (to finance “green assets”) and Contact Energy (to finance renewable generation assets).
One of the challenges with green bonds (as with any form of sustainable finance), is to have clear guidelines for issuance to promote confidence and integrity in the market and avoid “greenwashing”.
In New Zealand, the Financial Markets Association (FMA) has responded to concerns about “greenwashing” by publishing guidance on financial products that integrate non-financial factors (including green bonds) in December 2020 (the FMA Guidance). The FMA Guidance sets out how the ‘fair dealing’ provisions of the Financial Markets Conduct Act 2013 (FMCA) apply to integrated financial products including that issuers need to be able to justify the “green” label attached to an integrated financial product. In addition, the FMA has included a framework for issuers outlining the type of disclosure it expects. The key disclosures are:
- Non-financial features – to allow investors to understand the basis for the marketing label. The FMA expects that any non-financial outcomes are measured and reported on;
- Governance framework – how the issuer’s governance framework supports the non-financial aims of the product;
- Whether internal audit or external assurance is provided;
- Risks or costs associated with the integrated financial product; and
- Consequences of failure – such as if the product loses its green certification.
The FMA has also published an information sheet which provides that the “same class” exclusion (enabling an issuer to offer a new financial product without needing to satisfy the full disclosure requirements of the FMCA) is only available to an offer of green bonds if an issuer already has quoted green bonds with identical green features. This was disappointing to the market which had hoped that the “same class” exclusion would be available to an offer of green bonds off the back of an existing quoted vanilla bond given the matching credit profile. This would have reduced the barriers to entry to the green band market.
In addition to the FMA Guidance, the Green Bond Principles (GBP) developed by the International Capital Markets Association’s (ICMA) are widely accepted globally for providing guidance on green bond issuance. There is some overlap with the FMA Guidance, with the four key components of the GBP being:
- Use of proceeds – the GBP recognise several broad categories of eligibility for green projects;
- Process for evaluation and selection;
- Management of proceeds; and
In addition, the GBP recommend that one or more of the following external reviews are completed in connection with the green bond issuance:
- Second party opinion;
- Certification; and
- Green bond scoring/rating.
Where debt is being issued for climate transition related purposes (which may include green, social, sustainable or sustainability linked bonds), the ICMA’s Climate Transition Finance Handbook provides additional guidance in this area. This guidance clarifies the issuer level disclosures which are recommended to credibly position the instrument as financing the transition, particularly in ‘hard-to-abate’ sectors.
Green loans are a conventional loan where the proceeds are used for a specified ‘green’ purpose
A green loan is a conventional loan, where (similar to a green bond) the proceeds are to be used for a specified ‘green’ purpose (and there is guidance on what may be considered to be a ‘green’ purpose). The local green loan market is still in its infancy in Australia and New Zealand compared to the local green bond market. However, for many companies, the green loan market is more accessible than the bond market, due to the scale and costs often associated with a bond issuance.
There have been two labelled green loans in New Zealand to date; to Contact Energy and Meridian Energy. As both of these companies generate the vast majority of their energy from renewable sources (or all, in the case of Meridian Energy), the green loans provided to these companies are used to finance renewable projects or assets. Both Contact Energy and Meridian Energy have “green finance programmes” where their retail bonds, wholesale bonds, US private placement notes and bank facilities are all certified as green.
Similar to the green bond market, green loan principles (GLP) have been established by the Loan Markets Association (LMA) and the Asia Pacific Loan Markets Association (APLMA) to support the market’s development. The GLP build on the GBP and use the same four core components set out above.
Sustainability linked loans are a type of loan which incentivises sustainable objectives
A sustainability-linked loan is a type of loan which incentivises the borrower to achieve pre-determined sustainability objectives through applying either a discount on the margin if the objective is met or a premium if the objective is not met. The sustainability objectives can be bespoke to the borrower’s business (such as a reduction in greenhouse gas emissions or increasing Board diversity) or linked to a broad ‘ESG’ rating provided by a recognised provider. The loan can be used for general purposes as opposed to a specific green purpose (as is the case for a green loan).
Given the more general purpose, one of the advantages is the sustainability linked loan market may be more accessible to companies that do not have green assets or a specific green projects pipeline.
While the global market for sustainability linked loans has grown significantly in the last few years (largely centred in Europe), there has been a slower uptake in Australia and New Zealand. To date, New Zealand has only seen a handful of sustainability linked loans; to Synlait, Contact Energy and Southern Pastures but the pipeline is strong.
As for green loans, the LMA and APLMA have published guidance on sustainability linked loan principles. These include setting sustainability performance targets (to ensure the metrics are meaningful and the targets ambitious) and measurement of the targets. Reporting and external reviews are also recommended.
New Zealand’s first sustainability linked loan
MinterEllisonRuddWatts advised Synlait Milk Limited on its entry into the first sustainability linked loan in New Zealand in September 2019. The transaction saw Synlait enter a 5 year NZD50m bilateral facility with ANZ Bank New Zealand Limited. Then, in early 2020, the firm advised Synlait on a sustainability linked facility with BNZ for NZD50m. In each case, a discount or premium is payable on the margin depending on Synlait’s performance, reviewed annually, against a comprehensive set of pre-determined ESG criteria determined by Sustainalytics, a third party rating agency.
Demand for sustainable finance products is expected to increase significantly
The sustainable finance market sees no signs of slowing, with the global sustainable debt issuance in 2020 increasing by 29% from 2019’s total.
We expect further increased demand for these products from corporates as they seek to achieve their sustainability goals and demonstrate their ESG credentials in response to increased customer, social and regulatory scrutiny. The benefits of sustainable finance are recognised by the International Platform on Sustainable Finance Annual Report, October 2020 which notes the following “We believe that financial institutions, which are placing sustainability at the centre of their decision-making and promoting innovation to solve environmental challenges, will contribute to the common good while increasing their competitiveness”.
Where in the past, the focus may have been on environmental outcomes, we expect there to be strong growth in products which focus on facilitating and supporting economic activity which mitigates social issues and challenges and/or achieves positive social outcomes such as social bonds and social loans (both much like their green counterparts but for social purposes).
The growth in the popularity of social bonds and social loans has been recognised with the publication of Social Bond Principles by the ICMA and the Social Loan Principles by LMA and the APLMA (in April 2021) to promote transparency and integrity in the markets for these products. The Social Loan Principles are based on the same four components as the GBP and aim to provide a high-level framework of market standards and guidelines.
These instruments have been used in New Zealand with Kāinga Ora currently having $5.3 billion of ‘wellbeing’ bonds issued to fund sustainable and affordable social housing and a social loan being used for education purposes. With the increased demand for social housing in New Zealand as well as other social issues amplified by the COVID 19 and a focus on companies to implement more sustainable business practices, we expect that these social products (and sustainable finance generally) will become increasingly common and may even become a standard feature of many debt products.