ESG Focus: Linked Finance The Next Big Thing – Part 3

ESG Focus | Sep 15 2021

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Big End Of Town Eyes SLBs

Major corporations are using sustainability-linked bonds to fill their coffers to fund their green transitions, which is set to kick off in earnest in 2022. 

- A servant to many masters
- Issuers frameworks paramount to investors
- Materiality and pricing

Sustainability-linked bonds (SLBs) are one of the more innovative products to hit ESG markets and are aimed at the big end of town.

SLBs are an odd bird in the fixed-income world in that they can carry a floating rate, via a step coupon, rather than the traditional fixed rate.

One of the main reasons for this state of affairs is that SLBs were developed, in part, to incentivise the transition with penalties.

This means SLBs fall under both the transition finance (TF) and sustainability-linked finance (SLF) umbrellas.

Given the likely scale and impact of SLBs in transition finance, we will address that aspect in a separate article. 

We will also examine social impact bonds and development impact bonds (often both SLBs) in a separate article on impact investing.

This article is divided into two halves and examines the broader applications and challenges of SLBs. 

The first half examines the lay of the land, dealing with issues of materiality and covers some of the ground mentioned in our introductory article on sustainability-linked finance (see link below).

The second half examines the pros, cons and pitfalls of the market; its challenges and future; and early Australian issuance.

The new kid on the block

Sustainability-linked bonds (SLBs) only recently hit the market but issuance is expected to rocket as borrowers avail themselves of the cheap covid-19 funds flooding the world, filling their coffers to fund the green transition which starts in earnest in 2022.

Morgan Stanley’s report Sustainability-Linked Bonds: Materiality Is The Missing Link estimates the total SLBs issued since the market’s inception in 2019 to be US$57.7bn as of June 30, 2021, with 2021 issuance making up for than 75% of the total.

SLB turnover rose roughly 185% in the month of June alone and Morgan Stanley expects another $30bn will be issued by year-end, and another US$200bn within a few years. 

This compares with the vanilla bond market’s US$3.8trn a year pre-covid (now at US$2.8trn – a figure that could continue to face erosion as ESG markets gain traction).

The first SLB was issued by Italy’s ENEL (one of the world’s largest energy companies) in 2019. 

While SLBs are targeted squarely at the big end of town, smaller players that struggle in vanilla markets are likely to benefit from excess demand in the market’s early phases.

The SLB market is well diversified sectorally and is dominated by financials, utilities and REITS, all of which account for one third of total issuance; after SSAs (sovereign, supranationals and agencies), which represent more than half of issuance.

About 55% of SLBs issued to date are from private companies. When traced to the ultimate parent, that figure tops out at 15%. 

The European Central Bank (ECB) announced it would buy SLBs at the start of 2021, which should further fire demand.

A servant to many masters

SLBs were designed to compensate for shortcomings in the green, social and sustainable (GSS) use-of-proceeds (UoP) markets in supplying transition finance and broader sustainability funding.

GSS activity was largely confined to green infrastructure projects, given green assets are easier to ring-fence than social and sustainability assets.

This in turn meant issuance in social and sustainability UoP markets suffered liquidity constraints.

SLBs have a broader application than UoP bonds and can be used for any general corporate purpose, any sector, and can be directed to either social or green endeavours.

SLBs permit this unrestricted use-of-proceeds for general purposes on the proviso a good percentage of funds are allocated to pre-specified sustainability initiatives that align with the United Nations Sustainable Development Goals (SDGs). 

SLB projects can include: transitioning (reducing the carbon intensity of emissions and the broader business); water management (mainly reducing water withdrawal intensity); diversity; circularity; health; housing; infrastructure; industrial waste reduction; plastic-waste reduction; petroleum derivatives reduction; education; diversity; board diversity; and inclusion (ethnic diversity as a percentage of the workforce) – just to name a few.

SLBs carry penalties for failure to meet agreed sustainability measures such as step-down and step-up coupons – a typical carrot-and-stick incentive (see our previous article on sustainability-linked penalties in the link below).

The penalties are designed to encourage borrowers to meet targets and, in part, to compensate investors for lower transparency, as qualifying projects are not easily ring-fenceable.

The system is also designed to attract more borrowers and boost liquidity in ESG markets, to enrol the rest of the world in the sustainability drive.

SLBs also help entities embed their public sustainability commitments into their debt capital strategies.

Once the market matures, SLBs are forecast to offer greater flexibility, comparability/fungibility and accountability compared to UoP ESG bonds.

