A reality check for sustainable finance

Sustainable finance champions the hope to direct capital and corporate entities to address climate, environmental, and social challenges. And while government policies and financial incentive have successfully created a market, critical questions facing participants at Bloomberg’s third annual Global Regulatory Forum included whether sustainable finance is on course to reach the desired scale and whether it is achieving its intended purposes while addressing real market concerns.

Challenges with the labeled market

 BNEF, Bloomberg’s in-house research service, has been tracking the sustainable finance market for a long time, and one of the key challenges for determining how well the market is achieving its goals is understanding what the term “sustainable finance” includes. As Jonathan Luan, head of APAC sustainability research at BloombergNEF noted during the forum, when one defines “sustainable finance,” one is essentially making a judgment about it.

Some see sustainable finance as a label for green social sustainability instruments. However, that definition may be too small and too narrow. Others define sustainable finance as being about everything — that the entire financial system must be sustainable. There’s a large gap between the reality of sustainable finance and the more idealistic view that everything must be analyzed through the lens of sustainability.

BNEF researchers look closely at how the financial world engages with sustainable technologies like wind, solar, energy storage, hydrogen, electric vehicles, and carbon capture, and how it is using labeled instruments to do so. The labeled finance market now represents about $7.2 trillion in overall issuance.

Within that market, green bonds are by far the most popular sustainable debt instrument in the fixed-income world. The second most popular instrument is sustainability-linked loans (SLLs), which account for about $1.5 trillion in the market, while green bonds account for about $3 trillion. Green loans, sustainability-linked bonds, and social bonds account for $700 to $800 billion each. Sustainability-linked bonds represent a much smaller market at $280 billion.

The market saw two straight years of decline in annual issuance over the past two years, which may represent a reality check in terms of how the sustainable finance market is actually doing. The trend shows a divergence between instruments with clear use of proceeds and those tied to the borrower’s ESG targets. Sustainability instruments, which focus on both environmental and social outcomes, saw issuance picked up again in 2023. However, sustainability-linked instruments, like bonds and loans, that don’t have a specifically defined use of proceeds attached to them but are tied to an entity’s environmental performance — be that an ESG score or greenhouse gas target — have not bounced back. Their issuance last year stood at about 40% of the highs in 2021.

This suggests the market has delivered a reality check on whether or not these linked instruments are fit for purpose. But what are they really linked to?

BNEF has delved into the market, evaluating sustainability-linked bonds, which have a long road to drive impact. Part of the challenge are SLBs’ step-ups in their interest rate. If an issuer misses the target step-up by the instrument, there will be an instrument penalty of about 25 basis points, based on the BNEF sample.

The allocation of proceeds raised from sustainable debt represents another challenge. Funds raised through green bonds are focused on only a handful of sectors like renewable energy, clean transportation, and green building. Some of these sectors are already economically competitive, which means they may have cost-competitive ways to purchase clean energy or buy electrical vehicles. So they don’t require a green instrument to either demonstrate that they have green credentials or to provide an incentive like a lower interest rate.

Climate adaptation only receives about 1% in green bond allocation, while biodiversity receives only 0.2%. This shows that  green bonds rarely go to fund big challenges. Stakeholders that are looking at sustainable finance for the next big environmental problem may need to think again.

Transition financing strategies

Sustainable finance also includes another type of funding called transition finance. A $18 billion market, transition finance ideally funds the large portion of the economy that is still emitting carbon but has transition plans in place to reach climate targets. This is a nascent category receiving significant attention from regulators and financial market participants, but difficulties around its definitions and credibility has dragged down its annual issuance to $4 billion last year, from $5 billion in 2021.

The Glasgow Financial Alliance for Net Zero (GFANZ) has identified four strategies necessary for financing a whole-economy transition to carbon net zero, which include financing or facilitating the following:

• Development and scaling of climate solutions
• Focus on assets or companies already aligned to a 1.5 degrees Celsius pathway
• Focus on assets or companies committed to transitioning in line with 1.5 degrees Celsius-aligned pathways
• Accelerated managed phaseout of high-emitting physical assets

Such a transition will necessitate a common definition of transition finance as well as common methodologies for measuring impacts. Those methodologies will need to be applicable across markets and industry sectors in order to scale transition finance and provide for whole-economy decarbonization while also helping financial institutions standardize how they identify both risks and opportunities.

Standardization of definitions and methodologies can help financial institutions evaluate more complex investments. With an electric vehicle, it’s easier to identify the potential for returns because there are concrete outcomes. With something like biodiversity, however, an investor can’t as easily see impacts the way they can with a physical product like a green vehicle or building.

Supply chain difficulties are also an issue when it comes to how companies transition toward sustainability. Many supply chains have elements that do not yet have Community Sustainability Global (CSG) processes in place, and it may not be practicable for them to change suppliers. As such, encouraging these suppliers may often be the most effective route toward a sustainable supply chain.

Most major corporations tend to use their CSG processes as a competitive strategy rather than as a moral imperative, which results in a problem defining what the impacts of these CSG processes are. That’s because transition plans tend to be company specific as opposed to guided by standardized global frameworks and processes for scaling up.

In order to measure real CSG outcomes, one can employ several possible indicators:

• The level of carbon intensity over time per production unit (The data for this needs some very precise filtering to establish a valid metric)
• Standardization of reporting methodologies
• More available, accurate data in the emissions field
• Metrics that are not purely carbon-based but also compare how much low-carbon versus high-carbon energy is used

These indicators can fuel a far stronger focus on sustainability outcomes that are more complicated to address than decarbonization, including adaption, mitigation, and biodiversity — all of which are chronically underfunded and also underrepresented in corporate CSG strategies.

Learn more about how the financial industry is working to address climate change on our blog, or subscribe to our newsletter for further insights on measuring sustainability incomes. Need help identifying sustainable finance opportunities? Contact us.