ESG Focus: Linked Finance The Next Big Thing – Part 4

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FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future: 
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ESG Focus: The Next Big Thing – Part 4

As the big end of town seeks to fund its ESG ambitions with sustainability-linked bonds, FNArena checks out the pros, cons, pitfalls and future of the market from the investor’s perspective.

– Regulators, including ASIC and SEC, take aim at corporations
– Collateral, credit ratings and capital structures
– Investors weigh the pros and cons
– What’s in store for SLBs?
– Australian corporations dip toes in SLB water

By Sarah Mills

As the world’s largest organisations seek to tap the growing capital pools of ESG funds through sustainability-linked bonds (SLBs), investors are trying to sort the wheat from the chaff.

Demand is running high for ESG debt. It is a borrower’s market and SLBs are being heavily oversubscribed.

SLBs can still yield a greenium, but even if not, borrowers still benefit from easy placement and the green halo effect within the investment community, 

This sharply increases green-washing risks during these early days of sustainability investing, but that is the price investors are paying to lure large organisations that can easily issue in vanilla debt markets with existing sustainability frameworks.

Investors are being advised to closely examine the materiality of issuers’ sustainability frameworks and the liquidity of their investments.

In the meantime regulatory nets are closing in to reduce green-washing risks, but plenty of pitfalls remain.

Regulators sharpen their sights 

Once the SLB market matures, it should provide greater peer-to-peer comparability based on standard benchmarks such as carbon intensity and water-useage.

For now, however, lack of transparency and reporting on these metrics is an issue, creating a green-washers’ paradise and investor risk. 

In future there will be greater interplay between SLBs and regulatory frameworks; and regulatory and disclosure nets are rapidly closing in on markets.

For example, under the EU taxonomy, some corporations and banks will be required to disclose their share of EU taxonomy-aligned business activities. 

Given the EU taxonomy is likely to set the standard for other sovereign taxonomies, and this should help protect investors in other nations.

The Australian Securities and Investments Commission (ASIC) just released its Corporate Finance Update – Issue 6 which outlines its ruling on net zero gas emissions reporting.

ASIC says forward-looking net zero statements may be misleading unless underpinned by reasonable grounds (as should all forward-looking statements) and determines the following:

– Removal of net-zero statements that infer near-term implications;
– Disclosure of a company's vision to operate in a net-zero manner, the work proposed to meet the visions, the uncertainties and risks of the endeavour; and
– Inclusion of specific timelines within any net-zero statement.

These rulings will apply to sustainability reports, fundraising documents, periodic financial covenants reporting, customer supply chain standards and continuous disclosure requirements.

Bloomberg Green reports that the US Securities Exchange Commission (SEC) recently augured a crackdown on climate disclosure.

Unlike Europe which targets investment managers, the SEC is taking aim at corporations and their executives.

The SEC plans to release new disclosure requirements for US companies by the end of 2021 that is likely to include:

– Mandatory comparable and consistent disclosures that are "decision useful" for investors.
– Inclusion of such disclosures in form 10K securities filings
– Qualitative disclosures such as the link between climate risks and corporate strategy; and
– Quantitative disclosures such as carbon metrics on Scope 1 and Scope 2 emissions, financial impacts of climate change, and progress towards goals.

Disclosure on Scope 3 emissions (supply chains) is likely to be held back until Scope 1 and Scope 2 reporting is sufficiently established to make such measurements meaningful.

The SEC is also likely to set requirements for industry-specific metrics, including scenario analyses, relating to physical climate change risk and transition risk, and local laws.

And just to ensure the rulings have teeth, the SEC established the Climate and ESG Task Force to scan for misstatements and material gaps in climate-risk disclosures.

The Value Reporting Foundation is also developing a set of global reporting standards similar to the US Sustainability Accounting Standards Board.

But bonds are long-term assets, and most initiatives are at least 18 months out.

So those purchasing SLBs now need reasonable assurance that their investments will still be viable in 10 to 20 years.

Much depends on the tenor of the bond. Five-year SLBs are likely to carry less sustainability risk than a long-term SLB.  

Authorities smooth the way for rapid adoption

The European Central Bank (ECB) did not initially consider SLBs eligible for the corporate sector purchase program.

