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Sustainability-linked bonds: Market doubts spark rethink

The International Capital Market Association has responded to criticism of sustainability-linked bonds with further guidance, but admits more focus on impact and transparency could be beneficial.

By Chris Papadopoullos

Laurie Chesné from the International Capital Market Association’s working group would like to see progress reporting on sustainability-linked bonds. (Photo courtesy of Natixis)
  • Investors have raised concerns about the ambition and credibility of targets for sustainability-linked bonds coming to market.
  • The International Capital Market Association responded by publishing some 300 new key performance indicators for illustrative purposes.
  • Investors such as Pimco have welcomed the move, but insiders say future work may focus on alternative structures and a closer link to impact.

Sales of sustainability-linked bonds, which pay investors a larger coupon if issuers fail to meet certain targets, have grown rapidly since their arrival in 2019. But scepticism has emerged in some quarters, sparking a response from standard-setters keen to ensure confidence in this market at a time when concerns over greenwashing are increasingly rife.

These securities accounted for 15% of all green, social, sustainability and sustainability-linked (GSSS) bond issuance in the first quarter of this year, according to data from Capital Monitor sister company Global Data. Volumes fell slightly in the same period, but the overall trend has been one of steady growth (see first chart below).

However, doubts surfaced over this market last year. Some investors have been vocal about the pitfalls of sustainability-linked bonds, arguing that certain issues have incorporated weak key performance indicators (KPIs) with unambitious targets. Allocators have also questioned whether these deals have genuine impact, while Capital Monitor research has shown that some KPIs have been volatile and therefore less useful in tracking sustainability performance.

The International Capital Market Association (Icma) – a non-profit group that has developed guidance for issuers of GSSS bonds – used its annual conference last week to respond to criticism by publishing further guidance on sustainability-linked bonds. This included some 300 additional illustrative KPIs covering 22 sectors.

Icma added documentation in the form of a Q&A to offer advice to issuers, and a ‘sector materiality matrix’, to show how material each KPI was for each sector. Icma’s sustainability-linked bond 2021-2022 working group drew up the KPI registry and guidance.

Laurie Chesné, head of green and sustainable financing solutions for Europe, Middle East and Africa at French bank Natixis and a coordinator of Icma’s working group, tells Capital Monitor: “We continue to see some transactions where the selected KPIs are absolutely not covering the most material and core strategic sustainability topics for the issuer."

That sparked the idea of providing additional guidance and the concept of suggesting core and secondary KPIs, she adds.

More work to do

Nor will Icma’s new reforms mark the end of the road for its sustainability-linked bond improvement efforts. Issuers also need to communicate to investors a clearer link between sustainability-linked bond financing and sustainability impact, Chesné says.

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Some investors, such as Dutch fund house NN Investment Partners – recently acquired by Goldman Sachs amid the bank’s sustainable finance drive – do not consider sustainability-linked bonds as valid for inclusion in their impact bond funds.

More precise explanations are needed about how sustainable performance targets (SPTs) will be achieved, Chesné says, including costs estimates for doing so.

“It would be good to see progress reporting for sustainability-linked bonds,” she adds, “in order to reinforce correlation between the KPIs and SPTs in the transaction and effective actual impacts on sustainability.”

Chesné also feels more work is needed is on social – as opposed to environmental – aspects and that Icma needs to expanded on its intelligence and benchmarks on that front.

There have been few instances of sustainability-linked bonds with social rather than environmental KPIs as yet (see chart below), but there have been some large deals, such as a €1.85bn issue in September 2020 by pharmaceutical firm Novartis with KPIs relating to patient access. Teva, another pharma company, sold a $5bn sustainability-lnked bond with targets related to climate goals and patient access in November last year.

Chesné also feels there could be further innovation in structure. Some issuers, especially in the public sector, could look to set “remediation plans” after missing targets instead of a coupon step-up, she says.

Issuer and investor support

While sustainability-linked bonds have attracted some scepticism, there remains broad support for the concept from issuers and many investors. The latter group values them for their flexibility; unlike GSS bonds, sustainability-linked bond proceeds do not need to be explicitly tied to a specific project.

“It [the structure] really suits the way that we’re organised internally,” said Natasha Vowles, head of funding at UK supermarket chain Tesco, during the Icma event last week. “We don’t fund individual elements of the business or individual projects per se.”

Tesco has incorporated its Scope 1 and 2 emission reduction targets – long-standing goals it set in 2017 covering pollution from its own operations and heat and power purchases, respectively – into its sustainability-linked bonds' KPIs, she added. So it already has reporting and assurance in place for the relevant KPIs, Vowles said.

The group issued its first €750m sustainability-linked bond in January last year. It had an 8.5-year maturity with a coupon step-up of 25 basis points, with 2025 set as the observation year. It followed that with a £400m issuance later in 2021.

Investors continue to see a future for a product, provided issuers follow the guidance provided by Icma. The association’s working group have spent the past 12 months working with various market participants to further develop its sustainability-linked bond guidance.

Ketish Pothalingam, a London-based portfolio manager at $2trn fixed income fund house Pimco, said at the conference: “151 [financial institutions] contributed to Icma’s working group; that means that there’s real buy-in.”

"Key ingredients" for a good sustainability-linked bond

Pothalingam, also a coordinator on Icma’s working group, said at the event there were three key ingredients for a good sustainability-linked bond, all of which have been reflected in Icma’s new guidance.

Firstly, the KPIs need to be core, material and relevant. Material, in that each one must be a fundamental part of a company’s business, and relevant in that the group is committing to a change that is not simply continuing business as usual.

Second, the assessment date should be “somewhere intermediate to the maturity”. In some deals, the observation date has been placed close to the maturity date, so that a step-up would be paid on only one or two coupon payments.

Lastly, Pothalingam said step-ups in coupon payments should reflect the market and size of the issuer, such as high-yield versus investment-grade issuers.

For example, Public Power Corporation, a Greek high-yield issuer, provided a 50 basis point step-up that was assessed five years before the maturity date, offering a potential cumulative step-up of 250 basis points over the life cycle of the bond. That is the largest cumulative step-up of a sustainability-linked bond to date.

The additional KPIs published by Icma would help corporate bond issuers from different sectors come to market with sustainability-linked bonds, added Pothalingam.

The main issuers of such bonds have thus far been utility companies, such as Italy’s Enel, which sold the world’s first in 2019 and remains the largest issuer of such debt. It also sold what was at the time the world’s biggest sustainability-linked bond in June last year, at €3.25bn ($2.7bn).

With investors so keen to buy debt designated as green or sustainable and some sellers taking advantage of this appetite by offering weaker structures, it makes sense for Icma to seek to ensure standards of transparency and impact.

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