Navigating the evolution of sustainable finance

In light of COP28 initiatives, Hatch experts Jonathan Lee, Bianca Bustamante, and Manuel Araujo recently discussed the transformative journey of sustainable finance and its convergence with mainstream financial practices. In a conversation that revolved around the intricate dynamics of financing in the energy transition landscape, the group shed light on how bespoke sustainable finance solutions are seamlessly merging into mainstream financial frameworks and discussed the challenge of finding projects that truly meet environmental, social, and governance (ESG) criteria.

With particular focus on the myriad forms of sustainable finance including green, social, blended sustainability, and transition bonds alongside UN development goals, the evolution of sustainable finance from a separate stream into an integral part of the energy transition was brought to the forefront as this paradigm shift was explored alongside the heightened interest in energy transition financing.

Investors are using thematic bonds to reduce ESG risks, diversify their portfolios, and achieve environmental and social returns. By providing lessons and warnings for the global community as it expands sustainable finance, this investment is blazing a trail that can eventually reach into trillions of dollars in climate-related projects.

Notably, financing in the liquid natural gas space—particularly in the growing focus on decarbonizing new projects—now involves financial covenants that prioritize sustainability performance metrics. This is a significant change in the landscape, with project finance loans now also tied to covenants with sustainable criteria; a contrast from five years ago when project finance was not inherently linked to sustainable finance. Along these lines, bond issuances are also now being tied to sustainability metrics, representing another dimension of this evolving financial landscape.

While European markets have embraced sustainability finance, with interest rates linked to stable metrics, there has been a recent surge in interest from the U.S. and Canadian markets, aligning more with environmental considerations and integrating quantifiable metrics into the process. This task highlights the need to assess sustainability at all levels, including suppliers and their suppliers as more granular carbon emissions reporting data will become available. The covenants in the finance agreement regarding Scope 1 and 2 GHG emissions reduction commitments must be fully disclosed within the first two years of the transaction.

Sustainability metrics, including relevant carbon emissions, are more challenging to monitor within the global supply chain. The complex introduction of CBAM (Carbon Border Adjustment Mechanism) in the EU from 2026 will accelerate this assessment. CBAM seeks to ensure a consistent platform across both EU and non-EU producers in pricing carbon emissions into the cost of production. The first quarterly reporting for the cement, iron and steel, aluminum, fertilizers, hydrogen, and electricity industries is due January 31, 2024, and would cover the period from October 1 to December 31, 2023.

To take a broader perspective on ESG, there are particular challenges and nuances of assessing social and governance aspects; with the evolving nature of these criteria, especially in developing countries where social considerations extend to community engagement, inclusion, and adherence to cultural values, they can be difficult to evaluate and measure, which presents a new challenge: lender requirements.

With a growing trend of refusing investments in high carbon-emitting industries, these sectors are experiencing transition from penalizing projects to an outright refusal to finance them, especially in more developed regions, ultimately presenting the question of whether it’s possible to truly balance the ESG trifecta. There’s a complexity involved in aligning corporate policies with lender requirements, begging the question whether they are converging or diverging.

There are pitfalls, too, associated with sustainability-linked bonds (SLBs). Contrary to green bonds, where all or part of the proceeds must be used for financing or refinancing new or ongoing green projects, SLBs are debt instruments whose financial characteristics may vary depending on whether ESG goals selected by the issuer are met. This begs the question of whether the market should reward businesses for meeting targets or if they should be penalized for missing them, and if SLBs should be viewed as standard best practice or remain forward-looking performance-based instruments.ⁱ

In the US markets, the Made in America Act aims to ensure that materials used in federal infrastructure projects are domestically produced, requiring the Department of Commerce to set standards for determining the appropriate manufacturing processes to best employment opportunities. While this creates social governance, it leaves the matter of environmental standards dangling. To negate this, there’s potential to finance projects based on their decarbonization plans, which then leaves the social component of ESG hanging, particularly in the developing world.

Sustainable finance remains nuanced, with varied interpretations within the industry, but it’s worth emphasizing the distinction between financing linked to ESG criteria and financing projects focused on the energy transition. Ultimately, the goal of finding projects that encompass all three dimensions—environmental, social, and governance—faces challenges in achieving this trifecta.

As leaders in this space, Hatch aligns project execution with sustainability goals, taking care to ensure these priorities remain at the forefront of new technologies and decision-making processes. Together with our clients, we partner to ensure we’re investing innovatively, fearlessly leading the way toward a greener, brighter global economy.

We would like to hear about your challenges in achieving a net-zero future by 2050. We are at COP28 and we’re eager to share our experience, expertise, and lessons learned in the climate change arena.

ⁱ The pitfalls associated with sustainability-linked bonds - McMillan LLP