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May 18, 2022updated 21 May 2022 10:56pm

Sustainability-linked bonds: Weak KPIs cast shadow

Poorly defined KPIs are the ghosts at the sustainability-linked bond banquet, even though issuance is expected to grow this year.

By Adrian Murdoch

Gianfranco Gianfrate of Edhec Business School says issuers of SLBs can take advantage of some investors’ lack of expertise on sustainability. (Photo courtesy of Edhec Business School)
  • While global issuance of all types of green bonds is forecast to be flat in 2022, sustainability-linked debt volumes are expected to rise by 61%.
  • Investors face a challenge in assessing sustainability-linked bonds because of these structures’ often simplistic or opaque key performance indicators.
  • The general market acceptance of the 25 basis point step-up/step-down structure has little financial materiality for larger companies.  

While overall issuance of green, social, sustainability and sustainability-linked (GSSS) debt slumped this year, sustainability-linked bond (SLB) volumes have held up. But as the SLB structure gains traction, it is attracting more scrutiny, with questions growing around the robustness and credibility of targets being set by issuers.

Issuance of GSSS bonds fell by 28% on the same period last year to $203bn, according to rating agency Moody’s. Unfavourable conditions had conspired against the market, including Russia’s invasion of Ukraine, fears for global economic growth, inflationary pressures and the threat of accelerated monetary policy tightening.

A relatively brighter spot, however, was the sustainability-linked bond (SLB) market, with global issuance only falling 15% over the same period to $26bn. The trend was reflected in Europe, home to two-thirds of SLB issuance from corporates, according to Capital Monitor report ‘The Future of Sustainability-Linked Bonds‘. SLB issuance rose by 20.7% in the first quarter year-on-year to €19.8bn, according to the London-based Association for Financial Markets in Europe (Afme), as against an overall drop in ESG bond and loan issuance of 32.4% to €136bn ($142.5bn) in the same period.

This trend is tipped to continue. While volumes of other GSS-structured bonds are likely to decline or remain flat this year, Moody’s projects, it expects SLB issuance to grow 61% to $150bn.

And yet questions are increasingly emerging over whether the structure is rigorous enough, even among arrangers of such deals. Constance Chalchat, head of company engagement and chief sustainability officer for global markets at BNP Paribas, told Capital Monitor earlier this year she was seeing “a lot of greenwashing” around SLBs.

SLBs need “tough love”

Indeed, the structure needs some “tough love”, caught as it is in a financial “tug of war” between good intentions and profits, said Ulf Erlandsson, founder and chief executive of Stockholm-based non-profit think tank Anthropocene Fixed Income Institute (AFII), speaking during a webinar he hosted at the end of April that looked at SLBs.

The structure is straightforward: the debt has a coupon linked to sustainability-based key performance indicators (KPIs). The issuer pays less interest on the debt if it hits those targets but more if it misses them.

Companies issue SLBs both to raise capital and send a message. Martin Watts, director of treasury at UK property developer London & Quadrant Housing Trust, says “we really wanted to outline that we are serious around our environmental and social governance credentials”.

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But some see such messaging as taking priority over the actual sustainability impact of the debt itself. Much of the impetus behind SLB issuance comes from a desire for “signalling”, said Erik Bennike, head of credit investments at PensionDanmark, the €36bn ($41.1bn) Danish labour market retirement scheme, during the AFII webinar. And Gianfranco Gianfrate, professor of finance at Edhec Business School in Paris, calls it a “marketing wave”.

A further, arguably bigger, issue for investors is that SLBs are often based on simplistic or opaque KPIs that are hard to assess.

The first SLB was pioneered by Italian power company Enel in September 2019 with a $1.5bn 2.65% five-year bond and is a case in point. In April, the group announced that it had hit its sustainability performance target to increase installed renewable energy from 45.9% to 55% of total capacity.

“Bare minimum of decency”

“Nothing really revolutionary,” is how Gianfrate dismisses the power company’s achievement. The company just “stuck to the bare minimum of decency” in terms of KPIs, he adds.

AFII’s webinar, meanwhile, cited the €650m 0.375% eight-year SLB issued by Spanish energy company Repsol in June last year. Its KPI is linked to reducing the company’s carbon intensity by 12% by 2025. But the deal was described in a March paper published by Stéphanie Mielnik, director of research at AFII, and Erlandsson as “over-engineered”. They also questioned questioning Repsol’s use of relative targets rather than absolute ones, which mean it can continue to increase its carbon emissions as long as it boosts production.

There is no hint of such nuances in the second-party opinion report from ISS that supports the bond. This can make it difficult for investors to assess a bond.

After all, debt managers are “not well-versed in climate models that could allow them to assess the probability of actually meeting what may or may not be ambitious targets”, says Yvette Babb, a fixed income portfolio manager based in The Hague for US boutique investment bank William Blair, speaking during the AFII webinar.

Edhec’s Gianfrate supports this view. Most funds and banks do not have analysts who are strong on all aspects of sustainability, he says; some are stronger on climate, others on human rights. There are issuers that can take advantage of this “confusion and ambiguity”, he adds.

The second problem is the typical 25 basis point (bp) step-up/step-down for SLBs – a feature of 29 of the 38 such transactions tracked by Capital Monitor (see chart below).

Mitch Reznik, head of sustainable fixed income at $669bn fund manager Federated Hermes, argues that the coupon structure should strike a balance between “stinging” in terms of its level of penalty, and its financial risk. A 25bp step-up may be significant to a company with revenues of $100m, but “literally it has no financial materiality at all” for one bringing in $10bn or $50bn, he adds.

"Insouciant acceptance" of SLB step-ups

In a paper published at the end of March, Reznik was worried that the “insouciant acceptance” of the 25bp step-up could undermine investor confidence in SLBs. He calls for it to be linked instead to the size of the company.

Meanwhile, Chris Papadopoullos, economics editor at Capital Monitor, suggests replacing the step-up with an index. “Each year the bond’s coupon would depend on the index,” he says. Hence if a company’s emissions were to rise, the coupon on the bond would also increase. Further transparency could be created by tying a step-up to each KPI.

AFII’s Mielnik pointed to the first sovereign SLB from Chile, issued at the start of March, as a positive step. The $2bn 4.346% 20-year deal has two KPIs, one based on reducing absolute greenhouse gas emissions and the other on raising the share of renewable energy in the national electricity system, with each linked to a 12.5bp step-up. This should make it easier, she says, to assess the probability of sustainability targets being met.

Ultimately, it would not take a great deal to tighten up the SLB market, note certain commentators. As Erlandsson says: “If you construct and you engage with the issuers, you can drive issues to align with policy, environmental policies and sustainability policy.”

That will require investors, for their part, making their needs clear rather than investing in SLBs purely as a box-ticking exercise.

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