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Are sustainability-linked bonds really a green option?

Last year saw a slowdown in new SLB issuances, though there has been a weak recovery in the first half of 2023 (Photo: Fahroni/Envato)
Last year saw a slowdown in new SLB issuances, though there has been a weak recovery in the first half of 2023 (Photo: Fahroni/Envato)

Sustainability-linked bonds offer investors a profitable way to lend to companies with green and social targets, say supporters, but others are unconvinced by their credentials

Sustainability-linked bonds allow investors to provide companies with balance sheet financing linked to targets such as greenhouse gas emissions reductions or boardroom diversity, as opposed to financing specific projects through instruments like green bonds. Investors normally receive additional payouts in the form of coupon step-ups if these targets are missed, a practice that has been called into question by some experts for its rather perverse logic of rewarding investors for a company’s failure to be as sustainable as planned.

The market is still in its infancy, representing just 4 per cent of the $6.4tn of sustainable debt issued to date, shows a July BloombergNEF report. Italian utilities giant Enel issued the first SLB in 2019 in a move Nelson Ribeirinho, senior credit analyst at asset manager Mirova, describes as “a game changer”.

After a bumper 2021 for SLB issuances, there was a slowdown in new offerings in 2022 and a weak recovery in the first half of this year, says FTSE Russell.

SLBs have suffered a similar fate to other fixed income products in recent years, with high inflation and rising interest rates pushing investors away. There may, however, also be SLB-specific factors behind the slowdown in issuances.

Missed performance targets

SLBs normally have sustainability performance targets linked to the interest they pay out to investors. Enel, having issued $29.4bn in SLBs across 28 bonds, according to a June note by non-profit Anthropocene Fixed Income Institute, is by far the largest SLB issuer. The utility’s bonds carry interest rate step-ups in the event that emissions reductions targets are missed. Generally, these penalties are increases of 25 basis points on the bond’s original coupon, says FTSE Russell.

By mid-2023, 35 SLBs had been examined against their sustainability performance targets, says FTSE Russell. Polish oil refiner PKN Orlen missed an environmental, social and governance rating target with an observation date of December 31 2022, Greek utilities company Public Power Corporation missed an emissions target with the same date, and packaging manufacturer San Miguel Industrias missed a renewable energy SPT with a January 2023 observation date.

As well as large payouts to investors, missed SPTs could trigger ESG rating downgrades for issuers and have an impact on SLB pricing. “If they’re missing targets, that means more step-ups — either the targets are too robust or the corporate’s not doing enough,” says Jonathan McKeown, director of ESG at broker Davy. “In terms of issuance spreads, if they’re going to have to pay an additional step-up, then you’d expect the prices or the issuer spreads to be slightly lower.”

SLBs do not have a significant mark-up in price versus vanilla bonds, says Rob Lambert, portfolio manager at asset manager RBC BlueBay. But they tend to outperform during a downturn because their holders are more likely to be sustainable funds than conventional holders, which have different objectives beyond quick returns

“In the past couple of months, we’ve started to see SLBs outperform, given that a number of companies’ SPTs are now looking challenging,” Lambert says.

Two of Enel’s SLBs, which are expected to miss their SPTs next month, mature in 2030 and 2031, respectively. The lengthy timeline of some of these bonds means that missed SPTs could be lucrative for investors that hold them for an extended period.

“Some of these bonds are quite long-dated,” Lambert says, referring to the revenues received by their holders over an extended period. “If that coupon steps up at the start of next year, over 10 years it’s going to be a material addition to your coupon stream.”

Enel will meet SLB obligations

A number of SLBs are due for inspection in December against their SPTs. Not all issuers are expected to meet their objectives, suggests AFII.

Enel faces a yearly increase of $27mn in its interest payments for 10 of its SLBs — together worth $10.8bn — and its half-year reporting suggests that a target linked to the emissions intensity of its power generation would be tough to achieve, says AFII. The non-profit notes that in November, Enel announced in a strategic update that it is reducing its investment in renewables, and with other Enel SLBs targeting reductions in emissions intensity by 2024 and 2025, these targets may also prove difficult to meet.

An Enel spokesperson says: “The global energy system was disrupted by the extraordinary and unpredictable events which started in 2022. In this context, Enel confirms its full compliance to any contractual obligations arising from the step-up clause envisaged at the time of issuance.”

In the past couple of months, we’ve started to see SLBs outperform, given that a number of companies’ sustainability performance targets are now looking challenging

Rob Lambert, RBC BlueBay

PPC, meanwhile, confirmed in March that its own shortfall in its Scope 1 carbon dioxide emissions reductions was due to a need to increase coal-fired power generation to safeguard Greece’s electricity supply during the energy crisis, an AFII note shows.

Elsewhere, the non-profit puts San Miguel Industrias’s chances of meeting its SPT at “50:50”, largely due to a lack of available data. Limited recent reporting has created the risk of volatility, AFII says. Sustainable Views has contacted San Miguel Industrias for comment.

