September 24, 2022

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Solving the energy transition finance puzzle

This makes infrastructure debt a prime area of investment opportunity which can help provide a key to unlocking the energy transition puzzle. Yet, it’s a space that is just starting to be on the radar for Australian institutional investors.

While ESG alignment is well established for real asset equity investment – for example, the ability for shareholders to influence management practices and robust templates for KPI setting – it has traditionally been less clear how debt financiers can have a direct line of sight into their own ESG goals. Rather, they may have piggy-backed off the practices set by the equity holders.

However, this is changing and like most ESG initiatives, has originated from Europe and is disseminating into global best market practices.

The end product is well-structured private debt investments that allow debt investors the opportunity to influence the management of the borrowing company in a way which is aligned with their own goals.

Exactly how is this being achieved? Loans to borrowing clients or assets can be structured as green loans (or bonds), or as a sustainability-linked loans which are general purpose loans with underlying sustainability performance targets, or KPIs.

Borrowers are incentivised through loan pricing to achieve pre-agreed sustainability performance objectives. When these KPIs are achieved, the borrower is generally rewarded with a decrease in the applicable interest coupon to a pre-agreed floor.

Sometimes, if an ESG KPI is not met, the interest coupon increases. While green loans play an important role in the energy transition movement, they are primarily directed to financing green projects – typically renewable energy initiatives such as solar or wind.

Clearly a worthy cause – but unlikely to be sufficient to solve the energy transition problem alone.

The benefit of a sustainability-linked loan is in the breadth of opportunities that it can apply to. For example, energy storage, green hydrogen, renewable fuels and other emerging technologies are all going to be key as each sector navigates its own unique challenges and opportunities on the path to successful climate transition.

Sustainability-linked loans are becoming a more popular solution, with immense growth throughout 2021. According to the Institute of International Finance, global issuance of sustainable bonds and loans hit record highs of over $US1.4 trillion in 2021 and could reach over $US7 trillion annually by 2025.

Sustainability-linked loans are currently predominately issued in Europe, but I anticipate that they will become more prevalent in other regions in the coming years.
Careful structuring of these general-purpose loans can also be directed towards broader ESG issues, ensuring greater transparency through KPIs on the non-financial elements of the project.

For example, there is opportunity and flexibility in sustainability-linked loans to target Sustainable Development Goals specific to the company or infrastructure project undertaken. According to their principles, KPIs should ‘be material to the issuer’s core sustainability and business strategy and address relevant environmental, social and/or governance challenges of the industry sector’.

Data from Environmental Finance found that while the vast majority of KPIs focus on carbon/greenhouse gas emissions to date, there are a growing number of KPIs in other areas, including renewable energy, sustainable sourcing, gender equality and more.

Sustainability-linked loans offer structuring flexibility and the potential for real economic benefits and positive ESG change. They have the added benefit of promoting sustainable financing and energy transition in a multitude of ways, and rewards for integration and alignment rather than simply end solutions that don’t reward the journey.

If we do the sums on the numbers presented earlier – i.e. 50 per cent of a required $US275 trillion over three decades – the opportunity for debt investors to promote their own ESG goals, and not have them simply set by equity investors is clear.

The bridge that sustainability-linked loans offer between our energy transition needs and institutional investors’ desire for well-structured debt solutions is compelling.

Katrina King is general manager for capital solutions at QIC