But in September 2020, the ECB announced that certain SLBs would become eligible as collateral for Eurosystem credit operations and for Eurosystem outright purchases for monetary policy purposes from January 1, 2021.

Again, other sovereigns are likely to follow in the EU’s footsteps.

While not yet mandatory, the EU already encourages issuers to benchmark SLBs against the EU taxonomy, and those that do are likely to gain favour. 

Investors are likely to view poor reporting unfavourably.

Morgan Stanley advises investors observe a company’s general reporting track record, not just ESG factors, as gaps in reporting elsewhere could reflect on SLB performance gaps. 

Collateral, capital structures and seniority and collateral

The majority of ESG bonds are issued as vanilla senior unsecured issuance, which is true across the three ESG main labelled debt types.

Similarly, SLBs are rarely secured against collateral. 

Usually, social impact bonds (SIBs) are the only SLB likely to guarantee principle and are usually backed by an asset.

Secured issuance has come from the energy and utilities space and is more common among high-yield issuers. 

Utilities are most common issuers in the investment-grade market and offer collateral by way of first-mortgage bonds. 

SLBs have emerged across the capital structure with several deeply subordinated corporate hybrids already sold, and across the credit spectrum. 

High yield and un-rated issuers constitute as much as 35% of the volume to date, says Moody’s ESG Solutions.

Morgan Stanley also reports some variation in the structuring of SLBs that relates to seniority in the capital structure. 

All this homes investor focus on issuers’ credit ratings and capital structure, as well as pricing and opportunities relative to the more liquid vanilla market.

This suggests that for now, the greenium is likely to prevail to attract issuers.

SLBs have their own fan club – the pros

As with most ESG innovations, SLBs have their supporters and detractors.

FNArena covered the step-up, step-down debate in a previous article (see link below), and this section covers the rest of the debate.

Admirers of SLBs believe the ability to transition an entire business by using company-wide carbon-intensity as the key metrics elevates SLBs over project-level use-of-proceeds bonds.

They claim monitoring carbon emissions is also easier in the SLB format given metrics are built into the contract.

Primarily, they laude SLB’s ability to boost market volume, claiming the use of carbon-intensity is the key to standardisation, and standardisation is the key to liquidity.

They say SLBs mitigate diversification risks in ESG bond portfolios, drawing more investors, and allows companies that lack eligible use-of-proceeds projects to participate, further boosting liquidity.

SLBs also accommodate non-pure-play green or social businesses, diversifying the market.

Not everyone’s a supporter – the cons

But critics abound, particularly regarding the credibility of sustainablility performance targets (SPT) and key performance indicators (KPI). 

Impact investors are particularly critical, noting that in some recent issuance, the listed KPIs had already been achieved.

Stephen Liberatore, Nuveen’s head of ESG/Impact Fixed Income Strategy Team questions SLBs capacity to drive impact and prefers the greater accountability offered by use-of-proceeds (UoP) deals. 

“At their root, SLBs are general obligation or general corporate debt instruments, and the issuer retains full discretion for how capital will be allocated once it is raised,” says Liberatore on Nuveen’s website. 

“… reporting will be limited to a singular enterprise-wide carbon footprint or emissions reduction target. This makes it virtually impossible for an investor to know how the proceeds of the bonds were directed and what specific outcomes they delivered.”

“Impact investors want KPIs driven by specific projects. KPIs demonstrate the efficacy of the science and encourage borrowers and lenders to seek ways to lower the cost of capital for the most successful technologies that also improve resource efficiency within an issuer’s operations.

“Digging deeper, we are underwhelmed by the goals and penalties associated with recent SLB deals. 

“The goals or targets can be gamed to make them relatively easy to achieve, sometimes based on the issuer’s current trajectory, and without meaningful new investment. 

“We’ve seen 8-year and 10-year new issues that put off KPI disclosure and potential coupon steps into the fifth and ninth years, respectively. 

“And if the goals aren’t met, step-ups can be as low as 6.25 basis points or 12.5 basis point (from a 375 basis points initial coupon), which isn’t steep enough to incentivise management to make the targets a strategic priority. 

“Instead, it provides the issuer with a low-cost option of deploying capital as it see fits. 

