22 November 2023 • 7 minute read

Sustainable finance: The basics

Increasingly we hear the term 'sustainable finance' in discourse surrounding climate change. But what does it mean and why does it matter? In this guide we provide a summary of the basics behind sustainable finance.

What is sustainable finance and why does it matter?

Sustainable finance is a form of debt funding for investments that are tied to ESG initiatives. There is a correlation between the risk adjusted return of those investments and their sustainability practices or outcomes. Without finance flowing in the right direction, the world will not achieve its climate commitments.

Climate action requires significant capital, and the financial sector plays a central role in addressing the climate crisis and driving a transition to a sustainable economy. There are several sustainable finance instruments already available, including bonds, loans, debt-for-nature swaps, and blended finance.

Five ESG categories inform the taxonomy of sustainable finance instruments:

Green: proceeds from these instruments are earmarked for green initiatives such as renewable energy, pollution prevention and control, clean transportation, or circular economy.
Social: proceeds are applied to new and existing projects with positive social outcomes such as affordable basic infrastructure, food security, and socioeconomic advancement and empowerment.
Sustainability: proceeds will be applied exclusively to finance or re-finance a combination of both green and social projects.
Sustainability-linked: the financial and / or structural characteristics of the instrument may vary depending on whether the borrower / issuer achieves predefined ESG goals and targets. For example, a failure to meet a pre-determined ESG goal could mean an increased coupon rate payable on a bond, incentivising the issuer to achieve the ESG goal or face a penalty.
Blue: proceeds are used to finance water and ocean-based projects that have positive environmental benefits and focus on SDG 6 (Clean Water & Sanitation) and SDG 14 (Life Below Water).

Sustainable finance instruments typically fall into two categories:

Use of proceeds: Any instrument where net proceeds are exclusively used to finance or refinance, in part or in full, new and/or existing eligible projects.
KPI-linked: Any instrument for which the financial or structural characteristics can vary depending on whether the issuer achieves predefined sustainability objectives.

Various market standards underpin sustainable finance, including the International Capital Market Association's (ICMA) Green, Social, Sustainability, and Sustainability-Linked Bond Principles and the Loan Market Association’s Green and Sustainability-Linked Loan Principles. These voluntary guidelines seek to establish international best practice and promote consistency and transparency for issuers and investors to have a shared understanding of the requirements for investments to be considered “sustainable”.

Blue finance is also a growing area, with the size of the ocean economy expected to double by 2030 as compared to 2010.[1] In September 2023, ICMA together with the International Finance Corporation – a member of the World Bank Group, United Nations Global Compact, United Nations Environment Programme Finance Initiative, and the Asian Development Bank—developed a global practitioner's guide for bonds to finance the sustainable blue economy (Blue Bond Guidance). The Blue Bond Guidance builds on ICMA’s Green Bond Principles and provides clear guidance on the indicative categories and considerations for eligible blue projects.

What are some of the benefits to sustainable finance?

Sustainable finance has many benefits for borrowers / issuers, both commercial and sovereign, including:

Reputational benefits: tying ESG ambitions to financing signals to the market that a borrower / issuer takes seriously its ESG commitments, which can improve the borrower’s / issuer’s reputation and credibility.
Attract a larger investor base: the investment landscape continues to become more climate conscious. Sustainable finance can attract investors who will want to align their investment outcomes to ESG-centred initiatives, and not just be motivated by price.
Improvement in corporate governance structures: the borrower / issuer will need to establish internal governance mechanisms to comply with the relevant sustainable finance metrics for the taxonomies under which such financing has been raised. This may lead to greater internal rigour in corporate governance mechanisms.
Access to dedicated ESG-segments: given the exponential leap in the adoption of sustainable finance, there has been a proliferation of ESG-centred markets, including exchange traded funds, stock exchanges, and other asset classes which reference sustainable finance-linked products. Such dedicated segments can help ESG-aligned issuers attract a larger investor base and market the sustainable qualities of the instrument.

What are the challenges?

Whilst the benefits of sustainable finance are undisputed, it faces several challenges, including:

Sustainability-washing claims: these can occur where a financial instrument is marketed as being tied to sustainable targets which the borrower / issuer then fails to meet or fails to use those proceeds towards the indicated sustainable project. Sustainability-washing claims can lead to significant reputational damage and litigation exposure.
Scalability & high transaction costs: mitigation and adaptation projects often require significant capital investments. A sustainable finance product must be weighed against the borrower’s / issuer’s existing debt whilst also being of an appropriate size to implement the project in a meaningful way.
Focus on spending rather than outcomes: use of proceeds instruments can cause borrowers / issuers to focus on spending rather than actually achieving any dedicated key performance indicator (KPI) or outcome.
Quantifying ambition: it is critical that a borrower / issuer choose criteria that are ambitious and meaningful to their operations. Tying capital raising to KPIs and sustainability performance targets may encourage borrowers / issuers to adopt “easy” targets for fear of not achieving more ambitious and meaningful outcomes.

What's next for sustainable finance?

Sustainable finance is a key agenda item at this year’s upcoming COP28. Key focal areas include making climate finance more affordable and accessible, in addition to ensuring that every concessional dollar is matched by USD 2 or 3 in private capital. The UNFCCC Climate Champion 2030 Breakthroughs will also be released at COP28. These breakthroughs target mitigation goals for 30 major economic sectors. Achieving these breakthroughs will require significant capital, further spurring on interest in sustainable finance.

In 2022, the sustainable finance market was valued at USD 4.2 trillion, and it is projected to grow to USD 30.9 trillion by 2032. As we move closer to the deadline for net zero, interest in and familiarity with sustainable finance will continue to grow for both public and private sector entities. Scaling up and mobilising climate finance will be a critical tool in encouraging further investment and ensuring the world’s climate goals are realised. The market for sustainable finance products is expected only to grow as both the public and private sector increase their ESG ambitions on the path to net zero.

Further reading

Footnotes

^{[1] Guidelines for Blue Finance (ifc.org)}