Labelled Bonds’ Use of Proceeds: Transparency and Ambition Needed

Marina Petroleka, Global Head of Research, Sustainable Fitch, discusses green, social and sustainability bonds’ contribution to environmental and/or social impacts and the level of transparency and ambition in project or target selection, based on Sustainable Fitch’s ESG Ratings data.

Sustainable Fitch’s ESG Ratings provide a quantitative and qualitative assessment of the impact an issuing entity and its financial instruments have on the environment and society. We assign ESG Ratings to entities, to green, social and sustainability (GSS), and sustainability-linked debt instruments (collectively, ‘labelled instruments’), and to non-labelled instruments.

Most UoPs score well, but projects selected lack diversity

Among green bonds to which Sustainable Fitch has assigned instrument ratings, we find that renewable energy is the most common use of proceed (UoP) category, accounting for 27% of all UoPs in the rated universe, followed by energy efficiency (22%), clean transportation (16%) and green buildings (16%).

The selection of UoPs among the green bonds analysed indicates that issuers’ financed activities are aligned with key decarbonisation priorities, with around half of them focused on energy-related improvements. Issuers from the US have the largest number of frameworks that include renewable energy as UoP. This is perhaps surprising, given the lower regulatory pressure to decarbonise electricity in the US than in the EU.

Sustainable Fitch’s ratings methodology uses science-based taxonomies and sustainable debt market standards to assign scores to UoPs within green and sustainability finance frameworks. Clean transportation and renewable energy UoPs have the highest average score of 1 (on a scale of 1 to 5, with 1 being ‘Excellent’ and 5 ‘Poor’) indicating excellent alignment with best practices and environmental impact.

Among Sustainable Fitch’s rated bonds, we observe a skew towards green over social projects in sustainability frameworks. Green buildings is the most common UoP category, appearing about twice as often in sustainability frameworks as socioeconomic advancement projects, the second-ranked UoP. The top social UoP category is socioeconomic advancement, which are typically loans to SMEs owned by a target population, such as underrepresented minorities, women or rural residents.

Climate change projects skewed towards mitigation over adaptation

Climate change remains the predominant focus of most green, sustainability and sustainability-linked instruments within our ESG rating coverage. However, we note a disproportionate focus on climate mitigation relative to adaptation across most issuances, which we believe reflects a strong focus by issuers on managing Scope 1 and 2 emissions and exposure to associated risks.

Projects relating to green buildings and renewable energy tend to receive the highest share of UoP or KPIs, at an average of more than 70%. Other eligible project categories tended to receive a lower portion of overall UoP or KPIs. The significant focus on these categories is not surprising as combined greenhouse gas (GHG) emissions from the transportation and building sectors account for more than one-third of direct emission releases globally.

Scores under the UoP component of the ESG Framework Rating (ESG.FR) for climate mitigation projects generally fall between 1- Excellent and 2- Good, with an average score of approximately 1.41. This signals relatively close alignment with the established screening criteria.

We believe going beyond mitigation to focus on and finance climate adaptation is paramount, particularly for sectors such as real estate that remain most exposed to physical climate risks and are also the largest recipient of green and sustainable instrument-backed financing.

One encouraging sign is that adaptation projects are being implemented through labelled instruments in a number of particularly vulnerable sectors, including utilities.

More transparency and ambition needed in new projects and lookback periods

UoP labelled bonds can be issued to finance new projects or refinance projects that were originally financed under a conventional instrument. The vast majority of the bonds in our ESG instrument ratings data have limited additionality in terms of new projects. Within our rated instrument universe, 90% of bonds currently allocate between 1% and 24% towards new projects or do not disclose the information, while 5% of bonds allocate 0% of their UoP to new projects. Only 3% of rated entities allocate at least 75% of their UoP to new projects.

Our ratings data further show the vast majority of instruments do not follow best practices in terms of the lookback period for existing projects, which could be either financed or refinanced by the labelled bond issuance. The lookback period is the number of months or years an issuer will look backwards for eligible projects prior to the labelled bond issuance for which the proceeds may be used to refinance.

The best practice is having a lookback period of within one year, as a shorter lookback period supports greater additionality from the bond, enhancing progress towards sustainability goals and ensuring projects are relevant to the issuing entity’s sustainability targets. Our ESG Ratings data indicate instruments have a lookback period that is consistent with the standard market practice, which is 24 months. However, International Capital Market Association (ICMA) guidance in its Green and Social Bond Principles calls for a 12-month lookback period as best practice, which only 12% of rated instruments within our coverage have. Meanwhile, 49% of rated instruments that provide information on this indicator have a lookback period of between one and three years, and 38% have the lowest score, indicating a lookback period that is more than three years or not specified.

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