Interest in sustainability-linked bonds has surged among issuers, but how do investors feel about the innovative new format? Nordea Sustainable Finance Advisory has taken a deep dive, exploring investor reactions as well as the results of a recent investor survey on the SLB format.
Sustainability-linked bonds (SLBs) have made a strong debut on the sustainable finance scene after the publication of the Sustainability-linked Bond Principles in June 2020. So far, around 60 SLBs have been issued, tied to a wide range of key performance indicators (KPIs) and sustainability performance targets (SPTs). The bonds’ financial characteristics also vary among issuers, even if the coupon step-up structure, introduced by ENEL in 2019, seems to be accepted as the market standard.
For a more nuanced picture of the market, we decided to conduct an investor survey, to better understand investors’ approach to the format and their view on its different elements.
Investors generally positive, with some concerns
The responses from the survey show that the majority of investors are generally positive about the format and believe it has great potential to make a substantial contribution to the sustainable finance space.
Investor comments include:
“I think this could be an option for companies in transition mode, without sufficient green assets to issue a green bond.”
“… the sustainable investment universe can be broadened, many new issuers could appear on the radar.”
“We believe sustainability-linked bonds are especially strong in their contribution to decarbonization goals, as they tie the issuer’s entire operations to these specific goals. Sustainability-linked bonds are a good example of how issuers can credibly signal their sustainability targets by linking them to financial incentives.”
We believe sustainability-linked bonds are especially strong in their contribution to decarbonization goals, as they tie the issuer’s entire operations to these specific goals.
Investor respondent in Nordea's survey
The KPIs and SPTs used in SLBs are core to investors
When choosing what KPIs and SPTs to use for a Sustainability-Linked bond, a number of factors come into play. The Sustainability-Linked Bond Principles emphasise that the KPIs and SPTs should be ambitious and material. However, ambitiousness and materiality are to some extent subject to interpretation, and in the end, the market decides whether the KPIs and SPTs are relevant and ambitious for the specific issuer.
The investor survey yielded much input on the subject, with the majority of investors confirming that the ambitiousness and materiality of KPIs and SPTs are core factors when assessing an SLB. On the question, “What do you see as the key opportunities and challenges with the Sustainability-Linked Bond Structure?”, a large majority of the investors raised concerns about the problems related to adequately evaluating KPIs and SPTs.
“Difficulties in analysing selected KPIs for different sectors, difficulties in analysing whether KPIs are relevant”
“… sustainability-linked bonds rely on targets being ambitious, implying a more in-depth knowledge of the company you are investing in is necessary.”
“Identifying the relevant KPIs and credible, material threshold value could be challenging and brings up the risk of greenwashing?”
The concerns are valid, as investors need more extensive knowledge about a company and its industry sector to assess the ambitiousness and materiality of KPIs and SPTs and, thus, the size of the potential positive climate impact of their investment. What’s more, the format competes with the tangible nature of a use-of-proceeds structure tied to the green bond format.
We believe that as the market develops, the level of ambitiousness and materiality of KPIs and SPTs required by investors will increase. Ideally, we would like to see the market moving towards a higher demand for KPIs and targets verified by a third party, such as the Science-Based Targets initiative (SBTi). Over time, this verification will need to cover not just climate but also other themes such as water, biodiversity and more.
Identifying the relevant KPIs and credible, material threshold value could be challenging and brings up the risk of greenwashing.
Investor respondent in Nordea's survey
A coupon step-up structure is regarded as the market standard
Investors not only have to assess the ambitiousness and materiality of KPIs and SPTs; they also have to consider the financial characteristics of SLBs. When ENEL issued the inaugural sustainability-linked bond in 2019, it included a coupon step-up of 25 bps as a financial penalty if the company’s SPTs were not met. Since then, using coupon step-ups as a financial characteristic has become the market standard in the SLB space. However, a number of issuers have included other types of failure effects in their SLBs, including a higher redemption price, coupon step-downs, purchases of carbon offsets and donations to charity.
Our survey shows that most investors seem satisfied with the coupon step-up structure. However, some highlight the problematic reversed incentive, as investors benefit from issuers not meeting their sustainability goals. One investor concluded that:
“The most important necessary change in structure is to switch from reward to bondholders in case of miss towards an ESG friendly utilization.”
The reversed incentive is one of the biggest problems for the SLB format. Etihad Airways solved this incentive problem by committing to buy carbon offsets of an amount corresponding to between 5-25 bps on the notional amount of the bond, depending on the performance on the target. While carbon offsets could be a great solution for investors to ensure positive climate impact from their investments, the quality and quantity of carbon offsets are the critical factors. Furthermore, carbon offsets could also be seen as a way for companies to buy their way out of having to make actual progress on sustainability and reduce their emissions.
Moreover, all investors are not comfortable with issuers stepping away from the usual coupon step-up structure. Asset manager PIMCO in December 2020 released its own guidance document for sustainable bond issuance, stating that they prefer coupon steps structured like “typical bond covenants” and payments to investors rather than charitable donations.
The focus should be on ensuring that the financial characteristics of SLBs incentivise tangible positive climate impact.
Ensuring positive climate impact
We believe that, as the market grows, we are going to see harmonisation on the financial characteristics, reinforcing coupon step-ups as the market standard. However, the focus should be on ensuring that the financial characteristics incentivise tangible positive climate impact. In the case of a company using carbon offsets as a financial penalty for an SLB, the company should make sure to close the emissions gap between the target and their performance, as that would guarantee investors the positive climate impact they have invested in. Furthermore, the flexibility in financial characteristics should be utilised by issuers in a way that is relevant for the overall bond structure, regarding the targets and maturity of the bond. For example, an issuer setting targets matching the maturity of the bond should consider a higher redemption price rather than a coupon step-up.
The SLB market is still very young, and investors and issuers are still trying to figure out how to use the format in an efficient way. Investors are positive but have concerns about assessing the ambitiousness and materiality of the KPIs and SPTs. As the market grows, clearer market standards are likely to emerge, and hopefully, we will see increased demand from investors for the use of science-based approaches in the selection of KPIs and SPTs. We believe the sustainability-linked bond format, tied to material and ambitious KPIs and SPTs, is a great instrument to help issuers make their sustainability transition.
About the authors:
Jacob Michaelsen, Head of Nordea Sustainable Finance Advisory
Oskar Hagman, Nordea Sustainable Finance Advisory
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