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ESG Focus: Linked Finance The Next Big Thing – Part 5

ESG Focus | Sep 22 2021

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:

ESG Focus: The Next Big Thing – Part 5

The migration of big transitioners from use-of-proceeds and vanilla debt markets to SLBs is to begin in earnest so we check out transition SLBs along with the brown taxonomy, which deals with the tricky bond-principle demand of “do no harm”

– Transitioning the transitioners: the great migration
– Investors eye best SLB structures and frameworks
– Beware early issuance and look beyond the carbon profile
– The scary demand on corporations to “do no harm”

By Sarah Mills

 “When structured appropriately, we believe that the SLB format is best suited to accelerate decarbonisation of carbon-intensive sectors.”  – Jacob Michaelsen of Nordea.

Sustainability-linked bonds (SLBs) were designed largely to accelerate the transition of "brown" companies but will also be used to transition nearly every large company in the world.

Until recently, green finance has been exclusive.

The Materials, Energy and Industrials sectors have been slow to enter the ESG debt market given many carbon-intensive companies don’t qualify for use-of-proceeds (UoP) green bonds.

These sectors carry the highest carbon intensity (carbon intensity is set to become the universal carbon benchmark for SLBs) in the equity and credit universe and carry a carbon stigma, leaving them vulnerable to capital shortages as big capital rushes into ESG. 

Fossil fuel companies and companies with high fossil-fuel dependence also face disruption to their revenue streams and the withdrawal of fossil-fuel subsidies upon which they are heavily reliant.

But these are not the only sectors failing to qualify for the green finance club.

Any carbon-reduction investment requiring finance that is not "dark" green (such as solar and wind energy infrastructure) is generally classified as transition finance.

SLBs, and their brothers sustainability-linked loans (SLLs), generally fall under the transition finance umbrella, and dark green investment remains the province of the green bond market.

SLBs also accommodate non-pure play green or social businesses, meaning they can serve brown to green corporate issuance and offer investors a broader definition and diversity than use-of-proceeds bonds. 

Driving the appetite for sustainability-linked finance is the prospect of higher energy costs and rising regulatory risks for investors in environmental laggards.

Global emissions need to fall -7.6% or move a year each year for ten years to meet the Paris Agreement’s goal of a -60% cut by 2030.

There are also mumblings that the 2050 horizon is being brought forward to 2030. 

At the very least, companies should read this to mean that they should be focusing heavily on 2030 targets if they are to be in the race for 2050.

On the flipside, SLBs draw investors because they mitigate diversification risks in ESG bond portfolios.

Quick recap: carbon intensity, scope emissions and KPIs

Prior to reading this story, we recommend reading the previous story on transition UoP bonds (link below) but we include a quick recap here.

One of the main problems with UoP transition bonds that fund internal projects is that often the majority of a company’s emissions may be outside their own operations.

The sustainability-linked finance incentivisation structure solves these problems given key performance indicators (KPIs) can be linked to Scope 1 (operational emissions), Scope 2 (energy inputs) or Scope 3 (supply chain) emissions.

Add the three together and you get an organisation’s total carbon intensity or carbon footprint – and a risk profile.

Some companies have high Scope 1 emissions and low Scope 3 emissions. Others may have very low emissions from their own operations, but massive emissions throughout their supply chain.

For example, an oil producer could receive funds for carbon capture storage projects (many of which at this stage are highly dubious and are viewed by some as a fossil-fuel subsidy), while still racking up a carbon ledger throughout the rest of the company and through its supply chains.

SLBs, which are pegged to standard metrics such as carbon-wide metrics rather than specific projects, address this problem. 

Step-up coupons and penalties linked to pre-agreed performance metrics introduce a more powerful accountability mechanism. 

Investors need to ensure the KPIs are relevant to a company’s emissions profile. 

Companies may disclose 1, 2, 3 emissions but even within scope 3, there are 13 categories.

So two companies could be reporting the same scope but reporting on different categories, depending on their industry.

Transitioning the transitioners – the great migration

“Decarbonisation-focused SLBs comprise 61% (US$41bn) of the (SLB) market – by tying long-term cost of capital to decarbonisation, SLBs can incentivise companies to set more ambitious CO2 reduction targets,” reports Morgan Stanley in its report The Race to Net Zero Emissions

To date, the brown sector has been expected to tap use-of-proceeds (UoP) transition bonds but transition UoP issuance does not necessarily finance a move from an existing carbon-intensity state to a better one – the projects funded are simply not as dirty as they could be.

The incentivising SLB step-up coupon (see separate article in the link below) was designed to motivate companies to accelerate their transitions and to round up recalcitrant borrowers.

For example, the funds are not dedicated to just a wind farm, or solar installation, but towards a number of small steps towards decarbonisation.

SLBs do not necessarily have use-of-proceeds KPIs dedicated to environmental or social objectives but they do allow for unrestricted use-of-proceeds (some SLBs may not even have structures that support step-downs) creating a broader field for investor influence, and allowing a splitting of funds out of traditional vanilla markets. 

