Sustainability Linked Bonds Part 2: Challenges and Opportunities

By Richard Howard

“Mighty rivers might be easily leaped at their source” – Publilius Syrus

This is the second blog in a series on sustainability-linked bonds (SLBs). Find part 1 here.

Sustainability-linked bonds are a new sustainable financial product. These are bonds charactersitics of the bond are linked to sustainability performance targets (SPTs or ‘targets’). For example, the coupon or interest payments are linked to measurable environmental targets, and if the company fails to meet these targets the interest rate increases, meaning the company will have larger interest rate payments. A more detailed explanation of how sustainability-linked bonds work is given in part 1 of this blog series.

However, despite the name, sustainability-linked bonds (SLBs) are not automatically a win for the environment and there could be some potentially large unintended consequences if they are implemented in a haphazard manner. This is something the International Capital Markets Association (ICMA) has recognised, having recently released a series of guidelines to uphold the integrity of SLBs [1].

The One Concrete Benefit of SLBs

Before we have a look at the potential upsides and downsides of SLBs we must first acknowledge one concrete benefit: sustainability as a concept forms an integral part of the messaging of the bond.

This is done by highlighting either a single sustainable objective or a series of sustainable objectives, which can be marketed as an integral part of the bond (on a par with the interest rate and maturity date). As a consequence, environmentalism is given as equal importance as the financial aspects of the bond.

There is obviously a lot of nuance surrounding the details of SLBs, which we will discuss in the next section, but if SLBs take hold as a new weapon of green finance then sustainability (and the bond’s sustainability performance targets) will be front and centre in the investor’s mind as they price up any future strategic decision.

Points to Consider with SLBs

It would be very easy to quickly reel off a list of criticisms with SLBs and any potential harmful side-effects [2, 3]. However, each issue is far more delicate than that and your opinion will be influenced by both how you believe markets work and the best way to prevent climate change and environmental harm.

Each of these sections outlines a brief consideration when it comes to SLBs. 

Companies Do Not Have To Use The Money for Sustainable Causes

Unlike Green Bonds and Climate Bonds there are no restrictions on how the capital raised from the SLB issue can be spent. Last year’s bond issue by Enel highlights this point clearly, since they generate electricity using renewables, natural gas, and coal, as well as distribute natural gas. Although they have committed to exit coal in Italy [4], they will continue to operate fossil fuel generation capacity and distribute natural gas, and the money raised by the bond issue may possibly be put towards supporting those activities.

On the flipside, one of the criticisms of the existing green bonds is that they are too restrictive and that the rules (or lack of rules – depending on your perspective) limit the market liquidity. By creating a financial product which has clear and measurable goals from the start, SLBs hope to ease the process of applying for and selling the bond to investors (both from an accounting and a cognitive point of view).

How Do ESG, SRI, and Environmental Funds Play It?

At a first glance SLBs seem like a natural fit with environmentally and ethically minded investors. However, scratch the surface and it is not so clear cut as to whether SLBs are an automatic fit.

What if an SLB issuer fails to meet its targets? In that case, are the funds then obliged to sell the bond, because it is no longer seen to be environmental? Would the bonds suddenly flood the market because ESG investment managers are wanting to get rid of them?

This might be the case, but the financial system is about managing risk and this is just another type of risk. Regular Green Bonds will probably offer a higher level of certainty, especially if they are using the new EU Taxonomy Rules [6]. But having a variable level of risk allows the market to price in whether or not a company will meet its targets.

The skill of the fund manager will now have to extend to whether or not the company will meet the bond’s targets, and feed into a much wider debate about the company’s wider sustainability goals, as well as its governance.

Furthermore, if the ‘step up provision’ was triggered and the company had to pay a higher interest rate then then the fund would receive a higher return. It would be well within the fund’s powers to insert a clause into its investment strategy to state what it would do with the extra cash. Environmental charity? Invest in an environmental competitor? Carbon offsetting scheme?

Issuers Are Not (Yet) Obliged To Meet Their Goal on a Rolling Basis

Once the issuing company has hit its target it is free to invest in whatever manner it chooses. This means that it could go back to its old ways or undo efforts to put in place to achieve the specific goals.

This situation would be analogous to General Motors and the famed EV1 back in the 1990s, whereby GM produced a groundbreaking electric vehicle to meet Californian air quality regulations. Once the thread of the regulations had passed, GM subsequently repossessed most of the cars before destroying them [5].

