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Analysis: Sustainability-linked bonds face big reputation test

With sustainability-linked bond issuance now topping $80bn, a new Capital Monitor report takes stock of the market and asks whether these instruments can rival the impact of use-of-proceeds bonds.

By Chris Papadopoullos

Low hurdles? Some investors are concerned that sustainability-linked bond performance targets are not ambitious enough. (Photo by WoodysPhotos via iStock)
  • Total issuance of sustainability-linked bonds (SLBs) hit $80bn globally as of the end of last year, according to Capital Monitor analysis.
  • Enel has hit the SLB market’s first performance target, but there are concerns about whether such targets in general are ambitious enough.
  • Some investors remain sceptical about the impact that SLBs can have compared with green, social and sustainable bonds.

The nascent market for sustainability-linked bonds (SLBs) will face a number of key tests in the next 12 months, with the first step-up dates for major issues coming due against a backdrop of growing concerns about potential greenwashing of key performance indicators (KPIs).

Italian energy company Enel announced this month that it has hit its sustainability performance target for end-2021. The group has increased its installed renewable energy capacity beyond 55% of total capacity, meaning it will not have to pay an additional 25 basis points (bp) a year on each of three different tranches of SLBs.

Another major step-up event will be for Greek utility Public Power Corporation at the end of 2022, in respect of a high-yield SLB that would pay an additional 50bp a year until its maturity in 2028 if it fails to reduce full-year Scope 1 emissions by 40% this year compared with a 2019 benchmark, the largest cumulative step-up so far for an SLB in terms of basis points.

With all this in mind, Capital Monitor has today published a report taking stock of KPI performance, upcoming observation dates and step-up structures used by SLB issuers, entitled ‘The Future of Sustainability-Linked Bonds’.

Who are the big issuers?

Two-thirds of the $80bn in SLB issuance as of end-2021 has come from European corporates (see chart below), although Chile last month became the first sovereign SLB issuer with a $2bn issue targeting emissions and renewable energy usage.

Sector-wise, energy companies are by far the most common issuers of SLBs (see chart below), perhaps because they can condense their targets into a small number of easily measurable KPIs, such as emissions levels, emissions intensity and renewable energy capacity.

But the step-up structure of SLBs has so far proved prohibitive for a key part of the market: the banking sector.

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The European Banking Authority has said bonds with step-ups would not be suitable as capital products for commercial banks because the coupon could increase, thereby eroding an institution’s capital base. This has hampered issuance from the financial sector, which has been a large issuer of green bonds.

This is despite the fact that the European Central Bank has said it can accept SLBs as collateral for monetary policy operations and that they are eligible for its asset purchase programmes.

When it comes to sustainability KPIs, the Capital Monitor research shows that the nine SLBs for which at least one post-issuance report has been published are on course to hit their targets. On the face of it that is positive news, but it raises concerns for some about whether the targets being set are sufficiently ambitious.



The research also reveals a variability in KPIs that are based on emissions intensity and can be prone to denominator effects. Brazilian pulp and paper firm Suzano, for instance, recorded a drop in its emissions intensity in 2020 because its production increased on the back of strong demand, rather than because emissions actually fell. This finding underlines the issues facing those structuring sustainability-linked bonds around intensity targets rather than simpler metrics such as absolute emissions levels.

In respect of observation dates, most issuers have set them for 2025, which is being used as an intermediate target date for 2030 goals. Hence 2026, when many companies will announce whether they have hit 2025 targets, looks set to be a make-or-break year for the SLB market.

Doubts over KPI targets

As the SLB market develops, it may be difficult to judge what success looks like.

“I think the vast majority of SLB issuers will hit their targets, but this may look like issuers have not been ambitious enough,” says Bram Bos, who manages the green bond portfolios at NN Investment Partners, a Dutch asset manager recently acquired by Goldman Sachs.

Not everyone is convinced by SLBs, with some impact investors preferring the structure of debt – such as green, social and sustainable (GSS) bonds – that requires the issuer to specify how the proceeds will be used.

Bos says he does not yet consider SLBs as impact products on a par with green and other use-of-proceeds bonds. Part of the issue is that SLBs work by condensing impact into one, two or sometimes three KPIs.  

“Linking the coupon of a bond to specific ESG targets does not make the issuer by definition more sustainable,” Bos says. “There are currently few guidelines on how to define a SLB, which give issuers with the wrong intentions the possibility to participate in the sustainable finance market.” 

Bos points out several vagaries in this market: “What happens with an SLB after the KPI measurement date? Is the product still an SLB or sustainable product or just a normal corporate bond? What happens if, after a successful observation date in which the issuer is shown to have hit its sustainability performance target, it reverts and performs poorly?”

Hence SLBs are a second-best option for investors and issuers, Bos adds, and issuers serious about sustainability will tend to issue using a use-of-proceeds structure.

Similarly, US asset manager Nuveen, which runs the world’s largest impact bond product, does not consider SLBs fit for the $7bn Core Impact Bond Fund portfolio, preferring to focus on GSS bonds.

Still, some market participants view SLBs as more scalable than use-of-proceeds bonds because of the latter’s strict project origination requirements.

Step-up standards

Yet SLBs also breed some scepticism over their step-up structure.

Ultimately, the market is still finding its feet when it comes to best practice. The main guidelines for SLB issuers remain the Sustainability-linked Bond Principles published by the International Capital Market Association, and they offer a fair bit of room for variation of bond terms.

The report shows that the most common step-up is 25bp, with the observation date placed two to three years before maturity. For longer-dated bonds, such as those maturing in 2030, or higher-yielding bonds, the step-up tends to be higher. For instance, 100bp was offered in the case of Canadian telecoms company Telum.

In a research note published last month, analysts at Hermes Investment Management said: “We fear that insouciant acceptance of the 25bp step-up as a norm will eventually undermine investors’ confidence in the SLB market and, worse, this could weaken the ability of the asset class to align capital markets with corporate sustainability.”

The Hermes analysis suggests step-ups should be calibrated based on the scale of the issuer and with consideration of the credit risk posed by a step-up.

The idea of linking coupon payments to sustainability performance sounds sensible in theory and has generated a burgeoning market for a unique product. But it may need refining further if it is to persuade the more discerning sustainability-focused investors.



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