What are sustainability-linked bonds and how do they work?
What are sustainability-linked bonds and how do they work?
We often hear that sustainable, responsible, or environmental, social and governance (ESG) investing has gone mainstream or reached a tipping point. For fixed income, ESG is increasingly significant.
Without equity voting powers, however, it is not always obvious which avenues bond investors can use to actively invest in or engage issuers. A growing new generation of ESG bonds, clearly linked to sustainability, is opening up opportunities.
The pace of ESG bond issuance has increased over the past two years. Green bonds, where the capital raised is used on environmental initiatives or projects, make up the largest share. Last year, the volume of social bond issuance, where the proceeds are used for basic needs like quality jobs or access to healthcare, increased sevenfold, partially in response to Covid-19.
Also emergent and growing, but so far less widespread, are sustainability-linked bonds (SLBs). They are issued with specific sustainability performance targets (SPTs), which contain key performance indicators (KPIs), for example “percentage of recycled materials used in manufacturing by target year 2030.” If the SPT is missed, the bond is subject to a “step-up” clause, meaning the bond interest increases.
What are the origins of sustainability-linked bonds?
Italian power utility company Enel issued a Sustainable-Development-Goal-(SDG)-linked bond in September 2019. It targeted a 55% share of renewables in its power generation capacity by the end of 2021, with a 25 basis points (bps) step-up in case of failure. It linked the target to executive remuneration.
Since Enel still used coal-fired generation at the time, reaction from pure green bond investors was mixed. With a more forward-looking view, I believe the bond represented genuine environmental ambitions.
So far SLBs remain a small part of the overall landscape of ESG bonds, relative to green and social. Issuance has come from Europe mainly, but more recently from Latin America and Asia as well.
Since 2018, banks have extended sustainability-linked loans to incentivise borrowers to transition away from environmentally and/or socially harmful practices and improve external ESG ratings. This improves the environmental profile of banks’ own credit portfolios. The concept cements the connection between a borrower’s sustainability objectives and financing cost over time.
Sustainability investment is about profit with purpose, looking longer-term and going beyond just financial consequences. Any material impact on the company’s finances, operations and reputation due to progress related to SLB KPIs might also have an impact on the company equity price.
What are the pros, and cons, of sustainability-linked bonds?
An SLB represents or encapsulates corporate level objectives. They help a wide range of issuers to express their near-to-medium-term sustainability priorities. They also make their commitments explicit and measurable to bond investors, as well as to environmental regulators.
They can be helpful for companies aiming to establish ESG credentials from a lower base or from a less green sector or country. So SLBs are in some ways more inclusive and diverse.
The coupon step-up can also be conditional on multiple objectives. Take Brazilian paper company Klabin. The company’s SLBs have three KPIs, to be achieved by 2025: reduce water consumption, increase minimum reuse/recycling of solid waste and reintroduce at least two native animal species in extinction or threatened on the company’s land.
As with green or social bonds, companies will report annually on the performance indicator. Investors, however, need to check if the objectives have current and future relevance, and do not just relate to past management actions. They should also have lasting impact. Klabin’s KPIs are part of larger aims extending to 2030, and evaluated externally.
As the examples demonstrate, SLB frameworks give clear, measurable targets and impose financial costs on the company if they are not met. This gives investors visibility and a concrete basis for engagement with the company and holding the company to account.
At the same time, some have suggested that KPI failure would actually be the better outcome for investors since it would result in a higher coupon, so higher running yield. This is short-sighted in my view.
Failure to meet a KPI engenders reputational risk as well as depriving the company of any benefits of meeting the target. This could be reflected in a weaker share price or higher interest costs at a later date. Failure would necessitate a reappraisal of the investment decision, engagement with the company to understand the genuine reason and plan, and potentially divestment.
As a dedicated sustainable investor, achieving the objective on or before the intended date is key. If the objective is met, and provided it is meaningful, the company is fundamentally improving. This has various benefits: reduced costs through use of resources, aligning business operations with longer-term global themes, contributing to reduction of environmental risk or development of sustainable infrastructure. This is the basis for a solid long-term investment in my view.
