Sustainability in the financial sector has become increasingly important, both nationally and internationally. Governments and companies worldwide are stepping up their efforts and commitments to combat climate change. Switzerland is no exception to this trend and aims to achieve CO₂ neutrality by 2050. This article examines the diverse spectrum of sustainable finance instruments that are commonly utilized in Switzerland (see section 2), describes some challenges (see section 3) and provides an overview of the Swiss legal and the related regulatory framework (see section 4).

By Philipp Otto / Christian Schneiter (Reference: CapLaw-2024-61)

1) Introduction

From green bonds and sustainability-linked loans to impact investing and ESG-focused funds, sustainable finance instruments provide investors with opportunities to support projects and initiatives that prioritize sustainability and contribute to a climate-neutral economy. In recent years, the Swiss Federal Council has integrated sustainability considerations into its financial policy and has undertaken various reforms in sustainable finance. This presents a significant opportunity for the Swiss financial center to embrace sustainability within the finance sector.

Estimates from the Swiss Bankers Association in collaboration with the Boston Consulting Group indicate that an annual investment of CHF 12.9 billion is required to achieve this net-zero goal. This corresponds to a total expenditure of CHF 387.2 billion, with CHF 166.9 billion to be invested by 2030 and additional CHF 131 billion by 2040. Sustainable finance instruments play an important role in financing these substantial funds needs. Reaching the net zero target will require a considerable effort from the Swiss industry. To achieve this, all stakeholders (banks and other financial institutions, corporations and investors) will need to interact and a suitable legal and regulatory framework must be in place.

2) Sustainable Finance Instruments

The term sustainable finance is commonly used to refer to a range of finance instruments connected to ESG related aims which include, green, sustainability-linked and social financial products. Sustainable finance instruments are structured to align with ESG criteria, allowing investors to support and participate in sustainable financing while adhering to their environmental and social objectives. 

Both the absolute and relative number of green bonds in the Swiss market has been steadily increasing for years. The green bonds represent a total volume of CHF 25.6 billion, making up around 7.5% of the total Swiss Bond Index (SBI) bond volume. By the end of August 2024, there were 144 green bonds listed on SIX Swiss Exchange (SIX). The other sustainable debt finance instruments are less prominent in the Swiss capital markets with only one sustainability bond, five sustainability-linked bonds and four social bonds listed on SIX. Further, in the Swiss loan market, sustainability-linked loans are the most popular sustainable finance instrument. 

There are industry principles and guidelines for these kind of sustainable finance instruments which are published in particular by the Loan Market Association (LMA), the Loan Syndications and Trading Association (LSTA), the Asia Pacific Loan Market Association (APLMA) and the International Capital Markets Association (ICMA). These associations as well as rating agencies play an important role in promoting sustainable investments and providing transparency for sustainable finance instruments. 

a) Green and Sustainability-Linked Loans

A green loan is used as a general term for loans associated with green and sustainable lending. The funds from green loans are made available exclusively to finance, re-finance or guarantee eligible green projects. These may include financing initiatives such as pollution prevention and control, clean energy vehicle infrastructure, or sustainable water management. It is important to note that green loans do not involve pricing adjustments based on sustainability performance, unlike sustainability-linked loans. There is no specific guidance on the criteria for green loans in the Swiss frameworks (this also seems to be the case in the other local frameworks). However, Swiss lenders and borrowers use and refer to the Green Loan Principles (GLP), published by the Loan Market Association (LMA), the Asia Pacific Loan Market Association (APLMA) and the Loan Syndications and Trading Association (LSTA). To qualify as a green loan, it must comply with four core components: use of proceeds, project evaluation and selection, management of proceeds and reporting. Borrowers need to provide information on the environmental sustainability objectives of their green projects, the process for project selection, and the management and reporting of the loan proceeds. The GLP also recommend the use of qualitative and quantitative performance indicators to assess the impact of green projects.

