Sustainability-Linked Debt Instruments and Their Potential Credit Impact Through Cost of Capital

DBRS Morningstar released a commentary titled “Sustainability-Linked Debt Instruments and Their Potential Credit Impact Through Cost of Capital.” Sustainable debt, also called ethical financing or environmental, social, and governance (ESG)-related debt, saw a record year in 2020 with approximately $730 billion in issuance, growing 31% over 2019.

The commentary highlights the following:
-- New sustainable finance instruments (sustainability-linked debt) have emerged in the past three years, further boosting growth in sustainable debt.
-- Because these instruments are linked to pre-specified ESG-related objectives rather than use of proceeds, they allow a wider range of corporations to tap the sustainable debt market.
-- The cost of borrowing for a corporation that issues this new type of sustainability-linked debt is linked to whether it achieves or misses its predetermined sustainability targets or scores.

“While ESG credit risk factors typically focus on regulations that may impose financial penalties on a corporation, new sustainability-linked debt instruments may have a more direct effect on credit quality through cost of debt capital,” says Radi Annab, Vice President, Infrastructure, Power & Utilities. “As this asset class grows, more corporations will incorporate ESG objectives into their strategy. As investors focus more on ethical and sustainable portfolios, the link between achieving or missing ESG objectives and the cost of debt may become an increasingly important credit consideration.”