Rossana Chu (Managing Partner)
Jacky Chan (Associate)
Green, social and sustainability-linked bonds listed on the Hong Kong Stock Exchange adopt principles formulated by the International Capital Market Association (ICMA). This article introduces the core elements in those principles.
Green and social bonds are commonly known as bonds for funding green and social projects. As a contrast, a sustainability-linked bond provides general-purpose finance (i.e. not for specific projects) to the issuer but the issuers commits to achieve certain environmental, social and/or governance (ESG) targets and its financing cost will increase if such targets cannot be achieved.
ICMA is a not-for-profit association (Verein) under the Swiss Civil Code. Its mission is to promote resilient well-functioning international and globally coherent cross-border debt securities markets.
ICMA currently has around 600 members engaging in international debt capital markets. The wide variety of members include banks, securities dealers and brokers, asset and fund managers, insurance companies, central banks, stock exchanges, clearing houses, trading facilities and systems, credit rating agencies and professional firms. Members come from 64 jurisdictions globally, including Mainland China and Hong Kong.
In pursuit of its objectives, ICMA and its members work together to promote the development of international capital and securities markets by pioneering rules, principles and recommendations. One of its priorities is sustainable finance.
The Green Bond Principles, the Social Bond Principles, the Sustainability Bond Guidelines and the Sustainability-Linked Bond Principles are a collection of voluntary frameworks and outline best practices when issuing bonds serving green, social and/or environmental purposes. They emphasize transparency, accuracy and integrity of the information to be disclosed and reported by issuers to stakeholders (which should not be limited to the investors, but also include governmental bodies, issuers’ employees, business partners and customers, as well as the public).
Green Bond Principles2
Green bond is defined as any type of bond instrument where the proceeds or an equivalent amount will be exclusively applied to finance or re-finance, in part or in full, new and/or existing eligible green projects and which are aligned with the four core components of the Green Bond Principles which are:
1. Use of proceeds
All designated eligible green projects should provide clear environmental benefits, which will be assessed and, where feasible, quantified by the issuer.
The Green Bond Principles explicitly recognise the following broad categories of eligibility projects which are the most commonly used types of projects supported, or expected to be supported, by the green bond market:
The term “projects” includes assets, investments and related or supporting expenditures such as research and development.
2. Process for project evaluation and selection
The issuer should communicate clearly to investors (a) the environmental sustainability objectives of the eligible green projects, (b) its process in determining how the projects fit within eligible categories, and (c) complementary information on processes by which the issuer identifies and manages perceived social and environmental risks associated with the relevant projects.
3. Management of proceeds
The net proceeds of the green bond should be credited to a sub-account, moved to a sub-portfolio or otherwise tracked by the issuer, and attested to in a formal internal process.
The tracked net proceeds should be applied to eligible green projects. The issuer should disclose to investors the intended types of temporary placement for the balance of unallocated net proceeds.
The Principles recommend that the use of an external auditor, or other third party, to verify the internal tracking method and the allocation of funds from the proceeds.
Issuers should make, and keep, readily available up to date information on the use of proceeds to be renewed annually until full allocation, and on a timely basis in case of material developments. The annual report should include a list of the projects to which proceeds have been allocated, as well as a brief description of the projects, the amounts allocated, and their expected impact.
The Green Bond Principles recommend the use of qualitative performance indicators and, where feasible, quantitative performance measures and disclosure of the key underlying methodology and/or assumptions used in the quantitative determination. Issuers should refer to and adopt, where possible, the guidance and impact reporting templates provided in the “Handbook on Harmonised Framework for Impact Reporting”3 developed by ICMA.
Issuer should explain the alignment of its green bond or green bond programme with the four core components of the Green Bond Principles in a “green bond framework” or in the bond legal documentation that is readily accessible to investors.
Social Bond Principles4
Social Bond is defined as any type of bond instrument where the proceeds, or an equivalent amount, will be exclusively applied to finance or re-finance in part or in full new and/or existing eligible social projects and which are aligned with the four core components of the Social Bond Principles, such components being:
1. Use of proceeds
All designated eligible social projects should provide clear social benefits, which will be assessed and, where feasible, quantified by the issuer. They should directly aim to address or mitigate a specific social issue and/or seek to achieve positive social outcomes especially but not exclusively for a target population. A social issue is an issue that threatens, hinders, or damages the well-being of society or a specific target population.