“Another ‘loophole’ in the SLB structures exempts the issuer from including acquisitions from its reduction targets over the measurement period, which further undermines any genuine, enterprise-level commitment to environmental, social and governance (ESG) initiatives.”

Many also criticise the application of SLBs as a decarbonisation mechanism – its very raison d’etre.

These critics report a lack of consistency in decarbonisation target-setting and measurement abounds, hindering their effectiveness.

At the moment, it is easy to sell bonds in the primary market given supply and demand imbalances but these reporting issues may impact sales in the secondary market.

While most observers recognise these criticisms, they expect the situation will change once the market matures.

KPI materiality, credit ratings, and other issues

The demand-supply imbalance in the SLB market is also spawning risk.

“Even the ropiest of companies are refinancing at par,” says one observer of the imbalance between supply and demand. 

Brazilian meat-packer JBS Meat’s SLB drew fiery debate over KPI credibility but was still 5x oversubscribed.

Morgan Stanley warns investors of the importance of discerning the materiality of KPIs in its report Sustainability-Linked Bonds: Materiality Is The Missing Link:

“The core of the question is whether meeting a KPI is something that reflects on your credit standing as an issuer.

“It is difficult to make the case that the coupon step-up resulting from not being able to deliver on your ESG commitment is separate from your credit standing as an issuer.

“As more comparable companies come to the market, investors can afford to become more picky, selecting best-in-class peers based on KPIs and SPTs.”

Critics report other problems, starting with enforcement. 

At the moment, few SLB investors are likely to be able to enforce a judgment for breach of covenant.

Another challenges is the type of issuers coming to market. 

Many of the Latin-American issuers are international oil and gas companies. But this too should change.

Index inclusion is another.

“The risk with SLBs is that they may not be eligible for index inclusion according to EM (emerging market) bond index methodologies,” says Mary-Therese Barton, head of emerging market debt at Pictet Aset Management.

“So this next step in the market requires discussions around infrastructure as well as investor demand.”

From the issuers’ perspective, many point out that there is more pressure and sensitivity around the design of SLBs and that they are subject to more stress and scrutiny than when they issue standard use-of-proceeds funds, or vanilla debt.

Future trends in the SLB market

Over time, the amount of organisation’s capital linked to sustainability will become an issue; and it will be one metric investors can use to determine the prognosis for a borrower in a user-pays world. 

If a company has one SLB in a sea of vanilla issuance, then investors are likely to assume that the SLB issuance hasn’t had much impact on operations.

This will result in interesting dynamics, particularly between larger and smaller issuers. It is conceivable, for example, that smaller issuers could have low carbon intensity but struggle in the SLB market, resorting to the vanilla market if overlooked. 

Alternatively, they could approach the sustainability-linked loan market, which is more opaque and often a matter of corporate confidence.

So it is important for investors to examine a series of metrics.

To date, only energy giants Total and Enel have committed to issuing purely SLBs, but more are expected to join its ranks.  

Enel’s financing is now dominated by ESG-labelled debt. It has stated that all of its financing going forward will be in SLBs and is refinancing its vanilla debt with SLBs. 

The quality of reporting on SLB performance is also expected to improve given issuers must commit to publishing relevant updates in relation to a bond’s KPIs and SPTs.

These must be consistent and transparent, allowing investors to more accurately gauge performance. 

“Over time, we expect the financial features of SLBs to become more precise,” Rahul Ghosh, managing director for ESG Research at Moody’s ESG Solutions, tells Global Capital.

“Over time, a failure to hit targets could constrain an issuer’s ability to raise additional ESG financing and have material financial implications above the 25bp (penalty),” Ghosh says.

“As that differentiation becomes more apparent in the market, you’ll start to see more variability ex-ante in some of the pricing of the structures.

Innovation is also expected to feature

Leading Austrian electricity company Verbund in March issued a hybrid bond combing both green use-of-proceeds bonds (green bonds) and sustainability KPIs (SLBs), making it the first SLB to carry a dedicated green use-of-proceeds component.

The E500m 20-year bond with was 4x oversubscribed and the price tightened 28 basis points on the re-offer.

