Wed 09/15/2021 12:44 PM
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Editor’s Note: Below is the latest installment in Reorg’s Expert Views series. It is authored by Matthew Dunlap of Morrison & Foerster LLP: an overview of the growing high-yield ESG-related bond market and the development of market standards for bond issuers.

The world of finance is in thrall to a vowel and two consonants: E, S and G. Originally the purview of investment grade companies, environmental, social and governance (ESG) financings are now commonplace in the sub-investment grade, leveraged finance market.

While there are examples of ESG financings, both loan and bond, in the leveraged finance space prior to 2021, it was not until this year that the proverbial dam broke, with €16.6 billion and €10 billion of ESG-related leveraged loans and bond offerings, respectively, through H1 2021 alone, according to S&P Global Market Intelligence. The €10 billion of new bond issuances stands in stark contrast to only €2 billion in 2020 and €1.5 billion in 2019. The precise volume of financings differs based on how the market is defined, with Reorg’s databases including nearly €11 billion in ESG high yield deal volume in H1 2021.

The purpose of ESG finance, also commonly referred to as “sustainable finance,” is best exemplified by the goal of the European Commission (EC) to “channel private investment into the transition to a climate-neutral, climate-resilient, resource efficient and fair economy, as a complement to public money.”1

ESG loan and bond financings come in many guises, but can be broadly broken down into two categories: proceeds-based and sustainability-linked.

Proceeds-based financings include green, social and sustainable loans and bonds. The defining feature of proceeds-based financings is that proceeds must be used by a company for specified projects, the eligibility criteria of which is dependent on the type of project being financed (e.g. green or social).

Sustainability-linked financings can be distinguished from proceeds-based financings by the lack of restrictions on use of proceeds and links between certain characteristics of the financing instrument and corporate ESG targets.

Figure 1 below highlights some of the potential structuring considerations for companies exploring ESG financing options. This article will provide an overview of the two most prevalent instruments in the high yield ESG bond market - sustainability-linked bonds (SLB) and green bonds - discuss current market trends, and highlight what comes next as the ESG bond market matures.

Fig. 1: Company ESG Financing Structuring Considerations

High Yield ESG Bonds

High yield green bonds and SLBs are similar in all respects to traditional high yield bonds, except for the overlay of the applicable green or sustainability-linked characteristics. ESG bonds can be unsecured or secured, fixed or floating rate. While green bonds and SLBs have their differences, one unifying feature is that the failure to satisfy or comply with the applicable ESG bond characteristics does not give rise to an event of default under the indenture governing an ESG bond. For example, the failure for an SLB issuer to satisfy an identified sustainability performance target or a green bond issuer to provide a post-issuance proceeds allocation report would not result in a breach of the indenture. While this absence of investor recourse has led to criticisms in some corners, it should be viewed as a pull factor attracting companies to the nascent ESG bond market. In the long-term, we may see this feature evolve as the ESG bond market and investors’ expectations mature.

Fig. 2: Green Bond and SLB Overview

Green Bonds

Green bonds are proceeds-based ESG bonds that require issuers to allocate the net proceeds of an offering to an eligible green project. According to Reorg’s Market Maker database, nearly €4.4 billion of green bonds were issued in H1.The de facto voluntary framework for green bond issuances in the global ESG bond market is the International Capital Market Association (ICMA) Green Bond Principles (GBP) that were initially published in January 2014 and most recently updated in June 2021 to highlight certain key recommendations by ICMA. In July 2021, the EC established a European Union Green Bond Standard or EUGBS, a voluntary framework that builds upon existing green bond frameworks and principles, including the ICMA GBP. While the EUGBS proposal winds its way through the EU implementation process, companies have already begun issuing green bonds aligned with the EUGBS. Figure 2 above provides an overview of the ICMA GBP and the EUGBS.

The ICMA GBP specifies the core characteristics of a green bond:
(1) Use of proceeds for an eligible green project;
(2) Process for eligible green project evaluation and selection;
(3) Management of proceeds; and
(4) Reporting.