How do SLBs compare to green or social bonds?
SLBs reflect commitment at the issuer or company level. Green and social bonds tend to be more focused at the project level and on use of proceeds. While recent green bonds have originated from new sectors like leisure and autos, identifying sufficient or only green or social use of proceeds might be challenging for certain sectors or geographies, or for smaller businesses.
An SLB is more versatile and in its presentation and objectives can offer opportunity to issuers to communicate the strategic sustainability activities in detail and with a specific timeline. It has intrinsic advantages. If the issuer reaches its target, the overall sustainability and therefore fundamentals of the business are enhanced. If that does not happen, the issuer pays up and the investor is compensated and might choose to exit.
What investors might miss is the associated impact reporting, for instance where most green bonds provide reporting on specific projects. One thing to watch with SLB issuers in yearly reporting is the trajectory of progress and that details are provided – and not only nearer to the deadline. In both cases yearly verification by an independent and qualified external reviewer is essential.
Interestingly, Aeroporti di Roma, which is a green bond issuer, recently issued an SLB framework and bond as a complement to the green bond and its impact towards SDG 13 (Climate Action).
While investors could worry over the overall sustainability credentials of some green bond issuers, when it comes to SLBs the sustainability trajectory is very much the essence and a plus.
Are there particular sectors where SLBs are more important?
SLBs have broad appeal and open up the potential for all kinds of companies to issue. Retailers Tesco, H&M and Ahold have all issued SLBs with targets such as reduced carbon intensity, and the increased recycling of textile materials and food waste.
It can be particularly helpful to sectors where sustainability is challenging. So in shipping, for instance. Norwegian company Odfjell’s SLB is linked to reducing carbon intensity by 50% between 2018 and 2030. Sea transportation is essential to global trade, so we need transition within the sector. Odfjell’s framework can help us learn about shipping fleet replacement, technical improvement and alternative fuel. With this issue, if the CO2 emission reductions are missed, investors will be paid 1.5% (in Norwegian krone) extra on the principal amount lent, at maturity in 2025.
Looking at the SLB bond issues so far, have companies been ambitious enough with the targets?
We all need to catch up if the UN Sustainable Development Goals (SDGs) are to be achieved globally by 2030, so investors expect and urge companies to be more ambitious, and the sooner the better.
First, targets which are leading within sectors and/or geographical context are important and goals which can be achieved under different scenarios is key for credibility. This is developing over time. Second, involving stakeholders like customers and suppliers is important, to ensure sustainability objectives continue after the SLB matures, with company resources committed.
The SLB bond supply represents a small proportion of the ESG market overall, but it is growing fast in 2021. Diversity and ambition of targets should improve as investors negotiate with companies and develop a clearer picture of best practice.
How robust are SLB frameworks?
The Sustainability-Linked Finance Framework has been developed in accordance with the Sustainability-Linked Bond Principles, established by the International Capital Markets Association (ICMA) in June 2020. While this is recent, companies have experience from similar loan documentation. The framework needs to encompass selection of KPIs, calibration of SPTs, instruments structuring, reporting and verification. In general, an SLB with multiple objectives is interesting.
One might ask whether a step down clause would work. I think it could foster short-termism. The company may look to achieve the coupon reduction and then say job done rather than striving for ongoing improved sustainability.
Ultimately, any framework needs to be assessed holistically. The key thing to determine is whether the company is committed and ambitious, and the SLB objective(s) will make a difference and add value.
Will governments issue SLBs?
SLBs from governments or agencies will emerge and give scale and liquidity to the young SLB market. They will give investors as well as taxpayers concrete examples of sustainability targets, in doing so helping to “set the bar”.
Sovereign SLBs can be linked to job creation in social or environmental sectors, promoting equality, or setting up accessible electric vehicle charging infrastructure at scale. The global development banks could also assist technically to bring SLBs from emerging market member countries to focus on Sustainable Development Goals.
Governments can also offer technical assistance or technology which could then be featured in a sustainable-linked bond.
Governments can play a big part in driving sustainable change and acting as role models.
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