By Marie Lassegnore, Credit Portfolio Manager & ESG Director for Fixed Income and Cross Asset, La Française AM
WHAT ARE SUSTAINABILITY-LINKED BONDS (SLBs)?
Sustainability-linked formats are relatively new. ENEL Finance issued the first SLB in late 2019. The real innovation in the format was to look beyond the green or social aspects of the projects financed with the ‘proceeds’ of the bond issue. Indeed, the issuer’s commitment is at the corporate level. The issuer incorporates mandatory strategic targets. Otherwise, the issuer will be subject to a financial penalty (called a coupon step-up or premium; the increase is predefined). In practice, prior to issuing an SLB, the company will define environmental or social objectives (Sustainable Performance Targets - SPT), that will be measured using credible Key Performance Indicators (KPIs). If the company fails to meet its objectives by the target date, it will pay a premium for the remaining life of the bond.
For illustration purposes, consider a bond with a 1% coupon and a maturity date of 31/12/2028.
- Sustainable Performance Targets - SPT: “Reach carbon neutrality by 2050 with an intermediate 25% reduction in overall emissions by 2025”
- KPI1: “Reduce Scope 1 and 2 carbon emissions by 30% by 2025 vs 2021 level”
- Target date: 31/12/2025
- Coupon step-up: 0.15%
- KPI2: “Reduce scope 3 emissions by 20% by 2025 vs 2021 level”
- Target date: 31/12/2025
- Coupon step-up: 0.10%
- Therefore, if at the 31/12/2025 target date, the issuer falls short of the first KPI, it will have to pay a 1.15% coupon for the annual payments of 2026, 2027 and 2028. The coupon further increases to 1.25% if the issuer misses both targets (KPI1 & KPI2).
HOW DO SLBs SHAPE THE ESG DEBT MARKET?
The SLB format remained unused the year following ENEL’s inaugural issuance. Thereafter, it was widely adopted in late 2020 and almost mainstream in 2021. The widespread adoption was facilitated by the ECB, when it declared SLBs as eligible collateral if the Sustainability Targets were linked to environmental objectives.
The most interesting aspect of the emergence of the SLB format relates to how it quickly influenced the ESG debt market, which was dominated by green bond issuances until 2020. By the end of 2020 and excluding sovereign and government related bonds, the ESG corporate debt market was comprised of 81% of green bonds, 7% of social bonds and 10% of sustainable bonds. In one year’s time, this landscape changed substantially with the explosion of SLBs, making up 23% of 2021 primary issuance. As of January 2022, green bonds represent 70% of the mix and SLBs went from 0.1% a year ago to 10.7% of the ESG corporate debt market. (Source: Bloomberg and La Francaise AM)
HOW CAN THIS TREND BE EXPLAINED? THE GREATER FLEXIBILITY OF SLBs BONDS VERSUS GREEN BONDS
- The minimum issuance size of green bonds: The benchmark-size USD300m-500m green bond format only fits companies with sizeable balance sheets/operating cashflows and annual funding programs of several billion USD. The green bond format does not however fit the funding needs of smaller companies that seek only to raise USD500m every five years, for CAPEX funding or alternative corporate purposes.
- The limited eligibility of green projects: To be eligible for Green bond proceeds, green projects are subject to the Green Bond Principles and/or the Climate Bonds Initiative (CBI) as well as the future EU Green bond framework. Green bonds are more suited to certain types of sectors as the current industry breakdown demonstrates. The green bond market is dominated by governments (37%) and focusing on the corporate segment, financials occupy a large share (32%), followed by European Utilities (17%). Other sectors account for only 14% of the green bond market. (Source: Bloomberg and La Francaise AM)
SLBs, given their added flexibility, constitute an interesting alternative. The issuer of an SLB can use the proceeds for green or non-green projects or even for general purposes such as traditional operating expenses etc. It is no longer a question of size of eligible projects relative to total funding needs. The Green bond market scrutinizes, and rightly so, the projects, but also the companies that try to access this form of funding. There is a pronounced risk of ‘greenwashing’, which obviously could lead to reputational risk for a company operating in a highly polluting industry which would opt to come to the Green bond market. From our discussions with issuers from the cement and energy sector, the Green bond market presented more risks than opportunities. By looking beyond, the projects themselves, SLBs, which focus rather on the long-term commitment of the company (emission or social inequality reductions), underline the firm’s efforts, and provide transparency with regards to transition pathway without running the risk of “greenwashing”. Greenwashing remains a risk if those ambitions are judged insufficient, but it is minimized as investors in SLBs might be less committed to the format of the bond.