What follows is a high-level overview of the ICMA GBP. For a deep-dive, no better source can be found than the easily digestible ICMA GBP along with accompanying Guidance Handbook.

The quintessential feature of a green bond is that 100% of the net proceeds (or an amount equal to the net proceeds) must be used to finance or refinance an eligible green project. A “green project” has an expansive meaning as it includes tangible and intangible assets along with capital and operating expenditures. The ICMA GBP uses a big tent approach, identifying a non-exhaustive broad list of categories of eligible projects, examples of which are included in Figure 2 above. Marketplace examples of eligible green projects for the ICMA GBP aligned green bonds include (i) refinancing of recycling projects (Paprec), (ii) financing the development and production of vehicles with zero tailpipe emissions (Faurecia), (iii) investments for new renewable energy generation (Novelis) and (iv) acquisition or development of green buildings and promotion of energy efficiency (Neinor Homes).

The remaining green bond characteristics relate to ensuring compliance with the application of proceeds for eligible green projects and providing transparency to investors via reporting obligations. According to the ICMA GBP, in order to satisfy the process for project evaluation and selection, issuers should “clearly communicate to investors: the environmental sustainability objectives of eligible green projects, the process by which the issuer determines how [such] projects fit within the eligible [g]reen [p]rojects categories…and complementary information on processes by which the issuer identifies and manages perceived social and environmental risks associated with the relevant project(s).” Issuers address these points by publishing a green bond (or sustainable finance) framework on their website on or prior to a green bond offering. These green bond frameworks inform potential investors of an issuer’s alignment with the ICMA GBP, including identifying the eligibility criteria for their green bond issuances. Management of proceeds requires an issuer to periodically track the utilization, including temporary uses, such as short-term investments, of green bond proceeds until fully allocated to an eligible green project. The ICMA GBP recommends an issuer’s management of proceeds be verified by an external reviewer, specifically the verification of internal tracking and allocation of proceeds. An issuer’s policies concerning management of proceeds will also be identified in its green bond framework. Finally, green bond issuers should publish post-issuance reports, at least on an annual basis, providing information on the allocation and use of proceeds and the expected or achieved impact of the eligible green projects being (re)financed. In practice, an overview of an issuer’s expected allocation and impact reporting is detailed in its green bond framework.

The treatment of pre and post-issuance external reviews, where an independent third party assesses and verifies an issuer’s alignment with a green bond standard, is one of the key areas where the ICMA GBP and the EUGBS diverge on paper, although not in practice. While external review is one of the key recommendations under the ICMA GBP, and ICMA has published Guidelines for External Reviews, it is not a requirement. In contrast, the EUGBS requires external review and has proposed a registration process to ensure minimum professional qualifications for external reviewers of European green bonds, which is described in more detail below. Notwithstanding this distinction, in practice ICMA GBP-aligned green bond issuers generally appoint an external reviewer to provide a pre-issuance opinion verifying that their green bond framework aligns with the ICMA GBP and limited assurance on the annual proceeds allocation reports until full allocation of green bond proceeds.

Sustainability-Linked Bonds

While green bonds are limited to issuers with eligible green projects, the advent of SLBs has helped democratize ESG bonds. The core SLB feature that fosters such market accessibility is the flexibility afforded to issuers to use proceeds for general corporate purposes, in contrast to green bond proceeds being limited to (re)financing eligible green projects. In lieu of focusing on green projects, SLBs incentivize issuers to achieve pre-determined sustainability/ESG targets. This feature permits companies across industries to access the ESG bond market, including companies in the CO2-intensive industries such as energy, agriculture, forestry and fishing, and transportation and storage, seeking to transition to a more sustainable business model. In H1 2021, €6.5 billion of sustainability-linked bonds were issued in Europe, according to Reorg’s bonds database. Similar to green bonds, the de facto voluntary framework for high yield SLBs is the ICMA Sustainability-Linked Bond Principles (SLBP), published in June 2020. The components of the ICMA SLBP include (1) selection of key performance indicator(s), or KPIs; (2) calibration of sustainability performance target(s), or SPTs; (3) bond characteristics; (4) reporting; and (5) verification.