SLBs' broader field of influence is particularly helpful in emerging markets and for holistic investors, encouraging engagement in difficult markets.

Theoretically, using the KPIs and sustainability performance targets (SPTs) of SLBs linked to carbon emissions should also give a good picture of how much carbon should be removed/avoided over the life of the bonds.

This draws a conscious planning element into the equation, improves measurement and accountability, and depending on reporting requirements, creates a clearer picture of global carbon intensity.

SLBs not only incentivise more ambitious emissions cuts, they reduce investor concerns about greenwashing given the ever-increasing reporting demands and forward-looking performance indicators built into the bond contracts. 

So pressure is growing to transfer most “transition” bonds out of UoP markets and into SLBs, as well as from vanilla debt into sustainability-linked debt.

This world's migration will require a massive investment and fund managers will be seeking to safeguard this investment through SLBs and secure their long-term future.

Issuance: the good and the not so good

Morgan Stanley reports two interesting examples of brown issuance.

Italian energy and utilities giant Enel’s capital strategy has set something of a benchmark.

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 are refinancing its conventional debt using SLBs.

Nor have its KPIs proved too onerous. They were selected from a very narrow list of pre-existing metrics, each tied to emissions with step-ups linked to 2023, 2030 and 2031.

Should the pace of decarbonisation accelerate, Enel has at the very least locked in current expectations during a period of relative leniency and greeniums.

Meanwhile, US-based Enbridge was the second oil and gas company to issue under the ESG label, issuing a US$1bn 12-year SLB in June.

But Morgan Stanley reports the bond carried a nearly insignificant penalty of 5 basis points and failed to include indigenous people in report – one of their most important stakeholders.

Nonetheless, the issue was 3x oversubscribed and came in 5 basis points tighter than unlabelled debt, again revealing the demand for ESG bonds.

Enbridge set Scope 1 and Scope 2 emissions targets and one diversity goal.

But Morgan Stanley says that in the case of big emitters, diversity is more marketing than substance given it won’t affect the company’s bottom line and long-term viability and advises investors ensure KPIs match a company’s core business.

Preferred structures for SLB investors

SLBs should be backed by a powerful sustainability framework.

A well-structured SLB should drive the three legs of ESG and support the UN’s sustainable development goals (SDGs) to encourage organisations to position themselves more powerfully for the challenges ahead.

A good transition SLB should enhance both investors’ and borrowers’ ability to monitor carbon emissions and progress.

KPIs and SPTs should be relevant to a company’s core business and give issuers the ability to deliver beyond a business-as-usual pathway on sustainability.

SLBs can encourage entities to embed their public sustainability commitments into their debt capital strategies; helping them position for the future; demonstrate commitment; and lower funding costs.

Lack of consistency in decarbonisation target-setting and measurement hinders the effectiveness of SLBs as a decarbonisation mechanism.

“To achieve net zero, the absolute amount of emissions matter most, and we think absolute emissions reduction should become the standard for decarbonisation-focused SLBs, reports Morgan Stanley.

Carbon intensity subsumed into risk-reward equation

Carbon intensity is now a critical component of the risk-reward equation, and investors will be weighing this carefully.

Morgan Stanley reports that higher carbon intensity is likely to equate with higher yields: high emitters will offer higher yields than investment-grade companies.

Analysts say that to ensure progress and to ensure a company meets its KPIs, penalties should be included in a bond contract, and they should be higher than the step-up coupon as an added incentive.

Morgan Stanley also advised investors look at underlying production figures and trajectory to get a true feel for overall emissions. A 25% cut in intensity could be pared with 50% growth, wiping out the benefit.

Early issuance carries its own risk for investors

The Enel example highlights the powerful incentives for issuers to hit the market early.

Observers are concerned companies may rush the market, issuing heavily to pick up greeniums and lay down funds during the early period of lax standards.

Going hard and going early means investors are less likely to gain the decarbonisation benefit from future bond issuance with more ambitious targets and tighter standards, potentially leaving them holding a carbon lemon – which is why the frameworks and targets are so important.

It may also create a situation in which new issuance from a company may require them to decarbonise at a faster rate.

Morgan Stanley says extra bonds compound the need to decarbonise but do not represent additional carbon savings.

The investment bank reports that companies wishing to game the system can double down on their bet that they will meet their original goal but the path to net zero remains unchanged.

“Going forward, we are on the lookout for companies who are willing to increase their ambitions with new issuance or who select new and equally relevant KPIs to accelerate their transition,” says Morgan Stanley.

Energy intensive stocks have additional economic incentives to reduce their emissions intensity compared to average companies.

Trillions of dollars are need to reach net-zero emissions so it needs to be applied not only at a project level but an enterprise level. 

SLBs encourage whole-business model transitions while simultaneously allowing investment in green projects and other sustainability projects.

