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.

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