The Social Bond Principles give the following illustrative examples of social project categories which are the most common projects supported, or expected to be supported, by the social bond market:
Examples of target populations include:
2. Process for project evaluation and selection
3. Management of proceeds
The guidance and recommendations in the Green Bond Principles apply to these three components of the Social Bond Principles.
Issuer should explain the alignment of its social bond or social bond programme with the four core components of the Social Bond Principles in a “social bond framework” or in the bond legal documentation that is readily accessible to investors.
Sustainability Bond Guidelines5
Sustainability Bonds are any type of bond instrument where the proceeds or an equivalent amount will be exclusively applied to finance or re-finance a combination of both green and social projects. Sustainability bonds are aligned with the four core components of both the Green Bond Principles and the Social Bond Principles.
Certain social projects may also have environmental co-benefits, and certain green projects may have social co-benefits. The classification of a use of proceeds bond as a green bond, social bond, or sustainability bond should be determined by the issuer based on its primary objectives for the underlying projects.
Sustainability-Linked Bond Principles6
Sustainability-linked bonds are any type of bond instrument for which the financial and/or structural characteristics can vary depending on whether the issuer achieves predefined sustainability or ESG objectives. In that sense, issuers are thereby committing explicitly (including in the bond documentation) to future improvements in sustainability outcome within a predefined timeline. A sustainability-linked bond is a forward-looking performance-based instrument.
The Sustainability-Linked Bond Principles recommend a clear process and transparent commitments for issuers, which investors, banks, underwriters, placement agents and others may use to understand the financial and/or structural characteristics of a sustainability-linked bond. The Principles have five core components:
1. Selection of key performance indicators (KPIs)
The issuer’s sustainability performance is measured using sustainability KPIs that can be external or internal. The KPIs should be:
Issuers should publicly communicate:
2. Calibration of sustainability performance targets (SPTs)
A sustainability-linked bond is the issuer’s expression of its ambition level with respect of the KPI. SPTs must be set in good faith and should represent a material improvement in the respective KPIs, i.e. should be beyond a “business as usual” trajectory. Where possible, they can be compared to a benchmark or an external reference. They should be consistent with the issuers’ overall strategic sustainability / ESG strategy, and be determined on a predefined timeline, set before (or concurrently with) the issuance of the bond.
The target setting exercise should be based on a combination of the following benchmarking approaches:
3. Bond characteristics
The cornerstone of a sustainability-linked bond is that the bond’s financial and/or structural characteristics can vary depending on whether the selected KPIs reach the predefined SPTs, i.e. the bond will need to include a financial and/or structural impact involving trigger event(s).
The potential variation of the coupon is the most common example, but it is also possible to consider the variation of other financial and/or structural characteristics of the bond. The variation should be commensurate and meaningful relative to the issuer’s original bond financial characteristics.
Any fallback mechanisms in case the SPTs cannot be calculated or observed in a satisfactory manner should be explained. Issuers may also consider including disclosure in the bond documentation potential exceptional events (e.g. as significant change in perimeters through material merger/acquisition activities) or extreme events, including drastic changes in the regulatory environment that could substantially impact the calculation of the KPI, the restatement of the SPT, and/or pro-forma adjustments of baselines or KPI scope.
Issuers should publish, and keep readily available and easily accessible:
This reporting should be published regularly, at least annually, and in any case for any date/period relevant for assessing the SPT performance leading to a potential adjustment of the SLB’s financial and/or structural characteristics.
Issuers should seek independent and external verification (e.g. limited or reasonable assurance) of their performance level against each SPT for each KPI by a qualified external reviewer with relevant expertise, e.g. an auditor or an environmental consultant, at least once a year, and in any case for any date/period relevant for assessing the SPT performance leading to a potential adjustment of the SLB financial and/or structural characteristics, until after the last SPT trigger event of the bond has been reached.
The verification of the performance against the SPTs should be made publicly available.
As opposed to the pre-issuance external review which is recommended, post issuance verification is a necessary element of The Sustainability-Linked Bond Principles.
In structuring sustainability and ESG related bonds, the market practitioners should keep themselves abreast of the development in international guidance and standards, technological advancements, regulatory environment changes and, last but not least, the public expectations.