Structural Shift In ESG-Linked Debt May Make Issuance Easier, Law360

The capital markets have seen explosive growth in the issuance of environmental, social and governance, or ESG, debt in recent years. Green bond issuance alone in the U.S. has averaged approximately $60 billion for the past two years. ¹ 

While that amount is still significantly below the ESG offerings closed in Europe during the same period, the global sustainable finance industry is valued at approximately $40 trillion.² 

But we have witnessed a structural shift in these offerings that has gained momentum over the past several months. In recent years, many U.S. issuers had executed ESG transactions on a one-off basis, wherein the proceeds were dedicated to a specific project or projects.

And many issuers elected not to retain an independent second party to opine on the offering’s alignment with the respective set of ESG-focused principles. U.S. issuers are now increasingly opting to set up an ESG framework in advance of future offerings and obtaining a second party to opine on such framework at the outset.

While more time-consuming at the outset, such structure should provide additional flexibility as well as independent ESG verification on future offerings.

The advantages of ESG offerings to issuers have been generally twofold: (1) providing access to a larger investor base than would otherwise be available (i.e., those investors with ESG-focused criteria), and (2) providing evidence of good corporate citizenship regarding certain of the issuer's projects.

ESG encompasses three individual, but highly overlapping, elements: environmental criteria, social criteria and governance. The environmental element has been a mainstay of the capital markets since the late 2000s and has steadily increased since the International Capital Market Association first published its Green Bond Principles in 2014 and last updated them in 2018.³ 

Debt issued in this category is designed to support specific climate-related or environmental projects, and includes investments related to clean energy or pollution reduction.

The social criteria, described in the Social Bond Principles⁴ published by ICMA and last updated in 2020, focuses on projects “that address or mitigate a specific social issue and/or seek to achieve positive social outcomes.”⁵

The third criteria of ESG is governance — the internal system of rules, policies and procedures that govern the management of a company. The individual elements of ESG are, by their nature, intertwined.

Broadly speaking, when domestic issuers began issuing green bonds several years ago, the debt was often intended to finance a specific project or group of projects (i.e., a utility financing the construction of a wind farm). In such offerings, many issuers did not engage a second party to opine on the alignment of the project with the Green Bond Principles.

But several issuers have recently shifted from this one-off green bond strategy. Issuers are increasingly opting to establish a broader ESG-focused framework — or, in the case of certain issuers, solely a green bond framework — effectively serving as the issuer’s shelf for future ESG offerings.

We have seen an increase not only in this framework structure for obtaining a second-party opinion, but also an increase in the issuance by issuers of social bonds (aligned with the Social Bond Principles) and also sustainability bonds, where proceeds are being devoted to uses in line with both the Green Bond Principles and the Social Bond Principles.

A number of domestic issuers have put in place frameworks over the past three or four years. So far in 2021, AFLAC Inc., The Southern Co. Inc. and Truist Financial Corp. have all done the same. Note also that a few of the issuers in the list below have in place a green-only framework.⁶ 

Both ICMA’s Green Bond Principles and Social Bond Principles provide guidance on the same four components: (1) use of proceeds; (2) process for project evaluation and selection; (3) management of proceeds; and (4) reporting.

Note that the use of proceeds, reporting and any second-party opinions do not form part of the terms and conditions of the bonds and typically do not create specific contractual obligations. However, these elements are referenced in the disclosure documents.

An issuer’s framework will reside on its website — typically found on the investor relations page and will follow the four components of the Green Bond Principles and Social Bond Principles. The framework is often posted on the issuer’s website prior to marketing an ESG bond transaction.

The second-party opinion with respect to the framework will reside on the website of the second-party opinion provider for investors to review. Subsequent opinions are typically not provided for each issuance of bonds from the framework shelf.

Note also that the second-party opinion is in addition to the other reporting the issuer will provide, such as a website detailing the use of proceeds, management's assertion as to the use of any remaining proceeds and an attestation from the issuer's independent auditor regarding the use of such proceeds.