The same industry associations have released the Sustainability Linked Loan Principles (SLLP), which provide guidance on sustainability-linked loans. In contrast to green loans, the funds from sustainability linked loans are used to incentivize the borrower to achieve certain ambitious, predetermined, regularly monitored and externally verified sustainability goals through key performance indicators (KPIs) and sustainability performance targets (but the funds must not be used for specific green, social or sustainable projects). Accordingly, the SLLP include four key elements: (i) aligning with the borrower’s sustainability strategy, (ii) setting measurable targets to assess the borrower’s sustainability performance, (iii) requiring the borrower to report progress on sustainability targets and (iv) implementing a review process to assess the borrower’s performance against sustainability objectives. 

b) Green and Sustainability-Linked Bonds

ESG bonds come in various forms, with the most prominent being green bonds that are issued to support environmentally friendly business activities. Another noteworthy instrument is the sustainability-linked bond, wherein the issuer pledges to meet future sustainability objectives or targets. It is important to note that, unlike green, social and sustainability bonds, the proceeds from sustainability-linked bonds (same as for sustainability-linked loans) are not exclusively designated for specific sustainable projects, but rather for general sustainable purposes. In Switzerland, green and sustainability-linked bonds can be issued by financial institutions, private companies and entities or organizations owned or controlled by a governmental body or public authority, the Swiss Confederation being no exception. 

3) Key Challenges: Accountability and the Role of KPIs

Following the initial wave of enthusiasm surrounding ESG finance instruments, a realization gradually began to take hold within the market, prompting a reevaluation of their efficacy: It became evident that the issuance of sustainability-linked bonds, for instance, did not yield the anticipated accolades for issuers, leaving them without any substantial recognition for their efforts. Additionally, the marketing endeavors aimed at promoting these products fell short of their anticipated impact. This led many issuers and corporate entities to question the value of diverting their attention towards ESG debt instruments, instead emphasizing the need to concentrate on tangible initiatives that truly drive meaningful change, such as the implementation of robust policies aimed at effecting genuine reductions in carbon footprint and other critical sustainability metrics.

Furthermore, ESG-related funding instruments became a strategic tool employed by companies operating in traditionally carbon-intensive sectors, such as the gas and oil industry, to enhance their public image and bolster their reputational standing. By actively engaging in the issuance of green and sustainability-linked bonds, these organizations sought to create a positive perception from a rating perspective. While these initiatives may have generated favorable headlines and satisfied certain ESG requirements set by banks and investors, the underlying reality remained that the true impact on ESG factors remained largely elusive. This phenomenon underscored the need for a more rigorous and critical evaluation of the actual outcomes and effects of ESG debt instruments. The risk of these instruments primarily serving as vehicles for marketing strategies rather than driving substantive change became increasingly apparent.

In the pursuit of transparency and accountability, it is imperative to scrutinize the true impact of ESG debt finance instruments. The focus should shift towards ensuring that these instruments genuinely contribute to sustainable development, rather than merely serving as superficial gestures or mechanisms to polish the public image of corporations. The alignment of incentives, the establishment of rigorous performance indicators and the scrutiny of issuers’ commitment to effecting tangible change are essential steps towards fostering a more robust and impactful ESG finance landscape. As the market evolves, it is crucial to address these challenges and strive for greater integrity, effectiveness, and accountability in ESG debt finance instruments to truly advance the goals of sustainability and responsible investment.

Another major challenge arose within the realm of sustainability-linked loans and bonds with respect to KPIs which are used to evaluate the borrower’s performance. Borrowers must carefully choose the KPIs to align with their business goals and ensure that they are measurable using consistent methodologies. 

The KPIs result in a reduction in pricing if they are met or in an increase, if they are not. Usually, a failure to achieve a KPI does not trigger the consequences of an event of default but rather a higher margin respectively coupon rate. Since it can be financially profitable for the lenders if a borrower or issuer does not meet the KPIs, sustainability-linked loans and bonds can lead to misincentives from an ESG perspective. There have been instances where borrowers were required to spend the amount of the penalty payment on sustainability purposes if it failed a KPI. There is, however, so far no established market practice in this respect. Consequently, a prevailing sentiment emerged, questioning the fairness and efficacy of the existing incentive structure. The realization that the failure to achieve pre-defined ESG targets could inadvertently benefit investors raised profound questions about the integrity of the system and the alignment of incentives. This finally also opens the door for potential claims of greenwashing. Therefore, lenders should ensure that the selected KPIs are material and relevant to the borrower in order to incentivize meaningful sustainability change. The sustainability performance targets set should be ambitious and demonstrate significant improvements in the relevant KPIs. They should be comparable to external benchmarks, consistent with the borrower’s overall sustainability strategy and must be established within a predetermined timeline, ideally before or during the loan origination process. Determining these sustainability targets requires a robust non-financial infrastructure that relies on solid materiality assessments, reliable data and external metrics assurance as well as monitoring tools. Various benchmarking approaches, such as analyzing historical performance and comparing against industry peers and standards, are to be considered when defining eligible sustainability targets. Ahead of a transaction, the borrower and the lenders or dealer banks must collaborate to agree on the appropriate KPIs and sustainability targets for the deal. It has become common practice to seek external opinions to assess the suitability of the selected KPIs and targets and to review any subsequent modifications. In cases where external review is not sought, borrowers must demonstrate their internal expertise in validating methodologies, for instance with limited assurance by their ESG auditor. It is necessary for borrowers to thoroughly monitor the targets, including internal processes and staff proficiency, and share this documentation with the participating lenders.

