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October 21, 2021

A materiality lens is key to assessing the credentials of sustainability-linked debt instruments

Rahul Ghosh and Matt Kuchtyak
Moody's ESG Solutions

Sustainability-linked bonds (SLBs) and sustainability-linked loans (SLLs) are witnessing tremendous issuance growth this year, leading to more diverse issuer participation in sustainable debt markets. However, limited standardization has also resulted in growing market concerns in some instances over a perceived lack of ambition of sustainability performance targets.

To promote continued market integrity and enable ambitious sustainability pathways, we recently enhanced our methodology to better capture the relevance of KPI(s), or the extent to which selected indicators address the issuer’s core sustainability strategy and relevant ESG challenges of its sector.

One of the latest innovations in the sustainable debt markets, SLBs and SLLs are instruments for which the financial or structural characteristics vary depending on whether the issuer achieves predefined environmental, social and governance (ESG) objectives. By offering flexibility on the use of proceeds, they afford organizations with a forward-looking and dynamic way to embed public sustainability commitments into their financial structure.

The market for SLBs and SLLs is booming. SLB issuance volumes reached a record $61.6 billion in the first three quarters of 2021, a seven-fold increase from the full-year total in 2020 (Figure 1). Similarly, at a cumulative $136 billion, sustainability-linked loans (SLLs) in Q1-Q3 2021 were 57% higher than the $86.7 billion recorded during the whole of last year.

Figure 1, Sustainability-linked bond issuance by region, US$ billions. Sources: Moody’s ESG Solutions and Environmental Finance Bond Database
Figure 2, Sustainability-linked bond issuance by sector, % of total. Sources: Moody’s ESG Solutions and Environmental Finance Bond Database

The proceeds flexibility of SLBs and SLLs has opened the door to a broader range of sectors and issuers embracing the sustainable debt capital markets to finance their green and sustainability strategies. As Figure 2 shows, global SLB coverage includes companies from across traditional sectors seen in the use-of-proceeds market (such as utilities). However, companies from across food and beverage, autos, transportation & logistics, real estate, paper & packaging, health care and financials are also pricing SLB deals. Many companies in these sectors have been unable to raise more traditional use-of-proceeds sustainable debt financing in the past due to a lack of explicit environmental or social projects.  

SLBs and, to a lesser extent, SLLs remain very much in their infancy. The market is young and dynamic, and issuers, borrowers, investors and lenders are continuing to learn and enhance the effectiveness of these instruments to enable the transition to more sustainable business models.

Nevertheless, market growth and development have raised concerns about a perceived lack of ambition of sustainability performance targets – particularly within sectors that face enduring ESG challenges, such as those with carbon-intensive operations. As we have previously remarked, issuers will need to clearly articulate the robustness of sustainability performance targets (SPTs) embedded within SLBs and SLLs to ensure buy-in from creditors and lenders. This will become increasingly important as the market reaches critical mass that allows for inter- and intra-sector comparisons. Interim goals, historical performance, science-based criteria, transparency on scope and coverage and limited reliance on offsets are all factors that can strengthen the credibility of targets.

Enhancements to our approach reflect importance of materiality

Our methodology for second party opinions on SLBs and SLLs has always considered the scope of KPI(s) selected by the borrower in line with international guidance enshrined in the Sustainability-Linked Bond Principles (SLBP) and Sustainability Linked Loan Principles (SLLP).

To make this aspect clearer and more transparent, we have enhanced our methodology to explicitly quantify the scope of selected KPIs in addressing an entity’s core sustainability and busines strategy and addressing relevant sector ESG challenges. In practice, this means that our analysis of the relevance of a KPI will be influenced by a more quantitative sliding scale (Figure 3). Poor scope will result in a weak score in the “relevance” of the KPI, which will in turn result in only a “partial alignment” of the SLB or SLL to international standards and best practices.

Scope is just one element factored into our “relevance” assessment. We also consider the materiality of the KPI for the issuer/borrower’s current and future operations and whether it captures the most relevant sustainability challenge(s) for its industry. A KPI could cover 100% of the scope of a target, but is not considered relevant and material to either a company’s current or future business strategy or ESG challenges for the industry. In such a scenario, the 100% scope of the KPI would not lead to a higher overall “relevance” score.

KPI relevance is particularly important when considering greenhouse gas (GHG) emission targets. These make up the lion’s share of KPIs in the SLB market; however, many issuers to date have not explicitly referenced Scope 3 emissions – the broadest measure of indirect emissions – in their selected KPIs. In our analysis, we would expect GHG emissions-related KPIs to conform with the minimum requirements and recommendations set out in the SLBP. We would also score favorably the use of internationally-recognized carbon accounting methodologies, such as the GHG Protocol. However, to achieve “robust” or “advanced” scoring, an issuer would need to show that it meets requirements set out by the Science Based Targets initiative (SBTi) and, ideally, has received SBTi validation. This would mean that in instances where an issuer’s Scope 3 emissions are 40% or more of total GHG emissions, a Scope 3 target would be required to meet our highest scoring criteria. This would encompass all companies involved in the production or distribution of natural gas and/or other fossil fuel products.

Figure 3, Scale to assess scope of KPI(s) in our second party opinion methodology. Source: Moody’s ESG Solutions

The enhancement to our approach came into immediate effect last month and will be applicable to all transactions that are underway. We will not, however, update previously published SPOs given their point-in-time nature. We believe that these enhancements will help ensure that SLB/SLL targets remain ambitious and that SPOs can provide positive signals that support our transition towards a low-carbon, climate-resilient economy and society

Moody’s ESG Solutions provides insights and analyses on ESG themes and multi-stakeholder performance, climate-related risks and opportunities and global sustainable finance trends.

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