(Bloomberg) -- A former HSBC Holdings Plc banker says one of the most criticized sustainable bond structures on Wall Street has the potential to dominate the roughly $6 trillion ethical debt market.

Sustainability-linked bonds, which tie interest payments to a company’s environmental or social goals, have to build trust and transparency for the market to grow, said Daniel Klier, the chief executive officer of ESG Book, a data provider. Still, SLBs have more potential than the dominant green bond market that will likely hit a ceiling, according to Klier, the former global head of sustainable finance at HSBC. 

Borrowers can use money raised with SLBs to fund just about anything — including everyday operations — as long as they pledge to meet certain environmental, social or governance goals. Proceeds from green bonds, on the contrary, can only be spent on projects with a direct environmental impact. Those bonds make up the largest category of sustainable debt by amount issued.  

“The green bond market has its very natural limitations,” London-based Klier said in an interview. “As a treasurer, the worst thing that you can do is essentially compartmentalize your funding base. You want to have flexibility.”

Klier’s view is contrary to that of many others in the market given the sharp drop in sales of SLBs in recent quarters. Investors have become increasingly worried that companies’ targets lack ambition and the penalties that accompany the bond sales are immaterial. There’s also a growing concern that the label could expose issuers to potential legal risks. 

Governments and companies around the world, including Israeli drug maker Teva Pharmaceutical Industries Ltd., raised $44.5 billion in SLBs through July 19, a 23.8% drop compared with the same period last year, according to data compiled by Bloomberg. Issuers, meanwhile, have priced $340.9 billion in green bonds during the same period, a 21.5% jump compared with the same period last year. BNP Paribas SA, the top green bond underwriter, expects a record year for the green bond market. 

The global SLB market at the peak of its popularity grew almost tenfold between 2020 and 2021 as the lack of restrictions around the use of proceeds and the prospect of lower borrowing costs lured all kinds of borrowers into the nascent asset class. Teva didn’t immediately respond to a request for comment. 

‘Elephant in the Room’

Companies are tapping the green bond market to finance parts of their business considered to be environmentally friendly while the majority of what an automotive, airline or a shipping company does may not be truly green, said Klier, who would prefer to see a shift in the entire business operation. Targets that companies set when issuing SLBs, such as cutting company-wide carbon emissions, address the broader sustainability goals.

“The elephant in the room is how progressive is the company overall?” Klier said. “That’s why I always think that the green bond market will find this limit at 3%, 4% or 5% of the global capital market. Then you need to go into the core of the general funding pool.”

At the moment, there isn’t a lot of consistency around how SLB issuers set their ESG targets and what qualifies as ambitious or not. More rigor is needed as the market expands, said Klier, 42. The bonds are relatively complicated and require issuers to put frameworks in place and collect information that hasn’t been collected before. 

“Yes, you get a bit of PR benefit out of this,” he said, referring to issuers. “But it means that for the next five to 10 years, you have to measure, you have to report. If the instrument actually creates more transparency and forces companies to disclose more, we’ve already won a lot.”

ESG Pushback

The backlash in the US against investing strategies that factor in ESG issues will likely force borrowers to be more thorough when labeling bonds before taking them to the market, said Klier. Issuers are starting to spend more time with underwriters to make sure their SLB targets are ambitious and the penalties material, he said. 

“Every little crisis is a good thing because it makes an industry grow up,” he said. “I look at this as a sort of that point between ESG 1.0 and ESG 2.0 and ESG 2.0 is a lot more data-driven, a lot more sophisticated.”

Read more: Tougher Wall Street Scrutiny Resets $6 Trillion ESG Debt Market

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