4) Swiss Legal and Regulatory Framework: Where do we stand?

The legal and regulatory framework currently in place in Switzerland is mainly related to ESG reporting and further measures but there are no ESG rules specifically related and applicable to debt finance transactions: 

– Report on non-financial matters:

In 2020, the people’s initiative “responsible companies to protect people and the environment (Responsible Business Initiative) was defeated and, as a consequence, the counter-proposal of the Parliament entered into force in January 2022by which the Swiss Code of Obligations was amended with specific ESG related reporting obligations on non-financial matters and due diligence and reporting obligations on conflict minerals, metals and child labor . These can be considered as the most significant ESG rules for large corporations under Swiss law. Accordingly, since 1 January 2023 listed companies, companies with bonds outstanding and companies subject to supervision by the Swiss Financial Market Supervisory Authority FINMA (Companies of Public Interest) above a defined size during two consecutive business years (i.e. with at least 500 full time equivalents (FTE) and a balance sheet of at least CHF 20 million or a turnover of more than CHF 40 million) must prepare an annual report on non-financial matters. This report is required to cover various ESG aspects (environmental matters, in particular CO₂ targets, social matters, employee-related matters, respect of human rights and the fight against corruption). On 1 January 2024 the implementing Ordinance on Climate Reporting entered into force which clarifies a number of the reporting obligations set out in the Swiss Code of Obligations and obliges the affected companies to report publicly on climate-related issues. Further, on 26 June 2024 the Federal Council initiated the consultation process for the amendment of the Swiss Code of Obligations introducing stricter rules on non-financial reporting obligations in line with the corresponding EU reporting obligations, in particular the EU’s Corporate Sustainability Reporting Directive (CSRD). It is intended that the reporting obligations on non-financial matters will apply with respect to (i) companies of Public Interest irrespective of their size and (ii) companies which exceed two of the following thresholds in two consecutive years (provided that no exemption applies): (1) 250 full-time employees, (2) a balance sheet of at least CHF 25 million and (3) CHF 50 million in turnover. The possibility provided for in the current law to waive reporting (Comply or Explain Approach) is abolished. Due to the expanded scope of the new law, the Federal Counsil estimate that the number of Swiss companies affected by these new rules will increase from (only) approximately 200 under the current law to around 3,500 under the new law. Besides the expanded scope, more detailed and more comprehensive information would also need to be disclosed under the new law. Unlike companies in the EU, however, Swiss companies will have the choice, in relation to the sustainability reporting, to either follow the EU standard or another equivalent standard to be defined by the Federal Council in the corresponding ordinance. The consultation period will last until 17 October 2024. The revised rules can therefore not be expected to enter into force before January 2026.

– Due diligence and reporting obligations regarding conflict minerals and metals and child labor:

The rules regarding conflict minerals and metals and child labor apply to all companies with a legal seat, head office or principle place of business in Switzerland if (i) they place in free circulation or process in Switzerland minerals containing tin, tantalum, tungsten or gold or metals from conflict-affected and high-risk areas or (ii) they offer products or services in relation to which there is a reasonable suspicion that they have been manufactured or provided using child labor. Thus, these rules currently impact significantly more companies than the rules relating to reporting on non-financial matters. Further, these rules not only require the publication of a report but also adherence to certain due diligence standards.

– CO₂ Act and CO₂ Ordinance: 

Switzerland’s international climate obligations under the Paris Agreement have been implemented in the CO₂ Act and the CO₂ Ordinance. The over-arching goal of these is the reduction of greenhouse gas emissions by 2030.  