The first three components are connected and relate to the essence of a sustainability-linked instrument. A prospective issuer of an SLB needs to initially identify one or more sustainability KPIs that are material and relevant to its industry, operations and strategy2. To assist the KPI identification process, ICMA suggests consulting ESG reporting guidelines and frameworks such as those developed by The Value Reporting Foundation and the Task Force on Climate-Related Financial Disclosures. KPIs need not be strictly related to the “E” in ESG, however, in practice, environmental KPIs are the most prevalent in high-yield SLBs, with the most common being greenhouse gas emissions (Nemak, Picard, Public Power Corp., Constellium, Pfleiderer). Other examples of KPIs include energy consumption (Picard), recycled aluminum utilization (Constellium), recycled wood utilization (Pfleiderer) and waste intensity (Lonza Specialty Ingredients). Companies tend to identify and link KPIs to one or more of the targets of the 17 United Nations Sustainable Development Goals (UN SDGs). While ESG ratings provided by an external ESG rating agency (e.g. Sustainalytics, V.E./Moody’s) may serve as a KPI and/or SPT, these are currently rarely seen in practice.

It is important to note that a company that has not previously tracked ESG/sustainability KPIs, either internally or externally, cannot simply decide one day to identify KPIs and expect to immediately issue a credible SLB. Companies ideally should have a track record related to a corporate ESG/sustainability strategy in order for investors to assess past performance, identify trends, and determine whether a company’s SPT is truly meaningful and ambitious or merely represents the ordinary course of business. The ICMA SLBP, for instance, recommends a three-year lookback period for KPIs. The most recent historical KPIs will be used as the “baseline” when calibrating the SPT.

When setting an SPT, ICMA states that target should be, at a minimum, “in line with science-based scenarios, or absolute level…or to official country/regional/international targets” such as the EU Taxonomy or UN SDGs. The ICMA SLBP recognizes that an SPT’s ambitiousness will depend upon the issuer’s context, noting that “[s]ustainability priorities are likely to vary depending on the economic, social and political development of geographies in which issuers are domiciled or have the largest portion of their activities.” Additionally, ICMA encourages, but does not require, issuers to appoint an external reviewer to participate in the KPI selection and SPT calibration process by assessing the “relevance, robustness and reliability of selected KPIs, the rationale and level of ambition of the proposed SPTs, the relevance and reliability of selected benchmarks and baselines, and the credibility of the strategy outlined to achieve them…” In practice, high yield SLB issuers follow this recommendation by appointing external reviewers to verify that a proposed SLB aligns with the ICMA SLBP. The use of such external reviewers provides investors with some reassurance that the technical aspects of KPIs and SPTs have been analyzed by subject-matter experts and that the SLB they are considering investing in is ambitious and credible.

The third component of the SLBP - bond characteristics - refers to the financial and/or structural impact that arises in the event that an issuer achieves or fails to achieve an SPT. The bond characteristic is a feature that serves to incentivize an issuer to meet an SPT. In the high yield SLB market, this financial impact translates into a step-up in the bond interest rate. Specifically, market practice has coalesced around an aggregate 25 basis points, or 0.25%, interest rate increase. High yield SLBs typically see one (e.g. Public Power Corporation, Hapag-Lloyd) or two (e.g. Lonza Specialty Ingredients, Constellium, Picard, Nobian, Pfleiderer) KPIs/SPTs. For deals with two KPIs/SPTs, the bond interest rate can increase up to 25 basis points if the issuer fails to achieve both SPTs or 12.5 basis points (0.125%) if just one of the two SPTs is achieved. The failure of an issuer to achieve an SPT is not an event of default under current market practice, although there would be an indirect non-payment event of default where an issuer fails to pay the interest step-up following an SPT failure.