SLBs are particularly useful for transition financing given they incorporate measurable, forward-looking key performance indicators (KPIs) and sustainable performance targets (SPTs) into the structural and/or financial aspects of the bonds based on a standardized benchmark of carbon intensity.

Regulation and frameworks

The International Capital Markets Association (ICMA) published the sustainability-linked bond principles in June 2020, sparking a flurry of issuance.

These voluntary guidelines highlight five core components:

- selection of KPIs;
- calibration of sustainability performance targets (SPTs);
- bond characteristics;
- reporting; and
- verification.

The selected KPIs should be highly relevant to the issuer’s core business strategy and core sustainability challenges. They must be measurable, externally verifiable and benchmarkable.

They need to be under management’s influence, consistently quantifiable, and able to be verified by an independent third party. 

Investors are likely to favour borrowers with frameworks that align to ICMA’s principles, forcing the system into self-regulation.

Borrowers are expected to provide:

- up-to-date information on KPI and SPT performance based on meaningful baselines;

-  inclusion of a verification assurance report relative to the SPTs (the report should outline the borrower’s performance against the SPT and the impact and timing of SPT on the bond’s financial and/or structural characteristics); and

- any information enabling investors to monitor the level of ambition of the SPTs, such as a sustainability strategy, KPIs, and ESG governance.

At this stage, bond contracts tend to select metrics included in annual sustainability reports so investors can gauge progress.

Alternatively companies can provide relevant historical data for the past three years.

General characteristics of SLB issuance

Morgan Stanley estimates total SLBs issued since the market’s inception in 2019 to be US$57.7bn

European Union-domiciled issuers dominate the market given Europe is the ahead of the curve and is the current centre for ESG issuance. 

Euros and US dollars are the currencies of choice for SLB issuers. Chinese yuan rolls in at a distant third.

No one sector dominates issuance of the SLB markets (unlike UoP markets), which may appeal to those seeking to diversify through sectors. 

For example, SLBs offer investors exposure to more carbon-intensive sectors such as Materials, Energy and Industrials as they decarbonise.

As an example of non-energy sector issuance, fashion retailer H&M’s launched a E500m 8.5 year SLB in February 2021. 

The SLB terms require the company increases its share of recycled materials as inputs to 30% from 0.5%; reduce Scope 1 and Scope 2 emissions by 20%; and reduce selected Scope 3 emissions by 10% against a 2017 baseline by 2025.

Issuers’ frameworks paramount to investors

The quality of an issuer’s sustainability frameworks will likely determine their ability to curry investor favour.

A corporation’s frameworks should comply with both the ICMA principles, and the United Nation’s SDGs. 

The framework should also drive the three legs of ESG and include environmental, social and governance KPIs that are relevant to the core business; are measured from a baseline to avoid overstatement or double counting; and reflect the company’s geography and specific sustainability challenges. 

For example, Morgan Stanley criticises a recent Enbridge Gas SLB, noting the company should have included a Native American on the board given the nature and geography of the business. General board diversity would be considered a less impactful KPI for Enbridge’s situation.

The inclusion of second-party opinion in frameworks is considered another key signal of quality, depending on the opinion provider, and, is likely to become best practice and ubiquitous.

Regular external verification of SPTs and KPI is a must and auditors or environmental consultants are expected to verify performance against these at least annually. 

These expenses are expected to be paid by the issuer.

Moody’s ESG Solutions says investors should examine an issuer’s interim goals, historical KPI performance, science-based measurement criteria, level of transparency and ambition on scope and coverage; and ensure a limited reliance on carbon offsets.

“Robust commitments in these areas can strengthen the credibility of targets,” reports Moody’s.

To date most KPIs have been environmental; followed by multi-purpose KPIs. Social KPIs comprise a fraction of the total.

Structuring the bond and framework

Delving deeper into the ICMA principles, the association says an issuer’s framework should include:

Bond characteristics: financial/structural impact involving trigger events such as a coupon step-up between 10-75 basis points; or a premium/penalty payment. More innovative penalty clauses may develop.

Reporting: Issuers publish, at least annually, progress against the KPIs; verification assurance on performance impact; and information that enables investors to monitor SPT ambition.

Verification: Issuers need independent and external verification of their performance against each SPT for each KPI.

Calibration of SPTs: Issuers should provide regular disclosure on progress, just like any other significant information.  

The framework should be ambitious and strategically aligned. 

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