Sales of sustainability-linked bonds (SLBs) have already topped $25 billion this year as borrowers in Asia have followed the lead of pioneers in Europe and Latin America. Growth from here on in is expected to be exponential. JPMorgan says total issuance for 2021 could hit $150 billion.
It is easy to see why the format is proving so popular. Unlike traditional green, social and sustainable bonds, which require borrowers to use the proceeds of the deal for specific projects, the new format merely commits them to meeting one or more sustainability goals over a set timeframe.
This means that, for the first time, companies that would struggle to find sufficient sustainable projects to achieve the deal size required by big asset managers – usually $500 million – have a chance to tap into surging demand for bonds with an environmental, social and governance (ESG) component.
Yet as the market gains momentum, one leading investor has sounded the alarm over SLBs. In a recent blog post, Stephen Liberatore of US asset manager Nuveen said the structure was “lacking from the perspective of an impact investor”.
“We …feel compelled to alert investors that the credibility and robustness of these deals remain highly variable,” said Liberatore, head of Nuveen’s impact/ESG fixed income strategy team.
Much of his criticism was directed at the key performance indicators (KPIs) on which SLBs are based and which determine whether the borrower pays a penalty or receives a benefit during the life of the bond.
The first SLB, issued by Italy’s Enel in September 2019, included an incentive linked to the UN Sustainable Development Goals. Carbon emissions reduction has been a popular target, but KPIs have included everything from gender diversity to biodiversity. Multiple KPIs are also common.
Liberatore is concerned that many are not sufficiently ambitious. “The goals or targets can be gamed to make them relatively easy to achieve …without the need for meaningful new investment,” he wrote.
He mentions several deals this year that fell short in this respect, including “a US high yield issuer” and “an Indian cement company”.
The latter was presumably UltraTech Cement, which in February issued the first SLB from India. The deal’s single KPI involved reducing carbon emissions produced by 2030 but against a 2017 baseline.
“In the most egregious case,” Liberatore adds, “a structure included a KPI that had already been achieved.”
Damning
This sounds damning, yet it is hardly a new observation. Most sustainability-minded investors report turning down SLBs on the basis of weak KPIs. Bankers are also increasingly wary of being involved in deals that could lay them open to allegations of greenwashing.
The problem has also been recognized by ICMA. In the Sustainability-Linked Bond Principles, published last June, the association provided some guidance on the selection of KPIs. However, it is now working on more detailed guidelines, which are expected to include sector-specific targets.
Where Liberatore goes further than most critics of SLBs is in his assessment of the incentives for failure or success, which usually take the form of a relatively modest increase or decrease in coupon payments towards the end of the life of the bond.
It is hard to argue with his conclusion that many of these: “Aren’t enough of a penalty to keep issuers focused on the SLBs’ stated goals, once management considers cost of capital, acquisitions or other strategic initiatives.”
This is particularly pertinent given that many borrowers are getting pricing benefits at the outset. One bond investor estimates that SLBs can command a premium of 10 to 15 basis points, which clearly skews the incentives to issuance rather than compliance.
This deserves more scrutiny from banks and investors, as does the use of loopholes that exempt issuers from including acquisitions in reduction targets. As Liberatore notes, this: “Further undermines any genuine, enterprise-level commitment to ESG initiatives.”
Outcomes
Which brings us on to his final charge against SLBs, namely the fact that the use of general corporate targets means borrowers retain “full discretion for how capital will be allocated once it is raised.
“This makes it virtually impossible for an investor to know how the proceeds of the bonds were directed and what specific outcomes they delivered,” says Liberatore. “We strongly prefer use of proceeds deals in which the projects are specified at issue and the associated outcomes can be benchmarked, measured and reported.”
This is where the purported lack of impact in SLBs comes in. Yet many would argue the other way – that use of proceeds bonds may ensure that the funds raised go to green or social projects but don’t require the borrower to make any wider commitment to sustainability.
Thus an energy company could issue a green bond to pay for a solar power plant while still investing heavily in fossil fuels. “Investors like SLBs because they get management more on the hook than green bonds,” says a bond banker.
Neither SLBs nor traditional green bonds can really be said to produce impact or the concept beloved of ESG investors – ‘additionality’
There is something to be said for both sides – but only up to a point. Strictly speaking, neither SLBs nor traditional green bonds can really be said to produce impact or the concept beloved of ESG investors – ‘additionality’.
It is fairly certain that, in nearly all cases, issuers of both types of bonds would be doing whatever they are promising to do anyway, whether that is investing in renewable energy or committing to improving the proportion of women in their workforce.
Indeed, most are open about the fact that they see ESG-labelled bonds as a way of communicating their sustainability credentials to the market and other stakeholders – effectively as a form of PR.
Then again, there is a big question mark over whether genuine additionality can ever be achieved in public markets or whether it will remain the preserve of development banks, private equity firms and venture capitalists.
What is clear is that the level of scrutiny of issuers of ESG-labelled bonds is increasing. Most big asset managers today say that before investing in any of these instruments, they will want to be sure that the borrower’s overall sustainability strategy passes muster. “It gives us the right to ask questions,” says one.
This in turn means that the reputational risks for companies of coming to market with a sub-standard deal or a half-baked sustainability strategy are rising – which can only be a good thing, for investors and for society as a whole.
