Every growing business should consider sustainable investing. One way to do so is through debt capital, which involves loaning from an institution, such as an investment bank or venture capital firm. Debt capital is essential to a company’s financial success because it can be reinvested to increase net worth while decreasing the risk of debt distress.
Today, businesses are increasingly acquiring different kinds of debt that yield positive social outcomes and financial returns, or what’s known as sustainable debt.
If you want to invest in socially and environmentally friendly projects, here’s everything you need to know about sustainable debt, its different types, and its challenges.
What Is Sustainable Debt?
Sustainable debt is issuing bonds or loans to invest in projects or businesses that promote social or environmental causes. In recent years, this definition has become more granular in meeting the sustainable debt market’s evolving scope and complexity.
Sustainable debt is broken up into two categories:
- Activity-based products: Investing in a project or business with an intended environmental or social outcome. Examples of activity-based products that use sustainable debt funding include affordable housing and energy efficiency initiatives.
- Behavior-based products: Linking debt’s financial component (e.g., loan interest rates) with a sustainability target. An example of a behavior-based sustainability target is a company going paperless to fight deforestation.
In other words, activity-based products are project-focused, while behavior-based products are target-focused.
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DOWNLOAD NOWBonds vs. Loans
Since sustainable debt involves bonds or loans, understanding the difference between the two is vital.
- Bonds are debt instruments used to raise funds for a project. They have high market values and are publicly traded by governments or companies to raise capital.
- Loans typically can’t be traded in the market because they’re agreements between two parties that rely on a debtor repaying a creditor.
Leveraging sustainability bonds or loans depends on what you'd like your investment to achieve. What net financial and environmental benefits are you aiming for? If unsure, consider these six types of sustainable debt when creating your business strategy.
6 Types of Sustainable Debt
1. Green Bonds
Green bonds are activity-based bonds issued to finance projects with the goal of positive environmental change. Green bonds guarantee that money is used to finance green projects.
Ventures like renewable energy efficiency, clean public transportation, and pollution prevention all qualify for green bonds, as they focus on improving climate conditions or sustainable energy.
Although green bond issuance doesn’t yet have a market standard, financers refer to the Climate Bond Standard and Certification and Green Bond Principles (GBP). Sustainable debt investors should be familiar with these guidelines when considering green projects, since these bonds make up approximately 46 percent of sustainable debt in the market.
2. Green Loans
Green loans are activity-based loans that operate similar to green bonds, but with one exception: They exist within the private market. Green loans were first introduced to encourage homeowners to make energy-saving improvements to their property, such as installing solar panels.
Green loans are intended to motivate businesses to adopt green policies by introducing environmentally friendly services and products. The primary sources for green loans are commercial lenders or peer-to-peer lending.
3. Sustainability-Linked Bonds
Sustainability-linked bonds (SLBs) are behavior-based bonds. Their funding is based on whether an issuer achieves sustainability goals by a certain deadline.
For example, a company pledging to reduce its carbon emissions by a certain percentage can qualify for an SLB. If it fails to reduce its emissions according to the terms of the bond, then it must pay investors more money.
4. Sustainability-Linked Loans
Sustainability-linked loans (SLLs) are similar to SLBs in that they’re behavior-based. Yet, because they qualify as loans rather than bonds, SLLs operate within the private sector and can’t be publicly traded.
SLLs motivate businesses to hit sustainability targets based on incentives, such as positively fluctuating interest rates influenced by sustainability performance. Maintaining sustainability targets and keeping interest rates down ensures a company’s capital significantly increases and provides a steady cash flow for investors.
5. Sustainability Bonds
Sustainability bonds are activity-based bonds intended to finance or refinance a combination of green and social projects. These projects must be aligned with the core principles of the International Capital Market Association (ICMA). ICMA guidelines follow the same standards as the Social Bond Principles (SBP) and the GBP.
6. Social Bonds
Social bonds are activity-based and intended to finance or refinance projects targeting positive social outcomes, such as affordable housing, LGBTQ+ rights, and education equity.
As with green bond issuance, social bonds depend on guidelines provided by the SBP. These guidelines equip investors with the knowledge and insight to assess investments’ risks and desired outcomes.
According to Pacific Investment Management Company (PIMCO), social bonds during the COVID-19 pandemic have mitigated their impact on low-income communities.
The Problem of Impact Washing
While sustainable debt investing has clear social and environmental benefits, this growing market has led to the rise of a phenomenon known as impact washing.
Impact washing is the practice of embellishing or overstating a particular investment’s positive impact. Without laws and proper regulation for sustainable investments, some bond issuers or fund managers exploit this trend by declaring assets, stocks, or bonds as green without backing up claims or guaranteeing results.
Impact washing isn't always done with malicious intent. When a company fails to measure its sustainability impact accurately, it can unknowingly mislead investors regarding its environmental or social impacts.
At its best, impact washing is careless; at its worst, it’s immoral. Therefore, a good investment in sustainable debt requires fully understanding relevant market guidelines.
Green Bond Certification
One way to avoid the looming specter of impact washing is by identifying investments with the Green Bond Certification.
The Climate Bond Standard and Certification is a common framework used to guarantee that a project’s involvement in sustainable debt funding abides by the criteria laid out in the 2016 Paris Agreement. This certification is the bond equivalent of the fair trade consumer label globally recognized by bond issuers. It’s a quick, easy way for investors to differentiate legitimate green bonds from those guilty of impact washing, providing peace of mind that their investments make a positive impact.
Make Your Debt Sustainable
Investing in sustainable debt isn’t without risk. As long as you carefully research, plan, and understand your goals, you can make a large-scale, sustainable impact on the global market.
Whether you’re an aspiring or seasoned sustainable investor, it's never too late to guarantee your investments are truly eco-friendly.
Are you interested in helping your business sustainably invest in green initiatives? Enroll in Sustainable Investing—one of our online courses related to business in society—and download our free guide on becoming a purpose-driven, global business professional to learn how sustainable debt can enable organizations to make a difference.
