Be careful when you paint it green: As they become more aware of the practice of greenwashing, customers are demanding more transparency from companies when it comes to environmental claims.dimdimich/Getty Images/iStockphoto
Eugene Ellmen is a former executive director of the Canadian Social Investment Organization (now the Responsible Investment Association). He writes about sustainable business and finance.
A recent capital markets innovation – sustainability-linked debt – started with the great premise that companies borrowing to achieve social or environmental benefits should be rewarded through lower financing costs on their loans or bonds.
But what started out as a good idea developed a big problem. Lack of clear standards has created a rush of companies looking to use the mechanism to lower their financing costs at a time when many banks are keen to issue such debt to burnish their sustainability reputation.
With weak rules for setting social and environmental results, sustainability-linked debt has become tainted with greenwashing.
In Canada, potentially tens of billions of dollars of sustainable finance pledges by the banks are at risk of greenwashing if they can’t assure the public and their investors of the environmental and social benefits of their sustainability-linked debt.
Sustainability-linked loans and sustainability-linked bonds are different from much-older green bonds or loans, which are issued on condition that the debt is put toward a specific “use of proceeds,” such as a renewable energy facility or affordable housing project.
Instead, these loans and bonds are used for the general financing of an issuer or borrower, which pledges to achieve a sustainability performance target – for example, a reduction in corporate CO2 emissions by a specific date. If the borrower or issuer achieves the target, it receives an interest rate reduction from the lender or investor. Sometimes a failure will result in an interest rate increase.
This sounds good in theory. But often this performance promise has been tied to already established corporate goals, leading to no additional sustainability benefit. Or the debt has been used to lower overall borrowing costs which, in the case of some oil and gas companies, has resulted in higher CO2 emissions as they ramp up fossil fuel production. And still in other cases, the penalties have been so small that they have provided no significant cost for failure to meet the sustainability performance target.
Standards are sliding so badly that some banks are beginning to issue “sleeper” sustainability-linked loans – this credit has no predefined sustainability performance targets, which are instead negotiated after the loan is issued.
In Canada, Investors for Paris Compliance, a shareholder advocacy group, has brought these abuses to the attention of the Ontario Securities Commission and the Autorité des marchés financiers, Quebec’s securities regulator. The advocacy group wants the regulators to investigate whether Canadian banks are misleading investors on their sustainable finance commitments because of widespread use of sustainability-linked loans.
Tens of billions of dollars in sustainability-linked debt is being deployed by Canadian banks, part of the $2-trillion in sustainable finance the five major banks have promised to make in coming years for low-carbon and other environmental, social and governance purposes.
In its voluntary climate disclosures, Royal Bank of Canada RY-T reported that 38 per cent of its $84.8-billion in sustainable finance deployed in 2022 was in the sustainability-linked category, putting it at $32-billion. Similarly, Toronto-Dominion Bank TD-T reported nearly $25-billion in sustainability-linked loans in 2022, nearly twice the value of these loans in 2021.
For investors in the banks, sustainable finance is an important tool to help address Canada’s social and environmental challenges, particularly to help mobilize capital for the climate and energy transition. But it’s also a critical strategy to mitigate climate risks posed by heavy bank exposure to the fossil fuel industry. By watering down sustainability impacts, these loans and bonds jeopardize both these goals.
As well, Canada’s banks are coming under increased scrutiny on their climate policies and the carbon emissions caused by their financing activity. New rules published last year will require banks to disclose the full scope of their financed emissions at the end of the 2025 fiscal year.
Meanwhile, the issue is grabbing the attention of other financial regulators. Last year, Britain’s Financial Conduct Authority warned the British banks that sustainability-linked loans pose a risk of greenwashing and conflicts of interest.
The writing is on the wall. The banks need to tighten their criteria. Sustainability performance targets should be based on major social or environmental outcomes. And the interest rate benefit or penalty needs to be steep enough to create a significant incentive for the borrower to meet the target.
Regulators can help this process by requiring the banks to disclose emissions on their sustainable finance product lines, in keeping with broader emissions transparency requirements.
If the banks can’t find borrowers willing to play by these tougher rules, they should abandon the market altogether and focus on the clearer use-of-proceeds approach of green bonds and loans.