AFII also believes it is uncertain whether pharmaceutical company Novartis can achieve an SPT based on the number of patients it reaches annually in low and middle income countries via its more innovative treatments. While Novartis is on track to meet this SPT, with three years between the target’s last observation point and its next assessment, “even a low level of volatility will still create a meaningful chance of a miss”, it says.

“We are confident our SPTs are on track to be met,” a Novartis spokesperson says. “This is supported by the progress that we have made against our SLB targets in 2022.”

Targets ‘can be gamed’

For now, the lion’s share of these bonds are dedicated to environmental targets. According to FTSE Russell analysis published in August of 923 SPTs spread across 585 SLBs, 88 per cent of targets focus on environmental goals. Social and governance-related targets, meanwhile, made up 8 per cent and 4 per cent of these SLBs, respectively.

SLBs have attracted criticism from some quarters over their selection of targets, with some issuers opting not to capture all of their emissions within their SPTs. “We are underwhelmed by the goals and penalties associated with recent SLB deals,” writes Stephen Liberatore, head of ESG/impact in global fixed income for asset manager Nuveen in a 2021 blog post. SLBs do not fit within Nuveen’s impact investing approach, he says.

“The goals or targets can be gamed to make them relatively easy to achieve, sometimes based on the issuer’s current trajectory, and without the need for meaningful new investment,” says Liberatore, referencing an unnamed SLB that carried a key performance indicator that had already been achieved.

Oil and gas giant Eni and Teva Pharmaceuticals do not include their Scope 3 emissions within their emissions reduction targets, despite these representing the bulk of their emissions, says non-profit Climate Bonds Initiative.

Eni’s first Scope 3 emissions target seeks a 35 per cent reduction by 2030, which the company will be able to say whether it has been achieved or not in early 2031, once it has finalised its emissions counting. “The most long-term sustainability-linked bond that Eni has launched since it published its Sustainability-Linked Financing Framework expires in 2030,” says the company. “That’s the reason why Scope 3 target has not been considered yet.”

A Teva spokesperson says: “Teva’s Sustainability-Linked Bond Framework does include a Scope 3 Sustainability Performance Target which represents a public commitment to value chain (Scope 3) GHG emission transparency and reductions.

“Our Scope 3 GHG emission SPT is not included in our SLB transactions, as at the time of our debut issuance in Nov 2021 we had only just accounted for our full Scope 3 emissions for the first time. It should be noted that the measurement of Scope 3 emissions continues to evolve and is much less mature than that of Scope 1 and 2.”

In May, the Institute for Energy Economics and Financial Analysis criticised Eni’s plans to develop a gasfield in Australia, arguing that these were inconsistent with climate commitments made to retail investors who invested in its first SLB, which was issued in January 2023. At the time, an Eni spokesperson denied that the bond was linked to financing specific gas projects.

“We want to see oil and gas issuers being made to use Scope 3 targets,” says Climate Bonds Initiative senior analyst Matthew MacGeoch.

In other instances, experts suggest companies may have indulged in some creative counting to claim they have achieved the aims linked to a SLB. European chemical company Nobian did not pay a coupon step-up after its 2022 sustainability report demonstrated a sharp drop in emissions, but AFII head of research Jo Richardson writes in a May 2023 note that “it is unclear how this emissions reduction has been achieved”, and suggests inconsistencies in Nobian’s reporting. A Nobian spokesperson rejected AFII’s conclusions.

‘Rewarding investors for failure’

A review by the UK’s Financial Conduct Authority of sustainability-linked loans — a similar instrument that sees banks provide funding to companies, instead of investors via SLBs — found that borrowers were concerned about the reputational damage they might incur in response to missing SPTs.

Missed targets, however, can still help bring about change, since companies that fall short of their SPTs will have to explain this outcome to their investors, Richardson tells Sustainable Views.

Davy’s McKeown says that whatever the outcome, “if corporates are issuing SLBs, they’re putting their money where their mouth is”.

There is recognition, however, that SLB investors are being rewarded for the failures of their issuers. Restructuring the product could help to avert investors from profiteering from issuers’ shortcomings.

There are legitimate concerns around the step-up feature, the negative incentive in that, in a way, you’re rewarding investors for countries failing to achieve their target

Arend Kulenkampff, Nature Finance

Mirova’s Ribeirinho suggests an array of options for improving SLBs. He advocates for a higher step-up “above 0.5 per cent, ideally 1 per cent”, imposing heavier penalties on issuers that miss their targets. He also suggests a step-up that sits in proportion to the bond’s former coupon to reflect an environment of changing interest rates, along with “a mix of green bonds and SLBs [and] the inclusion of Scopes 1 to 3”.

Incorporating step-down payments — instead of step-ups — may also help to address “the perverse outcomes” of paying investors when issuers fail to meet their SPTs, says non-profit Nature Finance director Arend Kulenkampff, who specialises in sustainability-linked sovereign debt. This option would mean that investors would receive lower revenues from the bonds if targets are met, providing an added incentive for issuers to meet their sustainability targets.

“There are legitimate concerns around the step-up feature, the negative incentive in that, in a way, you’re rewarding investors for countries failing to achieve their target,” Kulenkampff says. “In a step-down only solution, you only have positive incentives.”

A service from the Financial Times