Green Bonds and Sustainability-Linked Bonds – What’s the Distinction? Phiroza Katrak

Back in 2007 the European Investment Bank issued its inaugural Climate Awareness Bond; it was the world's first green bond.   

Last November at the COP26 climate summit in Glasgow, Chancellor Rishi Sunak urged the global financial system to “rewire” for net zero.  To address the urgency to address climate change, he also set out the UK’s aim to the first net zero aligned financial centre. This included climate risk surveillance, mandatory sustainability disclosures, issuance of sovereign green bonds, better and more consistent climate data and proper global reporting standards.   

The UK issued its first green gilt in 2021, a £10bn issue with a 12-year maturity yielding around 0.9% whose proceeds can be used in six areas including renewable energy, climate change adaptation, energy efficiency and clean transportation. It was heavily oversubscribed, total bids from investors were close to £100bn.   

In March 2022 Chile became the first sovereign to issue a sustainability-linked bond to fund its long-term climate initiatives.   The Social Market Foundation, a cross-party public policy think tank in the UK, has urged the Chancellor to do likewise and do more to ensure the UK becomes a global hub of sustainability-linked finance. 

What’s the distinction between a green bond and a sustainability-linked bond?   

With ‘use of proceeds’ green bonds, the capital raised finances or refinances eligible, dedicated projects with clear environmental benefits and impact which will be assessed and reported on by the issuer through quantitative and/or qualitative performance indicators.  The International Capital Market Association’s Green Bond Principles, which are voluntary guidelines, outline various eligible green project categoriesi.  The bond’s legal documentation will describe how the proceeds are to be utilised and monies raised are held in a separate sub-account.   

Transparency of the bond’s sustainability objectives, strategy and process, and annual reporting and disclosure will therefore be central to investors’ decision-making.  Management of the project and progress towards the environmental and impact objectives are tracked throughout the project’s life through readily available reporting and there is often third-party verification of the bond’s alignment with its objectives and environmental benefit criteria. 

Issuers of green bonds in the UK include Transport for London Thames Water, SSE plc, National Grid, Barclays PLC, HSBC, NatWest (RBS Group).   

Sustainability-linked bonds (SLBs) do not finance a particular project, but there is a contractual link to meeting the sustainability target(s) as determined by the issuer.  The medium- to long-term targets, which are set at issuer level, should be clearly articulated, meaningful, measurable and have a lasting impact.   Investors and regulators would scrutinise the SLB’s objectives, targets and timescales, to assess whether the performance indicators have current and future relevance, that these are being met and are not simply the outcome of historic corporate decisions.  The entity issuing the SLB would report annually. Verification by an independent, qualified assessor of progress towards sustainability targets and within the prescribed timelines is also important.   

Failure to meet the objective(s) or target would entail a financial cost – an increase to the bond coupon, typically by 25bp – and business and reputational risk.   

Issuers of sustainability-linked bonds include Anglian Water (KPIs: net operational carbon emissions reduction and capital carbon emissions avoided), Hammerson (Scope 1, 2 and 3 greenhouse gas emissions reduction) and Tesco PLC (KPIs: Scope 1 and 2 greenhouse gas emissions).   

Credit assessment: Whether the bond is issued as ‘green’ or ‘sustainability-linked’, the servicing of debt, both coupon payment and principal repayment, remains the responsibility of the issuing entity and thorough credit analysis should not be overlooked.

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