Debt investors can help solve the puzzle of financing the energy transition
Conservatively, at least 50% of an infrastructure asset can be financed with debt, which is higher than real estate or private equity assets. For the most stable assets, this number can reach up to 90%.
This makes infrastructure debt a prime area of investment opportunity that can help solve the energy transition puzzle. Yet it is a space that is only just beginning to be on the radar of Australian institutional investors.
Although ESG alignment is well established for equity investments in real assets – for example, the ability of shareholders to influence management practices and robust models for establishing KPIs – it has always been less clear how debt financiers can have a direct line of sight to their own ESG Objectives. Instead, they may have relied on practices established by shareholders.
However, this is changing and, like most ESG initiatives, originated in Europe and is spreading into global market best practices.
The end product is well-structured private debt investments that allow bond investors to influence the management of the borrowing company in a manner aligned with their own objectives.
How exactly is this achieved? Loans to customers or borrowing assets can be structured as green loans (or bonds) or as sustainability-linked loans, which are general purpose loans with underlying sustainability performance objectives, or KPIs.
Borrowers are incentivized through loan pricing to meet pre-agreed sustainability performance targets. When these KPIs are achieved, the borrower is generally rewarded with a decrease in the applicable interest coupon to a previously 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 intended for financing green projects – typically renewable energy initiatives like solar or wind.
Clearly a worthy cause – but unlikely to be enough to solve the energy transition problem on its own.
The advantage of a sustainability-linked loan is the breadth of opportunities it can apply to. For example, energy storage, green hydrogen, renewable fuels and other emerging technologies will all be essential as each sector addresses its own challenges and opportunities on the path to a 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 has reached record highs of more than 1 .4 trillion in 2021 and could reach over $7. trillion per year by 2025.
Sustainability-linked loans are currently primarily 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 geared towards broader ESG issues, providing greater transparency through KPIs on non-financial elements of the project.
For example, there is opportunity and flexibility in sustainability-linked lending to target the specific sustainable development goals of the company or infrastructure project being undertaken. According to their principles, KPIs should “be material to the issuer’s business and sustainability strategy and address relevant environmental, social and/or governance challenges of the industry sector”.
Data from Environmental Finance revealed 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 lending offers structuring flexibility and the potential for real economic benefits and positive ESG change. They have the added benefit of promoting sustainable finance and the energy transition in multiple ways, and rewarding integration and alignment rather than simply ending solutions that don’t reward the journey.
If we sum up the figures presented earlier – i.e. 50% of the US$275 trillion required over three decades – the possibility for debt investors to promote their own ESG objectives, and not to simply having them set by equity investors is clear.
The bridge that sustainability-linked lending provides between our energy transition needs and institutional investors’ desire for well-structured debt solutions is compelling.
Katrina King is Managing Director of Capital Solutions at QIC