The final two SLBP components involve reporting and verification. Issuers should publish reports providing updates on KPIs along with “any information enabling investors to monitor the level of ambition of the SPTs.” The SLBP provides leeway for issuers to determine the level of information contained in such reports. The scope of ESG reporting undertaken by an SLB issuer will likely be ultimately influenced by investor expectations, market practice and existing ESG reporting regimes. These reports are neither included in, nor governed by, the customary reporting covenants of a high yield SLB indenture. In practice, an issuer includes disclosure in its SLB offering memorandum concerning its intention to publish SLB-related reports on its website. In connection with such reporting, alignment with the SLBP requires an issuer to appoint an external reviewer to verify its KPIs against the SPTs.

Next Steps: The Maturation and Evolution of the ESG Bond Market

As ESG bonds become the norm and not a novelty, focus is shifting to the consolidation and the maturation of the ESG bond market. This is best exemplified by the conversations and market developments around “greenwashing.” This is a common critique leveled at companies that are accused of promoting ESG strategies and policies, including the issuance of ESG bonds, solely for marketing purposes while not taking concrete, ambitious actions to achieve meaningful ESG goals. Left unchecked, actual and perceived examples of greenwashing could call into question the integrity of the ESG bond market. To address this threat to the ESG debt markets, we are seeing a number of developments and proposals, primarily arising in Europe, the region leading the ESG finance conversation.

The European Green Bond Standard: Tackling Greenwashing

The EUGBS exemplifies the EC’s desire to mitigate accusations of greenwashing and to strengthen the credibility of the green bond market. The EC views the EUGBS as “a standard for high quality green bonds,” a critique of the current green bond market, which the EC believes “… suffers from a lack of clear definitions of green projects, creating uncertainty and added costs for issuers and investors alike.”3. The EUGBS is intended to complement and build-upon existing green bond frameworks, including the ICMA GBP. However, while a green bond aligned with the more rigorous EUGBS would also align with the ICMA GBP, a green bond aligned with the ICMA GBP would not necessarily be aligned with the EUGBS. The EUGBS seeks to advance the green bond market by “(1) improv[ing] the ability of investors to identify and trust high quality green bonds, (2) facilitate[ing] the issuance of [...] high quality green bonds by clarifying definitions of green economic activities and reducing potential reputational risks for issuers in transitional sectors, and (3) standardis[ing] the practice of external review and improve[ing] trust in external reviewers by introducing a voluntary registration and supervision regime.”

Issuing a green bond aligned with the EUGBS, a “European green bond”, generally follows the ICMA GBP, with the core difference being that the proceeds of a European green bond must be used for an economic activity that meets (or will meet within a defined period) the criteria set forth under the EU Taxonomy Regulation (Regulation (EU) 2020/852). This requires an economic activity to (1) contribute substantially to at least one of the six EU Taxonomy Regulation environmental objectives4, (2) do no significant harm to the other environmental objectives, (3) comply with specified minimum (social) safeguards to ensure alignments with certain international standards5 and (4) comply with activity-specific technical screening criteria6. This mandatory link to the rigorous sustainability criteria of the EU Taxonomy Regulation is what distinguishes a European green bond from other green bonds and what, according to the EC, “ensure[s] that the bond itself is fully environmentally sustainable.” For investors seeking to allocate capital to bona fide ESG bonds, European green bonds provide much needed transparency.

Verifying the Verifiers

The EUGBS approach to external reviews of European green bond issuances serves as another example of how the EC seeks to inject transparency and integrity into the ESG debt markets. For one, the EUGBS requires the pre and post-issue external review of an issuer’s European green bond factsheet and reports. Under the EUGBS, the EC has also proposed the establishment of a registry of approved external reviewers for European green bonds that would be supervised by the European Securities Market Authority. This registry would provide for a centralized accreditation regime for external reviewers, requiring such external reviewers to have “adequate qualifications, professional experience, and independence … to ensure adequate investor protection.” The requirement of minimum professional qualifications for, and the oversight of, external reviewers distinguishes the EUGBS from other frameworks, including the ICMA GBP, which promote voluntary guidelines for external reviews and reviewers.

