Sustainability-linked instruments: Setting sustainability targets
Sustainability-linked instruments are the newest iteration in this fast-evolving marketplace. No doubt inspired by the increased mandatory adoption of ESG assessments, sustainability-linked instruments tie company performance on set environmental and / or social targets to the cost of financing.
For market participants new to the responsible and sustainable scene, of which there are a rapidly increasing number, spotting the differences between these securities and their predecessors may not come easily. The key difference is that issuers outperforming their ESG targets can result in coupon interest payments being lowered; conversely, an ESG assessment coming in below a minimum threshold would trigger higher financing costs for the remaining term of the instrument’s agreed lifecycle.
Enel was one of the first to issue sustainability-linked bonds when it launched a three-tranche debt offering in October 2019 (at 5-year, 8-year and 15-year maturity tenors). In October 2020, the company became the first issuer to launch a sterling-denominated sustainability-linked bond, raising GBP500 million on a 7-year bond, an issuance that was so oversubscribed the bonds could have been sold six times over. Enel is seeking to generate value by contributing to the achievement of SDG 7.2 – to “increase substantially the share of renewable energy in the global energy mix by 2030”. Failure to achieve its stated objective by the end of 2022 will result in an additional coupon interest payment of 0.25% for the remaining life of the bond.
Examples of recent sustainability-linked bonds:
Source: Bloomberg, EdenTree, HSBC; * in low- and lower middle income countries, where SIT stands for Strategic Innovative Therapies
We believe one of the attractions of sustainability-linked instruments is that they offer issuers an opportunity to eschew some of the costs arising from demonstrating accountability. While the explicit linking of performance objectives to funding costs is welcome, these securities come without core ingredients we would generally seek in sustainable bonds, such as the stated use of funds, the mandatory ring-fencing of bond proceeds, as well as the management and reporting of fund disbursements. From a company perspective, sustainability-linked debt funding could be interchangeable with other monies for “general corporate purposes” and yet these instruments benefit from the strong investor demand for ESG products.
To the uninitiated, and without much research into the underlying mechanics, these instruments could easily pass for other ESG vehicles with more transparent and stringent frameworks regarding how they deploy, manage and report on their use of proceeds. This calls for investor vigilance not just at an instrument level, but also encompassing the issuer’s wider corporate operations – analysis which has long been a staple part of EdenTree’s responsible and sustainable screening process.
An example of why such scrutiny is recommended is the recent EUR850 million issuance of sustainability-linked notes by LafargeHolcim in November 2020 (note, this is not held in any of EdenTree’s portfolios). Even though the company’s goal of reducing its CO2 emissions by 17.5% from a 2018 baseline appears noble, the company’s core business is cement manufacturing, a highly carbon intensive process which failed to meet our ESG criteria. More significantly, alleged abuses* by its subsidiary in Syria did not augur well for responsible investment according to the EdenTree Business Ethics pillar.
*Following an inquiry into indirect financing of armed groups in Syria, LafargeHolcim admitted that it had resorted to “unacceptable practises” to continue operations at a factory in the country. The factory was closed and its CEO at the time of this internal investigation has since resigned.
ECB offers a boost
In late September2020, the European Central Bank (ECB) added sustainability-linked bonds to the universe of securities that it considers acceptable for the purposes of collateral and eligible for outright purchase via its monetary policy initiatives. This includes its ongoing Asset Purchase Programmes and its Pandemic Emergency Purchase Programme from 1 January 2021 onwards, subject to compliance with all other eligibility criteria.
The ECB has stipulated that coupons on qualifying securities must link to environmental performance targets noted in the European Union’s taxonomy or climate-related UN Sustainable Development Goals.
This means, in its current form, the Novartis bond shown in the table is unlikely to qualify for ECB purchases, nor for use as collateral, as its performance metrics are of a social rather than an environmental nature.
Despite its sole focus on the environmental factor, the participation of a major central bank in this fledgling market is still a welcome development that could ultimately result in larger issuance aimed at sustainability.