Into the Mainstream

Justine Leigh-Bell, Executive Director at Anthropocene Fixed Income Institute, surveys the sustainability-linked bond market and outlines steps to widen the investor base.

Sustainability-linked bonds (SLBs), which first emerged in late 2019, have seen a ramp-up in adoption, as more corporates and sovereigns set ambitious commitments to transition towards net zero carbon emissions.

The market has grown to US$279 billion, totalling 768 bonds from 469 issuers as of November 2023, according to Climate Bonds Initiative’s (CBI) inaugural report on SLBs. Corporate issuers have dominated the SLB market, seeing an opportunity to lower borrowing costs in the form of green premiums, or greeniums. Sovereigns, including Chile and Uruguay, have also issued SLBs.

While volumes spiked in 2021, fuelled by Enel’s whopping €3.25 billion SLB in June that year, issuance has since dipped slightly, due to market concerns around the new instrument’s credibility in the absence of agreed standards and a strong framework. In addition, the SLBs coming to market were all set at a 25 basis points coupon step-up, which doesn’t take into consideration how ambitious – or unambitious – key performance indicators (KPIs) targets are.

“There was good progression in the first years [for SLBs], but then the same angst and misconceptions emerged around the product [as seen previously with green bonds]. A lot of questions were being asked, especially around ambitions, which made investors [nervous],” Justine Leigh-Bell, Executive Director at Anthropocene Fixed Income Institute (AFII) told ESG Investor.

Yet despite these initial issues around ambition, trust and credibility, Leigh-Bell believes that SLBs are the ideal structure to enable the net zero transition.

“Green bonds, sustainability bonds and social bonds have a huge role to play in delivering on commitments to hit 2050 targets and will continue to do so. However, SLBs play an important complementary role, acting as that layer of accountability and continuing to open up the market. They can bring in the hard-to-abate sectors, which are on the backfoot and do not have the required capex in place,” she said.

Option pricing

Another problem limiting greater adoption is that the majority of SLBs issued to date have been under a use-of-proceeds (UoP) financing model more commonly seen in green bonds, where proceeds are used for specified green projects and assets. This is considered restrictive to a large portion of the market outside the investment grade large corporate or developed economy sovereigns, as well as in the hard-to-abate sectors, as Leigh-Bell pointed out. This is because the UoP model ties proceeds to specific projects whereas SLBs were intended to fund whole-business or whole-economy transformation.

“The green bond market has taken 10 years to build out the infrastructure for UoP-labelled debt to flourish. But the UoP model was then applied to an SLB structure, which is designed to channel general corporate proceeds and a completely different beast,” she explained.

AFII recognised that the instrument had to be treated differently to UoP bonds and released a 2022 paper that proposed an option-pricing approach, commonly used

in derivatives trading, to help investors objectively measure the fair value of coupon step-ups. This will help drive greater – and much needed – ambition in transition planning by issuers, according to Leigh-Bell.

For example, if an issuer sets an ambitious target, then it will achieve a lower cost of capital based on the level of ambition. At the same time, it is signalling to the investor that there is a greater probability it will not meet its target, at which point the investor would receive a higher pay out. “This allows the investor to hedge its risk,” explained Leigh-Bell.

But if the investor ends up investing in a company that performs well, from a transition perspective, it will deliver overall impact to the investor’s portfolio, etc. “It’s a win-win on the investor side,” she said.

However, this is not the way in which some firms in the ESG investing community look at things. Instead, this group of investors has tended to move away from market dynamics and taken an ‘ESG orthodox’ approach of not investing in companies that might fail to meet specific KPIs.

As such, taking an option-pricing approach will help widen the investor base beyond the ESG investing community, according to Leigh-Bell. It lets traditional bond investors, who may not understand the nuances of different policy frameworks and developments in the ESG space, take a well-understood market risk approach and be more confident in holding SLBs that are either going to step-up or step-down, with a pay out on the back of ESG performance.

