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One year of the Sustainability-linked Bond Principles: the market takes off rapidly despite credibility concerns

Some praise the huge market potential and early sector diversification, while others worry about robustness of deals

2021 is set to be the breakout year for ESG in fixed income. While the pace of issuance for ESG-labelled debt began to pick up in the latter half of 2020, this year has already smashed records for issuance. 

Moody’s estimates that as much as 10% of global debt issuance this year could be ESG labelled – amounting to as much as $650bn.

While the majority of ESG bonds are made up of 'use-of-proceeds' bonds – through which issuers promise investors to spend their money on green, social or sustainability projects – the newer sustainability-linked bonds (SLBs) have made a significant contribution, with $8.6bn of issuance in Q1 alone. However, questions remain over their viability and impact as an ESG investment.

SLBs allow issuers without a significant amount of green or social expenditure to make sustainability commitments and get involved in the ESG-debt market.

'They put investors’ returns directly at odds with meeting sustainability objectives'

Instead of identifying eligible expenditure as in a use-of-proceeds bond, issuers are able to spend the proceeds on whatever they like, and instead commit to specific ESG-related KPIs. Depending on the specifics of the deal, they will either pay a penalty for missing them or be entitled to a coupon discount if the targets are achieved. In one example from a €500m issuance from Greek utility Public Power Corporation in March, the coupon will increase by 50bps if the firm fails to meet its 2022 target of a 40% cut in emissions.

The first such bond was issued by Enel in 2019 but it was not until the publication of the Sustainability-Linked Bond Principles by ICMA in June 2020 that issuance really took off. According to figures from Moody’s, quarterly issuance did not cross the $1bn mark until Q3 2020. But since then, quarterly issuance has jumped – the first quarter of 2021 saw $8.6bn worth of sustainability-linked bonds issued, and Berlin Hyp became the first bank issuer.

However, some have criticised the sustainability-linked structure. One European bond investor, who asked not to be named, said the asset class presented a number of problems for credible sustainable investors. 

"The first is that they don’t specify the allocation of proceeds, they only give a corporate target, and it's usually one that the company is already well on its way to meeting. That means there's no need to change behaviour or spend money on new things – they simply raise money against something they know they’ll achieve regardless of the deal." 

He says that, while investors know where their money is going when it comes to green bonds, SLBs don't offer any visibility on how the debt will actually be used. "People think they’re buying an equivalent to green bonds, but in reality you can put anything in there," he says, pointing to one issuer whose SLB has a target for increasing overall renewable energy capacity, but whose renewable energy assets are, on closer inspection, not aligned with environmental and social limits. "If you’re an issuer wanting to finance projects that aren't really Paris Aligned or aligned with the EU taxonomy, you can just put a target on it and stick it in a SLB to avoid the scrutiny of the green bond process; and we see that happening all the time."

"And that's before you even get to the fact that they put investors’ returns directly at odds with meeting sustainability objectives," he continues. "You get a higher coupon when the issuer doesn’t meet its target, which is just stupid because essentially they’re asking me to bet against the company meeting its target, or reduce my returns."

Steve Liberatore, Head of ESG and Impact for Global Fixed Income at US asset manager Nuveen says that, while the asset class does have promise, “the credibility and robustness of these deals remain highly variable".  

Moody’s figures show that the most common penalty for missing a target is 25bps. The penalties often only come into effect one or two years before maturity.

“We think more frequent measurement would be beneficial,” said Liberatore. “Typically what we’re seeing is a 7-year term where in year five you get a measurement and you get a step up if you haven’t achieved it. That doesn’t seem as though it’s as incentivising a structure as what you could potentially put in place.” 

A good sustainability-linked deal should have “an aggressive material desire to improve with a material penalty for not improving”, he added.

The need for material KPIs and genuine sustainability commitments was echoed by Paul O’Connor, Head of EMEA ESG Debt Capital Markets at JP Morgan. “I think we should apply the same mindset to the process of KPI selection and target-setting for all ESG-linked financing instruments,” he said.

“To my mind, these instruments are only helpful to the development of the ESG debt markets if they communicate and incentivise implementation of a meaningful strategic intent on the part of an issuer to either address ESG-related challenges relevant to the business model, or capitalise on ESG-related opportunities,” he added. 

'Over a third of the 43 deals we looked at since June 2020 were from non-investment grade issuers, whereas encouraging high-yield supply has been a challenge for the use-of-proceeds market' – Rahul Ghosh, Moody's

However, some say that these problems are to be expected in a market that is just over a year old.

“When we started to do green bonds almost 10 years ago the question was ‘what is green?’”, said Tanguy Claquin, Head of Sustainable Banking at Credit Agricole CIB and Deputy Chair of the Green Bond Principles Executive Committee. “We are now entering a world where we need to establish what is material and what is ambitious for an SPT [sustainability performance target] and a KPI, and that is an even more difficult question”.

“I don’t want to minimise the fact that some structures may be better than others but given the number of [KPIs] that can be taken, the various industries and company specifics, I think we have a lot of work to be done to provide guidance on what is material and what is ambitious,” he added.

This is echoed by Rahul Ghosh, Managing Director of Outreach and Research at Moody’s ESG Solutions. “With any new product that grows quickly, there's talk about market integrity. We saw that with the use of proceeds market, too, back in 2014/15,” he said. 

Recent Moody’s analysis also suggests that sector diversification of sustainability-linked bonds is greater than in the early days of use-of-proceeds bonds.

“Over a third of the 43 deals we looked at since June 2020 were from non-investment grade issuers, whereas encouraging high-yield supply has been a challenge for the use-of-proceeds market,” said Ghosh.

While he does admit that best practice is still developing, given that relatively few bonds reference Scope 3 emissions or science-based emissions targets, Ghosh said that as more issuers came to market, investors would be able to better scrutinise both KPIs and penalties. 

“As we see the market grow, investors will be able to better price the potential impact of not meeting SLB targets, and that should begin to be reflected in coupon adjustments,” he said. 

One day on from the first anniversary of the sustainability-linked bond principles, ICMA has also released an updated version of both the green, social and sustainability bond principles, which were referenced by an estimated 97% of sustainable bonds issued in 2020.

The first update to the green bond principles in three years, the new guidelines encourage issuers to supply information on how far their green or social projects are aligned with official or market-based taxonomies, as well as heighten transparency on issuer-level sustainability strategies and commitments. 

ICMA has also issued illustrative examples to facilitate the selection of KPIs for sustainability-linked bond issuers, underwriters and investors.