- Sustainability-linked bond issuance is now worth about 10% of the whole sustainability bond market.
- Most deals contain KPIs that fail to fully factor in credit risk or the relative ease on which targets can be hit to the issuer’s benefit.
- Energy company Sembcorp has a financial incentive to see coal plants continue as a going concern but still benefits from hitting a KPI linked to reduced GHG emissions.
In what is proving a very exciting new asset class, sustainability-linked finance is facing a handful of challenges that could prove detrimental to its development. The recent agreed sell-off of coal assets by Singapore energy company Sembcorp to mitigate additional capital costs has raised a few eyebrows with some questioning whether it makes a mockery of the asset class.
To re-cap: A factor for the shareholder-approved $1.5bn sale of its Indian coal power plants to Tanweer Consortium was the avoidance of higher interest payments on Sembcorp’s sustainability-linked debt. However, the terms of its sale are such that Sembcorp retains liabilities in the coal assets and is supporting Tanweer Consortium with a deferred payment loan.
A prevalent user of green-linked debt, Sembcorp hit the headlines after issuing it’s sustainability-linked bond signed in September last year anchored by the International Finance Corporation (IFC).
Sembcorp’s KPIs are linked to its carbon footprint. Through the sale of the plants, the company’s greenhouse gas emissions intensity will reduce and, all things being equal, it will not trigger a 25basis points (bps) step-up clause.
By standard definition, sustainability-linked bonds are any type of bond instrument for which the financial and/or structural characteristics are dependent on predefined sustainability/ ESG objectives are hit or not.
As the International Capital Market Association (ICMA) defines it, by raising money via a sustainability-linked bond, “issuers are thereby committing explicitly (including in the bond documentation) to future improvements in sustainability outcome(s) within a predefined timeline”.
But are Sembcorp’s actions within the spirit in which the sustainability-linked bond market should operate? As Capital Monitor noted last week, the market seemed somewhat unphased, but given the energy company has a financial incentive to ensure the ongoing success of the coal plants, it doesn’t look as if it is.
Financed emissions
And this is not bridge loan or a short-term financial fix. The terms of the loan are such that Sembcorp may not get fully paid back for another 24 years. It presumably agreed to those terms because it sees a future for the plants. Is that an explicit commitment to a future sustainability outcome?
Anthropocene Fixed Income Institute (AFII) was very quick to spot this. By playing banker to the consortium, Sembcorp is effectively shifting its emissions from Scope 1 and 2 to Scope 3 – those connected with a company but outside its direct control. “In this deal, a physical asset simply shifts to become a financial asset on the balance sheet,” it says.
In acknowledging the financial climate for funding coal is worsening, Sembcorp is supporting the consortium in order to prevent any dramatic financial instability both to it and to itself. The Singaporean company openly admits the cost of financing the step up on the bond would put investors’ noses out of joint, so needed to offload the coal assets.
So, if this was such an obvious risk to Sembcorp why opt to raise capital through a sustainability-linked bond in the first place? The result is a financial decision that potentially risks tarnishing investor trust in a very promising asset class.
Nneka Chike-Obi, head of research for Asia Pacific at Sustainable Fitch acknowledges this: “[This case] could lead to fewer or less ambitious KPIs,” she says. “Many investors place SLBs alongside conventional bonds from a sustainability perspective due to the possibility of the issuer missing targets, compared to green or social bonds where the use of proceeds is clearly defined and will finance a sustainable activity.”
It’s hard to gauge how bond investors feel about this transaction; many were reluctant to talk to Capital Monitor about it. Given the profile of the bond itself – a first in Southeast Asia and underpinned by the multilateral bank IFC – and the issuer, which is part owned by Singapore’s Temasek, there might be some anxiety to puts one’s head above the parapet. Spokespeople from both ICMA and IFC chose not to comment on the deal.
Under pressure to mature
The situation comes at a time when sustainability-linked bonds are under increased scrutiny. By June this year, the cumulative issuance reached $147bn, accounting for 10% of the total sustainable bond market, according to Sustainable Fitch numbers. Energy and utility companies are by far the most likely to issue them.
The vast majority of the deals, much like the Sembcorp bond, contain step up clauses (as opposed to step down, whereby the issuer is incentivised to achieve a KPI in return for reducing the cost of its repayments), most of which are set at 25bps and typically set to trigger near the end of a bond’s duration.
Many have questioned the wisdom in settling on around 25bps, arguing its not sensitive to traditional credit factors. Sustainable Fitch wrote in October:
“Our analysis of Fitch-rated SLB issuers finds almost no correlation between an issuer’s credit rating and the coupon step-up… Essentially, SLB coupon step-ups do not reflect the issuer’s credit rating. There is also no indication that step-ups are structured based on the ambition of the targets or on the cost required to achieve them.”
Aside from risk pricing, Sustainable Fitch also flags the potential moral hazard of a boat load of sustainability-linked bond with step up clauses, given the fact investors benefit from issuers’ failure meet environmental or social goals.
Why the lack of the bonds with step down clauses is not entirely clear. AFII believes one factor could be how parties agree if a KPI has been truly hit.
“Uncertainties around the return profile of the instrument with potential future yield drop and subsequent painful discussions with end investors as well as the actual achievement of sustainability impact seem to be barriers to adoption.”
This sounds plausible. But given the huge stakes at play to find innovative ways to financially support sustainable behaviour, investors should grow a proverbial and accept they need tackle such conversations head on.
For the good of the sector, let’s start by being honest about how Sembcorp has handled its own way of achieving sustainability impact.
