November 26, 2024

By Vasundhara Saravade & Anik Islam

Canada faces a significant challenge in funding its transition to a net-zero, climate-resilient economy by 2050. The financing gap is estimated at C$115 billion per year. At the same time, current capital flows from public and private sources are far lower, growing from just $15 billion to $22 billion in 2023, according to the Royal Bank of Canada. This leaves a gap of more than four times larger than current investment levels.

The Government of Canada rolled out a net-zero economy framework, committing more than $160 billion since 2016 through policies, regulations, information tools and funding mechanisms such as the Canada Growth Fund, investment tax credits and sovereign green bonds (totaling C$11 billion).  

While these spending commitments are crucial, there is a disconnect between commitments and actual spending. Corporate Knight’s Climate Dollars project estimates that of C$48.6 billion allocated for federal climate investments between 2015 and 2024, only C$34.3 billion was spent, highlighting a 30% gap in funding that was either behind schedule or unspent.

Financing the transition seems even more challenging now with rising borrowing costs, climate policy uncertainty and global political constraints. To unlock long-term private capital to help fill this financing gap, we must ensure Canada meets its climate goals and strengthens trust in innovative sustainable finance solutions.

One promising tool for this purpose are sustainability-linked bonds (SLBs).

What are SLBs and what makes them unique?

Sustainability-linked bonds are a sustainable finance tool designed to help issuers—like corporations or governments—improve their performance on environmental, social and governance targets. Unlike green bonds, which direct funding to specific green projects (e.g., building wind farms), SLBs focus on overall organizational sustainability performance.

What sets SLBs apart is their ability to:

1. Tie financial incentives or penalties to an issuer’s success in meeting sustainability goals.
   1. Example: If a company fails to reduce its greenhouse gas emissions (GHG) by a promised percentage, it might face higher interest rates on the bond.
2. Allow flexible use of funds, including for activities that aren’t traditionally “green” but still contribute to a low-carbon transition.

Key features and challenges

Similar to the green bond market, SLBs follow globally recognized voluntary frameworks, such as the International Capital Market Association’s SLB Principles or the Climate Bonds Initiative’s SLB Standards and Certification. Issuers can use these frameworks to identify relevant environmental, social or governance areas of improvement, create investment plans and provide annual disclosures and third-party verifications. Doing so allows issuers to follow the best market practices regarding sustainable finance.

Several features that set SLBs apart from conventional sustainable finance tools are the use of key performance indicators (KPIs): the what or measurable indicators of performance, and Sustainability Performance Targets (SPTs): the how much and by when or the specific targets set for these indicators.

• Example: A company might commit to reducing its carbon footprint (the KPI) by a certain percentage over several years (the SPT).

These design features are promising but they could be misused if they’re not guided and monitored by the market. The need to avoid greenwashing has already led SLBs to face some criticism:

• At the instrument level, issuers could benefit from lower borrowing costs (through a “greenium”) without meeting their targets or could take advantage of loopholes and buy back the bonds to avoid penalties.
• At the market level, critiques include weak transition plans to show how issuers plan to achieve their targets or increasing transaction costs impeding market development (like costs associated with tracking new types of data or lack of standardization of existing data).

Market players can overcome these challenges by working together to build a blueprint around the market through policy guidance, taxonomies or standards. The Smart Prosperity Institute believes that these barriers are worth addressing to realize the benefits of SLBs as part of Canada’s climate funding strategy.

SPI takeaways: Canada's path forward on SLBs

Many Canadian companies or financial sector actors can’t issue or invest in green finance because of their carbon-based model or internal resource constraints (such as a lack of internal funds for sustainability improvements or limited expertise in accessing green finance). This makes it hard to scale up climate finance today to match the enormous transition challenge we face over the next five years.

If done right, SLBs provide an alternative option where financing addresses transition needs and engages transition actors, without compromising on governance aspects like accountability or fiduciary duty. However, before tapping into this tool and its potential, policymakers and other market participants must address current market critiques. If we get the design right and provide the necessary market support, it will be worth the effort given the need for increasing sustainable finance to transition-oriented sectors and activities in Canada.

Our upcoming Smart Prosperity Institute SLB Policy Brief takes a deeper dive into the state of the market and its potential for having positive policy and corporate outcomes in addressing Canada’s low-carbon transition as well as diversifying sustainable finance flows.