This situation could be avoided by companies having a pipeline of SLBs. Each of which have stricter and stricter targets strung out into the future and therefore investivising them to keep meeting environmental targets. This would very much mimic the manner by which existing companies use the bond market, and have a continuous stream of capital to service existing debt.

Furthermore, the phrase “bitten once, twice shy” comes to mind. If a company was to roll back any sustainability gains then their access to future SLBs would probably dry up quite quickly. SLBs have the potential to create a sort of ‘environmental credit score’.

Lack of Ambition, Greenwashing, and Regulation

If the SLB’s targets are not ambitious enough or structured correctly then then accusations of greenwashing could start flying around. If the market for SLBs grows too quickly then the demand for products labelled ‘green’ or ‘sustainable’ could potentially compromise the whole project, by investing in poor quality SLBs. Weaker and weaker targets could be set, softening their environmental impact, and undermining confidence.

It is in the interest of the wider green finance and green investment industry to maintain the integrity of these investments, and this is the reason for the ICMA’s latest set of voluntary guidelines. But it is difficult for a subset of the financial industry (i.e. ESG and sustainable finance) to regulate the rest of the financial industry.

One option would be to introduce regulation. This might be on a par with or draw from the new EU Sustainable Finance Taxonomy. SLBs would then be drafted within the bounds of the regulation. This, however, might go against SLBs market principles, since they have the potential to be more flexible than the EU Taxonomy.

The other option would be to always tie the bond’s targets to wider global environmental targets (see next section).

Not Necessarily Aligned To Global Goals

The targets are not obligated to be benchmarked to wider environmental goals, and there is a risk that they are too specific to the individual company.

It would be possible to give them greater relevance by linking them to external environmental goals with quantifiable milestones (e.g. Paris Climate Agreement, IPCC Pathways, and the UN Sustainable Development Goals (SDGs)) And linking the targets to external goals would the added benefit of sitting within an existing framework, with common terminology, definitions, and language. This would also ease the analytical burden for both issuers and investors and make the goals much easier to communicate.

Conversely, if a company wants to portray itself as aligning with Paris and net-zero then SLBs might be the easy way forward. These are legally binding contracts with clauses, which set out clear measurable goals. If a company were to meet one or several of these goals then it would serve as evidence that they are meeting their environmental milestones.

Other Issues

There are a host more issues which could affect SLBs, for example:

  • How would the step-up provisions be enacted? Could there be drawn out legal issues and court battles? Could this affect the price of SLBs?
  • Could a company set overly ambitious goals or lax penalties, knowing full well it would not meet the goals, just to access the SLB capital market?
  • Would predatory investors covert bonds of companies they expect to miss their targets?

Conclusion

Although sustainability-linked bonds have the word ‘sustainable’ in their name, it is not a given that they meet everyone’s definition of sustainable and are 100% good for the environment and the climate. We have run through a list of potential issues with these new bonds above.

However, what SLBs have in their favour is that they are still very new and, therefore, it is the optimum time to ensure that the problems listed above are addressed. Expertise and know-how can be transferred from their Green Bond and Climate Bond cousins to ensure that SLBs can throw their weight behind the Great Decarbonisation.

In the next part of the series we will dissect the ICMAs Sustainability-Linked Bond Principles in more detail.

References

  1. ICMA, Sustainability-Linked Bond Principles, Voluntary Process Guidelines, 2020, https://www.icmagroup.org/assets/documents/Regulatory/Green-Bonds/June-2020/Sustainability-Linked-Bond-PrinciplesJune-2020-100620.pdf
  2. https://www.reuters.com/article/enel-ditches-green-bonds-for-controversi/enel-ditches-green-bonds-for-controversial-new-format-idUSL5N26O403
  3. Linklaters, ICMA’s Sustainability-Linked Bond Principles align with ENEL issuance, 2020, https://lpscdn.linklaters.com/-/media/digital-marketing-image-library/files/01_insights/publications/2020/june/gc20033_anatomy_of_a_sustainability_a4_flyer_finalb_screen.ashx?rev=eb1eb08e-6c3a-49a0-8786-f33005122286&extension=pdf&hash=105C001252C829299F711B8ACC7D02C4
  4. https://renewablesnow.com/news/enel-wants-coal-exit-quickly-and-its-hydrogen-100-green-exec-says-702607/
  5. https://www.nytimes.com/2006/06/28/movies/28kill.html
  6. https://ec.europa.eu/info/publications/sustainable-finance-teg-taxonomy_en

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