– Financial sector specific regulations:

FINMA is the main authority of climate-related regulation in the Swiss financial sector. It revised its “Disclosure – banks” (2016/01) and “Disclosure – insurers” (2016/02) circulars in May 2021. Accordingly, large banks and insurers that are supervised by FINMA must outline the main financial risks associated with climate change and how they affect financial planning, company strategy, and business models. They must also provide quantifiable data on their climate-related financial risks, together with a description of the methodology used, and the process for detecting, evaluating, and managing these risks. The Task Force on Climate-related Financial Disclosures (TCFD) recommendations served as the foundation for the new FINMA regulation. Further, FINMA introduced the FINMA Guidance 01/2023 “Developments of management of climate risks” that entered into force on 1 January 2024, the FINMA Guidance 03/2022 “Implementation of climate-related risk disclosures by category 1-2 Institutions” and the FINMA Guidance 05/2021 “Prevention and Combating Greenwashing”.

In addition to this, Swiss financial institutions are driven by self-regulation. Organizations such as the Swiss Bankers Association (SBA), the Swiss Sustainable Finance organization (SSF) or the Asset Management Association (AMAS) therefore play an important role promoting ESG investments. Both, the SBA and AMAS have taken a number of measures in recent years to help the Swiss financial center establish a leading international position in the area of sustainable finance. For instance, the SBA issued sustainable finance guidelines which provide for rules for (i) financial service providers on the integration of ESG-preferences and ESG-risks and the prevention of greenwashing in investment advice and portfolio management, as well as (ii) mortgage providers on the promotion of energy efficiency. Both sets of guidelines are binding for SBA members and entered into force on 1 January 2023. A particular concern of the SBA is that Swiss withholding tax places financial instruments issued in Switzerland at a disadvantage to the international competition. Already in 2021, the SBA called for a rapid and pragmatic reform of withholding tax in order that sustainable products and services in particular can be positioned competitively in the international marketplace. Further, AMAS introduced “Self-regulation on transparency and disclosure for sustainability-related collective assets” in 2023 which was replaced by version 2.0 on 1 September 2024. Accordingly, AMAS members that produce and manage sustainable financial products are subject to certain binding organizational, reporting and disclosure obligations.

5) Outlook

Looking ahead, the future for the ESG angle in debt finance in Switzerland is generally promising and presents significant opportunities. This rapidly evolving field serves as a valuable tool for aligning funding requirements with the broader ESG objectives of both corporates and the financial sector. As the industry matures, there is a growing emphasis on integrating ESG targets within corporate frameworks, thus leveraging financial accounting practices and methodologies. Further, the incoming non-financial reporting obligations will require a precise alignment between ESG debt finance transactions and the non-financial disclosure requirements. As shown above, this shift towards greater integration brings several benefits. Firstly, it reduces the margin for error and enhances the precision and accountability of ESG performance measurement. By aligning ESG targets with financial accounting practices, corporates can ensure more accurate tracking and reporting of their sustainability initiatives. Secondly, a closer alignment also facilitates the efficient combination of funding needs with corporate sustainability goals. 

While the ESG angle in debt finance is still in its early stages, the focus on beneficial outcomes for both corporates and banks, as well as the real impact on sustainable change, remains crucial. The industry is increasingly recognizing the importance of generating tangible results and meaningful impact. As stakeholders continue to refine their approaches and best practices, there is a growing potential for ESG debt finance to drive positive change and contribute to a more sustainable future. Nevertheless, there remains a degree of indeterminacy regarding the precise composition and configuration of sustainable finance instruments and the triggers to be incorporated. Thus, in order for sustainable finance to realize its full potential in Switzerland the introduction of further incentives on a legal as well as regulatory level should be considered.

In conclusion, the outlook for the ESG angle in debt finance in Switzerland is characterized by ongoing development and increasing alignment with financial accounting practices. This presents a unique opportunity to efficiently combine funding needs with corporate sustainability goals. By focusing on generating beneficial outcomes and tangible impact, the Swiss industry can further enhance the effectiveness and relevance of ESG debt finance in driving sustainable change.

Philipp Otto (philipp.otto@nestle.com)
Christian Schneiter (christian.schneiter@vischer.com)