One issue of which issuers should be aware when looking to launch an initial ESG bond offering is timing for posting their framework and second-party opinion or other guidance to their websites. While some issuers already regularly disclose ESG-focused information on their website, and maybe even an annual sustainability report, other issuers might not have previously disseminated such information publicly.

Issuers pursuing a registered offering should be mindful of Rule 168 of the Securities Act⁷  to ensure that any information posted to their websites immediately prior or during the offering regarding their framework or attestation will fall within the safe harbor and not be considered part of the offering.

Another somewhat related issue to this new structure is the ability to reopen an ESG bond. There have been several reopeners of green bonds that were issued to fund specific projects.

A number of green reopenings have also funded additional green projects that have been developed since the time of the original green issuance. In each of these cases, we believe there would be a conversation about the use of proceeds of the reopener to ensure that the additional projects were in line with the original offering.

However, under the new framework method of issuing ESG bonds, it would seem an even clearer call that, absent any non-ESG hurdles, the particular series could be reopened. But a similar analysis would still be advisable — making sure that the eligible projects in the reopener were in line with the eligible projects of the original series.

As ESG issuances become a more dominant feature of the investment grade debt world in the U.S., we predict that ESG-related disclosure will also become more commonplace, and eventually could be required.

While some issuers already voluntarily disclose progress toward achieving ESG-related goals in their Securities Exchange Act disclosure, some investors argue that a lack of uniformity among such disclosures complicates their analysis and are increasingly demanding standardized corporate ESG disclosure.⁸ 

The U.K. government recently proposed mandatory climate-related financial disclosures by 2022 for certain issuers, and the U.S. Securities and Exchange Commission recently created a new ESG-related enforcement task force and indicated that comprehensive disclosure framework could be imposed in the future.

Market participants should stay tuned as both this market, and market practice, continue to evolve and mature.

Notes:

¹ Alastair Marsh, U.S. Falls Further Behind Europe in Fast-Growing ESG Market, Bloomberg.com (Dec. 21, 2020).

² Id.

³ International Capital Market Association, Green Bond Principles: Voluntary Process Guidelines for Issuing Green Bonds (June 2018), available at https://www.icmagroup.org/sustainable-finance/the-principles-guidelines-and-handbooks/green-bond-principles-gbp/.

⁴ International Capital Market Association, Social Bond Principles: Voluntary Process Guidelines for Issuing Social Bonds (June 2020), available at https://www.icmagroup.org/green-social-and-sustainability-bonds/social-bond-principles-sbp/.

⁵ Bonds that are issued pursuant to both the Green Bond Principles and the Social Bond Principles are often referred to as “sustainability bonds”.  Note the confusing distinction with “sustainability-linked bonds,” whereby the issuer includes certain financial and/or structural characteristics in the debt instrument that are linked to whether the issuer achieves predefined sustainability objectives. The principal difference between sustainability-linked bonds and green or social bond issuances is that the bond documentation for “sustainability-linked bonds” is directly tied to the issuer achieving certain predefined targets. One domestic example is NRG Energy Inc.’s December 2020 bond sale tied to its goal to achieve a 50% reduction of absolute greenhouse gas (GHG) emissions by 2025, and reach net-zero GHG emissions by 2050. Issuers typically incur an interest rate penalty for failing to meet defined targets.

⁶ Note, too, that Avangrid, Inc. has in place a Framework for Green Financing but has opted to obtain a Vigeo Eiris second party opinion for their inaugural and follow-on green bond issuances.

⁷ Rule 168 provides an exemption from the prospectus requirement under the Securities Act for certain communications of regularly released factual and business information and forward looking information.

⁸ Declan Harty, Top SEC official signals ESG disclosures are coming, S&P Global Market Intelligence (March 15, 2021).

The opinions expressed are those of the author(s) and do not necessarily reflect the views of the firm, its clients, or Portfolio Media Inc., or any of its or their respective affiliates. This article is for general information purposes and is not intended to be and should not be taken as legal advice.