The Rise of ESG Bonds in Corporate Financing

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Bennett Jones LLPSustainable investing has gained significant traction in recent years as a way for companies to exhibit corporate social responsibility in the community by meeting a wide range of environmental, social and governance (ESG) targets. Increasingly, issuers are also finding they are being financially rewarded for such investing strategies, some claiming pricing bumps of up to 20 basis points (bps). ESG bonds—an umbrella term that captures green bonds, social bonds, and sustainable development bonds—are some of the most popular capital-raising initiatives used for reaching these targets. Over the past five years, the number of corporate green-bond issuances continues to grow as both public and private issuers try to demonstrate increased environmental and social consciousness to their investors.

ESG Bonds on the Rise

ESG bonds are debt instruments that encourage investments based on the issuer addressing certain ESG criteria. ESG bonds can have defined project-based use-of-proceeds structures, including green bonds or social bonds, and also target-based structures, such as sustainability-linked bonds (SLBs) that incentivize the issuing company to achieve higher ESG standards across the board.

ESG bonds are gaining attention in financial markets as companies seek to increase their "green" or sustainability credentials through a focus on renewable energy, pollution reduction, or climate change adaptations and initiatives. Companies issuing these bonds are not only addressing their increasingly scrutinized role as corporate citizens, but are also attracting new waves of socially-minded investors that are supportive of ESG initiatives. Climate change concerns in recent years have pushed both investors and companies to incorporate ESG into their corporate operations or investment portfolios.

Given the rise in global awareness of ESG factors, socially-responsible bond issuances showed strong growth over 2020, and continues to increase in popularity. In September 2020, more than $50 billion in green bonds were sold, and by October 2020, the green bond issuance reached the $1-trillion mark in total issuance.

Green Bonds

Green bonds generally require that the proceeds of any issuances be allocated only for use in "green" or sustainable purposes. Sometimes referred to as climate bonds, the proceeds from these instruments must be spent on designated ESG projects, and companies must track and report to debtholders how they have spent the money raised. Traditional green bonds have enabled an effective method of raising capital, but the burden on issuers to meet certain reporting requirements on the use of proceeds can be onerous. Before issuance, companies must adopt a formal ESG financing framework and maintain records of the use of proceeds throughout their lifespan.

Often, green bonds are issued to finance diverse projects related to sustainability, such as energy conservation and efficiency, clean energy, protection of biodiversity and ecosystems, and environmental rehabilitation. Green bonds are attractive to investors who value ESG factors and who seek to diversify their investment portfolio. To date, the majority of green bonds target climate change, including projects aimed at climate change mitigation and adaptation. The World Bank issued its first green bonds in 2008 and continues to remain one of the largest issuers of such bonds. Since green bonds were first introduced, the global market has expanded rapidly with the entry of various green bond issuers.

In Canada, Export Development Canada issued its first green bonds in 2014, and in that year, Ontario became the first province to issue green bonds to fund public transit infrastructure. Recently, green bond popularity has only increased in Canada—large corporations raised a record $235 billion in green bonds in 2020. Additionally, last August, Brookfield Renewable committed to issuing $425-million worth of green bonds and in October, Canada Infrastructure Bank also announced that it will use green bonds to implement its $10-billion growth plan, which aims to attract investment to increase sustainability of Canada's infrastructure.

In February of this year, British Columbia Investment Management Corp. (BCI), one of Canada's largest pension funds, committed $5 billion in green bonds. The move is a part of a broader plan to reduce BCI's carbon exposure over the next five years, as an alternative to full-fledged divestment from the carbon-intensive sector.

Sustainability-Linked Bonds

Sustainability-Linked Bonds (SLBs) are relatively new to the market but have soared in popularity over the past year, as they provide more flexibility for issuers who are hesitant to issue green bonds due to increasingly onerous ESG disclosure requirements and given the fewer Key Performance Indicator targets (KPIs) required. Unlike traditional green bonds whose proceeds are tied to "green" or otherwise sustainable purposes, proceeds from SLBs can be used for any general corporate purpose. SLBs provide flexibility, as they do not require specific ESG projects to be carved out from ordinary business activities.

As forward-looking, performance-based instruments, SLBs permit issuers to address ESG concerns and attract sustainability-focused investors without the financial restrictions and disclosure obligations commonly associated by traditional green bonds. Instead of providing funding for specific projects, issuers of SLBs commit explicitly to future improvements in sustainability outcomes within a specific timeline. The flexibility of the instrument permits the issuer to craft specific financial and/or structural characteristics that will be triggered if the issuer achieves pre-defined ESG performance targets.

In September 2020, pharmaceutical company Novartis AG raised €1.85 billion using SLBs during its first-ever ESG-bond issuance. The company set targets for increasing patients' access to malaria and other treatments in certain countries by 2025. If it fails to meet those targets by the deadline, then the coupon rate will increase 25 bps for the following three annual coupon payments until the bond matures in 2028. In 2019, Italian utility company Enel SpA issued $1.5-billion worth of notes in its inaugural ESG-bond issuance, pledging increased use of renewable sources and greenhouse gas emission reductions by the end of 2021. Enel SpA also committed that if it does not meet this target, its interest rates will increase by 0.25%. Enel SpA has been rewarded for this choice: it estimated that its sustainability-linked debt cost it 15 to 20 basis points less than non-ESG debt.

ESG Bond Issuances in Canada

While Canada remains a relatively small player compared to China, the United States, and other larger European markets, Canadian issuers have an increasingly material presence in the ESG bond market. As that market continues to expand, Canadian issuers will likely find more investors keen to reward sustainable financing solutions.

Canadian companies are currently involved in the project-based green bond market, but no Canadian company has yet issued SLBs. However, in December 2019, Maple Leaf Foods Inc. became the first issuer to be provided a sustainability-linked loan in Canada. Similar to pre-determined targets on SLB notes, the amended credit facility permits Maple Leaf Foods Inc. to reduce their interest rate if it meets certain preset targets on carbon emissions, electricity, waste, and water use.

Additionally, in June 2020, the International Capital Markets Association (ICMA) released Sustainability-Linked Bond Principles (SLBPs). The SLBPs are voluntary process guidelines that recommend structuring features, disclosure recommendations and reporting standards intended for current and future SLB market participants, signaling that SLB financing will likely continue to increase in popularity. Issuers who have an interest in expanding their ESG presence will be able to take advantage of these financing alternatives, while increasing their access to capital and attracting a new investor base. Since ICMA's publication of the SLBPs, the SLB market has gained traction, with three U.S. entities announcing in September 2020 that they intend to issue SLBs in the near future, so it is likely that this trend may start to develop north of the border as well.

The Canadian financial sector continues to place a strong focus on ESG-related investing, and particularly after BCI's recent announcement, more involvement in the SLB space will likely take place in the near future. In January 2021, Montreal's Power Corp. announced it had partnered with a number of large financial institutions to create a $1-billion fund committed to investing in renewable energy projects over the next 24 to 36 months across North America, suggesting an increased affinity for sustainable investing closer to home. Accompanied by the new climate-focused political agendas south of the border, environmentally responsible financing will only continue to grow in Canada.

Issuers considering an ESG bond issuance will need to consider a number of factors to ensure that their legal obligations are able to be met, and such an offering will align with corporate strategy and desired capital structure through the life of the bonds. Additionally, issuers will need to be comfortable with the ongoing disclosure and governance obligations associated with ESG bonds. 

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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