The investors AFII has engaged with to date have been very receptive to this approach, she reported. “Investors and issuers are talking the same language once price is brought into the discussion,” said Leigh-Bell. “So by focussing on valuing those options, we will have a much more even playing field between investor and issuer.”

However, a consensus among the investor community is needed for option pricing to work, she added. For example, there needs to be an agreed threshold for what is considered to be ‘ambitious’ and ‘increasing ambition’ when it comes to KPIs for SLBs. Industry players like CBI and International Capital Market Association are working to set guidance, as well as looking at different KPIs, such as absolute emissions instead of intensity of emissions.

The second point is around financial materiality and how to price KPIs that are more on the qualitative side, difficult to measure and have very little data behind them. Currently, emissions is the main metric that can be measured and a financial value attached to. “But when other KPIs are added into the mix, it confuses investors and they don’t really know what to do with that,” she explained.

Yet, progress is already being made in addressing these issues, according to Leigh-Bell, because of the deeper relationship between SLB issuer and investor. In addition, data that was quite scarce is starting to become available, because of the need for tracking and reporting to evidence KPI target achievements. “We are starting to have better data, better transparency, better disclosure, and better relationships with investors,” Leigh-Bell added.

All eyes on Enel

Italian energy utility Enel is a prominent issuer of SLBs, being the first-ever issuer in September 2019 and the single biggest issuer with 30 SLBs totalling US$31.1 billion, which makes up about 40% of its overall share of public debt outstanding.

However, there is uncertainty over whether Enel will hit its 2023 sustainability performance target tied to the Scope 1 emission intensity of power generation.

“AFII is watching Enel very closely. It will be very interesting to see how the market reacts,” said Leigh-Bell. “In some cases, the market has shown a reaction to misses or successes when the trigger dates come up, but there are other cases where the data is just too insignificant to draw any conclusions.”

Enel continues to assert that it will hit its carbon intensity targets. But if it misses, AFII has estimated there could be an annual increase of US$27 million to Enel’s interest cost.

“It’s quite a significant amount of capital that Enel will need to dish out to investors,” said Leigh-Bell. “But it shows that the market is working, as we wouldn’t want a situation where a company gets away with missing its target. And if it stays committed to the course, we’ve now got a mechanism that is helping to drive that change.”

She pointed to the example of PKN Orlen. The Polish oil refiner was among the first to miss its target, which was tied to its MSCI ESG rating, so it had to pay a step-up. A year later, it received a better rating so there was a step-down. “Importantly, Orlen didn’t quit – it stayed the course and remained an SLB issuer,” said Leigh-Bell.

Investor influence

According to Leigh-Bell, investors now have a significant amount of influence in the SLB market. She reports that climate-focused investors are becoming common participants in many roadshows when companies raise capital.

“A handful of large investors in this space are driving the agenda, as they can articulate the expectations that they have around KPIs. Some investors just won’t accept anything that doesn’t have Scope 3 targets, while others want to see Scope 1 and 2 emissions at the very least. We are starting to see some investors wanting to see KPIs around water security and other things beyond emissions,” she added.

But Leigh-Bell also said that issuers are finding it difficult when there isn’t a unified voice across the investor community as to expectations. “Some investors have set the bar very high, which is difficult for companies to achieve. Therefore, the company walks away and won’t issue the SLB,” she said. “Yet there are still those investors that don’t know what to ask, or are sitting on the fence and not participating in the market.”

For this reason, the AFII has tried to shift the conversation to the quantitative side, which can help overcome challenges to the market pricing effectively. “We have to move away from a morality-led stance behind investing or not investing in something that’s going to fail or succeed [to meet KPIs], because ultimately what we’re trying to do is get everyone moving in the same direction,” Leigh-Bell said.

Clearly, the SLB market has several important issues to address and iron out. But by bringing pricing firmly into the discussion, Leigh-Bell believes that there is a chance of building a market where SLBs can bring about real change.

“We are at a critical moment for the SLB, taking it from a niche product to a scalable product,” she said. “And while it’s not being thrown into the bin just yet, it’s certainly not meeting its full potential.”

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