- Investors are sceptical of the sustainability credentials of the $80bn sustainability-linked bond market.
- Criticisms centre on the size of the step-up, what happens to the bond after the step-up, and whether sustainability can be condensed into a few indicators.
- An index-linked structure may provide better incentives for issuers and help win over discerning investors.
Despite rapid growth in issuance over the past few years and the publication by the International Capital Market Association (ICMA) of a dedicated set of principles, the $80bn sustainability-linked bond market has yet to win over all impact investors, a key segment where buy-in is needed.
NN Investment Partners, the Netherland’s based asset manager recently taken over by Goldman Sachs, and US asset manager Nuveen, do not include sustainability-linked bonds in their impact bond funds, preferring to stick instead with use-of-proceeds bonds such as green and social bonds.
The ICMA defines them as any type of bond where the components of it can vary depending on whether the issuer achieves predefined sustainability or ESG objectives.
Concerns raised by investors include the size of step-up, which can sometimes appear too small, the relevance of key performance indicators (KPIs), and whether sustainability can really be condensed into one or two of them.
Further to that, there are questions about what happens after the step-up date – is the bond still a sustainable one? What if the issuer’s performance reverts after the observation date? Capital Monitor research shows that some KPIs chosen by issuers have been volatile on an annual basis, potentially making them less useful as a measure of progress.
One solution to make the structure of sustainability-linked bonds more trustworthy would be to replace the step-up structure with something akin to an index-linked one, where performance is measured over a given period rather than at a single point in time.
Under the step-up structure, an issuer usually has up to three KPIs that must reach a certain level by a certain date – for example, to reduce carbon emissions by some percentage by 2025. If they achieve the target, the coupon is the same from 2025 onwards; if it misses its target, the coupon rises (typically by 25 basis points) for the remainder of the lifetime of the bond.
The vast majority of issuers, as our research shows, have a single observation date, usually placed in 2025 as an intermediate target for a 2030 target.
An index-linked solution
In contrast, an index-linked sustainability-linked bond would tie the coupon of the bond to the performance of the KPI (or KPIs) for each year of its life. The issuer would have to generate a sustainability index, which could be linked to a single KPI or a weighted formula of any number of KPIs.
For example, it could start at 100 and rise if the KPIs worsen and fall if they improve. Then the same methods for calculating the coupon and principal as for index-linked bonds can be used. To use emissions as an example again, if the issuer reduced its emissions in any year by such an amount that its index dropped by 10%, a 300 basis point coupon would be adjusted downward by 10% to 270 basis points.
The adjustment could also apply to the principal, so if the emissions of the company climbs and its index rises 10% over the bond’s life cycle, a $1m sustainability-linked bond would return $1.1m to investors at maturity. The adjustment would have a floor so that the principal could not shrink and the coupon could not turn negative.
Such indices are already being produced. In Capital Monitor’s research on ESG-linked remuneration, we found some financial institutions, most notably Banco Santander, already generate internal sustainability indices in order to calculate bonuses for chief executives. Its calculation includes the proportion of women in senior positions and volume of green finance it provides, among other categories.
Beating the step-up
It gives the issuer a sense of urgency; the quicker it improves sustainability performance, the quicker this is reflected in its debt repayments. There is gradation in the reward and punishment; the issuer is incentivised to build on successes and limit failures, which is not the case in a binary step-up structure.
This would have several advantages over the current sustainability-linked structure. First, performance of the indicators matters for the entire lifetime of the bond. There would not be instances where an issuer achieves its target at an observation date and then reverts.
It also means the issuer’s success is not constrained to a single point in time, where they may be lucky or unlucky in any particular year. In the case of Suzano, a Brazilian pulp and paper manufacturer, its emissions intensity KPI decreased sharply in one year because output rose strongly on the back of high demand rather than any improvement in efficiency. An index-linked structure would help negate the difficulties caused by volatile KPIs by ensuring that success or failure does not depend on a single year’s measurement.
Perhaps another advantage is that the index-linked structure has been around for the past 40 years, and would not require a huge intellectual leap for investors to make. The UK introduced bonds linked to the retail price index in 1982, which now make up one-quarter of the UK’s debt stock.
Some issuers have already used the step-up structure to do something similar to an index-linked structure by using repeat issuances with staggered observation dates.
Enel, the first sustainability-linked bond issuer, has issued a series of such bonds with a range of maturities and observation dates. Taking its programme as whole, it has similar properties to an index-linked security; KPI performance matters over time and depends on several observation dates over the course of the 2020s rather than a single one. The different single step-ups combine to produce a gradual reward mechanism.
Enel is unique in this regard – more should follow suit. For while there is value in the simplicity of the current step-up structure used by issuers, it is proving too simplistic for some.