It won’t just be linked to debt but equity issuance, asset-backed structured solutions, etc, reports Jacob Michaelsen from Nordea's website.

A few teething problems to solve

For now, the market is just finding its feet and big capital will be working hard to iron out the teething problems.

Complexity of design could deter investors, particularly those whose investment mandate precludes it. 

Insufficient demand could hurt liquidity but this should sort itself out long-term given the global trend to greenify finance globally.

Observers notes that because use of funds is unrestricted, an oil and gas company could in theory issue an SLB and then fund a project antithetical to environmental progress.

Green-washing remains the ubiquitous risk to investors but an SLB at least provides a way to mitigate credit risk in an era of tightening ESG-linked regulation.

Don’t look at carbon profile in a vacuum

Given the green transition is the first sustainability ball to kick off in earnest, it is easy to forget that companies’ long-term sustainability will hinge on more than just carbon measures.

JP Morgan stresses the importance of including non-carbon KPIs in a bond contract/framework noting the total amount of emissions is important but that this can be difficult to discern from KPIs.

Alongside emissions intensity, investors should seek bonds with KPIs around industrial waste reduction, water useage, reducing plastics and other petroleum derivatives such as petrochemicals, chemicals, other emissions such as sulphur oxide, and education, diversity and inclusion objectives such as women on boards and racial/ethnic diversity as a percentage of the workforce.

This gives a clearer view into a company’s sustainability culture and commitment.

Investors need to ascertain the methods used to achieve growth going forward. Growth versus emissions management is considered critical.

JP Morgan advises investors ask whether an issuer is winning capital share or market share because of improved emissions, or marketing, or the economy.

Significant investment is required to measure emissions, and this is likely to create an extra moat for large companies.

Transition bond principles

And of course, no bond story is complete without listing the Climate Bond Initiative (CBI) bond principles.

A joint CBI/Credit Suisse initiative – Financing Credible Transitions Paper – says issuers seeking to use the transition label must use the following five principles:

– Align with zero carbon by 2050 and nearly halve emissions by 2030;

– Be led by scientific experts and not be entity or country specific;

– Be sure that credible transition goals and pathways don’t count carbon offsets;

– Include an assessment of current and expected technologies that can be used to determine a decarbonisation pathway; and

– Be backed by operating metrics rather than a commitment or pledge.

As SLBs, sustainability-linked transition bonds should follow the CBI’s Sustainability Linked Bond Principles and provide:

– Up to date information on KPI performance including baselines;

–  A verification assurance report relative to the sustainability performance target outlining performance against SPTs and the related impact and timing of such impact on the bond’s financial and/or structural characteristics; and

– Any information enabling investors to monitor the level of ambition of the SPTs. Sustainability strategy, KPI/ESG governance KPIs and SPTs.

And as with all sustainable bond principles, the proceeds must be applied in a fashion that “does no harm” – a bit hard to determine in the transition area but this is likely to be based on an agreed benchmark.

All eyes peeled to the brown taxonomy

Credit Suisse’s Marissa Drew reports that the European Technical Expert Group (TEG) on sustainable finance has advised technical screening criteria for significant levels of harm to environmental objectives – the so-called "Brown Taxonomy criteria”.

Fitch ratings reports the European Commission (EC) is likely to introduce an “unsustainable” activities list, which it says may standardise negative (exclusion) screens and shift capital away from brown sectors.

The brown taxonomy was proposed in response to feedback during the creation of the green taxonomy that noted a green taxonomy alone would not generate Paris-aligned targets because it does not encourage a move away from those that underline the Accord (capital flows and sustainability-linked finance are considered less capable in themselves).

A brown taxonomy could pave the way for tougher capital requirements for environmentally harmful activities – the brown penalising factor.

It is one of the most poorly defined and potentially impactful areas of pending legislation.

For example, a brown taxonomy has considerable implications for capital charges in prudential regimes and has drawn criticism, in some cases pitting sovereign regulators against financial regulators.

 “It is also likely to spark evaluation of structural policies, such as competition or taxation, insofar as these support unsustainable activities, such as fossil fuel subsidies,” says Fitch.

The European Technical Expert Group expects the final European Taxonomy would comprise three performance levels: “substantial contribution” (green); “intermediate contribution” (neutral) and “significant harm” (brown).

At the moment, TEG is identifying activities for which no technical solution exists for improvement.

Once a decision is made on these, implementation will be swift, the EC aiming for first reporting in 2023.

There is also an “intermediate performance” or “intermediate transition” category that applies to the pace of progress of transitioners, although that could be tied in to the “intermediate contribution” category given a preference for simplicity.

Coming up

Next in the sustainable finance series will be sustainability-linked loans, primarily the province of the banks and private equity, which will be taking carriage of global-transition finance outside of the bond market. 

Linked Finance The Next Big Thing Part 1 (

Linked Finance The Next Big Thing Part 2 (

Linked Finance The Next Big Things Part 3 (

Linked Finance The Next Big Thing Part 4 (

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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