A Forthcoming European Sustainability-Linked Bond Standard?

The EC has recently indicated that it will look to apply a similar rigorous approach to other types of ESG bonds as it has to green bonds, noting in a July 7, 2021, communication on Strategy for Financing the Transition to a Sustainable Economy that “to facilitate additional capital flows to interim transition efforts, the Commission will work on other bond labels, such as transition or sustainability-linked bond labels” by 2022. One trend we are likely to see, at least in the European ESG debt market, is companies opting to align green bond issuances with the more stringent requirements of the EUGBS to demonstrate to investors their heightened commitment to ESG/sustainability. There have already been such examples, including Verbund AG’s green and sustainability-linked bond issued in March 2021.

SLB Bond Characteristics: Time to Push the Envelope

In parallel to the discussions around greenwashing and the credibility of the ESG bond market, there are also conversations concerning ways to improve the sustainability characteristics of SLBs, specifically to move beyond the simple coupon step-up described earlier to more creative impacts in the event of a failure to achieve SPTs. For example, I have previously advocated replacing the coupon step-up with a feature whereby an issuer, upon a failure to achieve an SPT, would be required to invest amounts comparable to a coupon step-up, or some other predetermined amount, on an annual basis for the purpose of furthering its SPTs or broader corporate ESG strategy. The primary benefit of such a mandatory reinvestment is the transformation of an SLB into a more holistic ESG instrument that creates a virtuous sustainability cycle in lieu of investors simply receiving an economic benefit from an issuer’s failure to achieve its SPT. Bond investors that have a heightened focus on the promotion of ESG/sustainability would welcome such a development even if it meant losing out on the economic benefit of a coupon step-up. An additional impact of a mandatory ESG reinvestment requirement is that it provides the ESG features of an SLB more “teeth” in terms of an issuer’s covenant package (a common argument raised by investors in ESG bonds) in the sense that an issuer’s failure to reinvest would result in a covenant breach.

There are some limited examples in the SLB market of companies contemplating bond characteristics other than just a coupon step-up. For example, in addition to the customary coupon step-up, the sustainability-linked financing framework of LafargeHolcim, an investment grade issuer, contemplates bond characteristics if an SPT is not reached of “[a] payment of up to 75 bps of notional to a research institute or NGO…active in the fields of climate research or climate change mitigation …” or “[a] top-up of the R&D budget of up to 75 bps of notional earmarked to projects aimed specifically at reducing the carbon intensity of cement production in LafargeHolcim’s operations.” The only obstacle to this SLB market development appears to be the inertia of market practice and the potential loss of an economic windfall for investors.

The ESG bond market is still in its infancy with terms and market practice still under development. As companies, investors, corporate stakeholders and society as a whole sharpen their focus on ESG factors and sustainability, we can expect the evolution and refinement of ESG bonds to more closely align with the ambitious actions required to address climate change and social and economic inclusion.


[2] The ICMA SLBP notes that “KPIs should be: relevant, core and material to the issuer’s overall business, and of high strategic significance to the issuer’s current and/or future operations; measurable or quantifiable on a consistent methodological basis; externally verifiable; and able to be benchmarked...”


[4] These environmental objectives are: (1) climate change mitigation;, (2) climate change adaptation; (3) the sustainable use and protection of water and marine resources; (4) the transition to a circular economy; (5) pollution prevention and control; and (6) the protection and restoration of biodiversity and ecosystems.

[5] Such international standards include the OECD Guidelines for Multinational Enterprises (2011) and the UN Guiding Principles on Business and Human Rights (2011).

[6] The technical screening criteria must specify how an economic activity (1) makes a substantial contribution to one or more of the EU Taxonomy’s environmental objectives and (2) does not significantly harm the other objectives. On June 4, 2021, the EU Taxonomy Climate Delegated Act was formally adopted by the European Union, identifying the initial technical criteria for economic activities that contribute substantially to climate change mitigation and climate change adaptation. Technical criteria for the balance of the EU Taxonomy environmental objectives are forthcoming.
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