If one of the two SPTs is not met by December 2032, a 25 basis point step-up kicks in.

The KPIs and SPTs are:

– KPI1: Newly installed production capacity of hydropower, wind power and photovoltaic (PV) solar renewable energy. The SPT is set at 2000MW by 2032 from a baseline of 8,687 MW in 2020.
– KPI2: Additional transformer capacity to facilitate interaction with the grid and integrate renewable energy: The SPT is set at 12,000 MVA by 2032 from a baseline of 30,810 in 2020.

This type of combination can help address investor concerns about SLBs and the limitations of use-of-proceeds bonds and opens the door to tailored solutions.

Many issuers are also including an option to issue SLBs alongside UoP green bonds in their frameworks.

Morgan Stanley’s head of ESG structuring for global capital markets, Cristina Lacaci, notes that investor demand also exists for non-green KPIs.

“… Investors are open to other KPIs and we have already seen several bonds with water conservation, waste reduction or diversity KPIs,” says Lacaci.

“Over time, we will increasingly see frameworks with several KPIs to address companies’ various priorities.

“As the product matures, greater differentiation among SLBs of different tenors and credit quality is also likely.”

At the moment, the ECB cannot invest in non-green KPIs such as social KPIs but this is forecast to change.

Australians dip toes in SLB water

Given the bar for ESG funding has been set sufficiently low, corporations are racing to jump on the sustainability-linked finance bandwagon: pulp and paper companies; steel companies; oil and gas producers; luxury goods purveyors and retail and private equity.

Brazilian companies have been very active, with emerging markets approaching 25% of global SLB volume, reports Morgan Stanley.

SLBs from Asia represent less than 8% of global issuance but the region has issued its own loan principles, which is expected to promote issuance. 

Australia was quick to enter the market.

Last June, oil & gas contractor Worley ((WOR)) hit the market with a E500m 0.875% no-grow five-year senior unsecured SLB, yielding 0.99%. 

The company was the first Australian corporation to issue an SLB and was 15th in the world.

The bond does not include a step-up but instead opts for a one-off 25bp penalty at maturity or on early redemption, suggesting that shorter dated debt issuers may opt for one-time penalties rather than step-ups.

Given the low rate, 25bp represents a substantial impost should the company fail to meet targets and cut its Scope 1 and Scope 2 emissions by 2030 and encourage customers to cut emissions. 

The SLB does not include KPIs on Scope 3 emissions, which demand a company-wide cut in carbon intensity.

The issue was well oversubscribed and gained the lowest coupon for any five-year euro issue from a BBB-rated Australian corporate, pointing to the strong demand for investment-grade Western issuance. 

Worley’s SLB was the first time any issuer anywhere structured its inaugural deal in this format.

It was the first drawdown of the company’s US$2bn euro-medium-term-note program at a sub 1% rate, thanks to the company’s very sticky order book of greater than E1.7bn.

Wesfarmers ((WES)) was the first company to issue an $A-denominated SLB, following hot on the heels on Worley’s euro issue.

The company issued A$1bn in seven-year and one-year maturities which was 2.5 times oversubscribed.

The bond was linked to two KPIs: increasing the proportion of renewable energy used by the retail divisions, and reducing carbon emissions intensity for the ammonium nitrate production in their chemicals, energy and fertilisers division.

Prudential has signed a $4bn revolving credit facility, with margins linked to its sustainability performance. This is the first deal of its kind by a major US insurer and pressures others to follow suit.

FNArena’s next article in this series will discuss the application of SLBs to transition financing.

Linked Finance The Next Big Thing Part 1 (https://www.fnarena.com/index.php/2021/09/07/esg-focus-linked-finance-the-next-big-thing-part-1/)

Linked Finance The Next Big Thing Part 2 (https://www.fnarena.com/index.php/2021/09/13/esg-focus-linked-finance-the-next-big-thing-part-2/)

Linked Finance The Next Big Things Part 3 (https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/)

FNArena's dedicated ESG Focus news section zooms in on matters Environmental, Social & Governance (ESG) that are increasingly guiding investors preferences and decisions globally. For more news updates, past and future: 
https://www.fnarena.com/index.php/financial-news/daily-financial-news/category/esg-focus/

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