Sustainability-Linked Bonds: An Appealing Concept that Disappoints

Sustainability-linked bonds (“SLBs”) are a recent addition to the ESG (environmental, social, and governance) fixed income family: an SLB’s coupon increases if its issuer fails to meet a self-imposed sustainability target by a set date.

That innovative coupon step-up, linked to sustainability, is the key difference between SLBs and Green, Social and Sustainability (GSS) bonds.

Just like GSS bonds, SLBs can serve as tools to boost their issuers’ sustainability credentials. Unfortunately, these promising bonds share one other trait with GSS debt: the way they’re structured now, they often disappoint when it comes to ESG impact.¹

An Attractive Alternative to GSS Bonds

Italian utility Enel was the first company to issue an SLB, in 2019. Enel agreed to increase the bond’s coupon by 0.25 percentage points (pp) if it failed to raise its share of renewable capacity to 55% by 2021, a target it has since achieved.

Since then, Enel has become the largest issuer of SLBs, with nearly $25 billion outstanding tied to various sustainability goals. The company has gone farther still, pledging to only issue sustainability-linked debt going forward.

SLBs’ greater flexibility than GSS bonds was what initially attracted Enel²: GSS bond proceeds are ring-fenced to fund only green or social projects³, but SLB proceeds can finance any purpose, from acquisitions and working capital to general corporate purposes.

Since Enel’s debut, SLBs’ flexibility has attracted many firms eager to tap the ESG market but unable to issue GSS bonds because they lack green or social projects. As a result, SLB issuance has grown rapidly, from $6 billion in 2019 to more than $100 billion in 2022.

Figure 1: SLB issuance has grown rapidly, from $6 billion in 2019 to more than $100 billion in 2022. (lhs: $ billions; rhs: %)

Source: PGIM Fixed Income * Total ESG-labeled bond issuance includes GSS bonds and SLBs.

How We Assess SLBs

Not all SLBs are as robust as Enel's. At PGIM Fixed Income, our framework for assessing SLBs considers, first, how material the key performance indicators (KPIs)⁴ are that an issuer has chosen. In other words, we look at how well an SLB's targets reflect that issuer's environmental or social impacts.

Next, we assess if those KPIs represent an ambitious improvement over its “business as usual.” We also assess how transparent an issuer is as it progresses towards those targets.

Additionally, we assess the SLB’s structural features: are its sustainability target dates appropriate, given the bond’s tenor? And does the coupon step-up provide enough financial incentive (for the issuer) and compensation (for the investor)?

Weakness in any of these criteria leads us to view the SLB as no more "ESG" than its vanilla counterparts.⁵ Ultimately, we want to see an SLB that advances its issuer's sustainability, beyond what its vanilla bonds achieve.

At Best

The primary benefit of a well-structured SLB is to reinforce an issuer’s commitment to its sustainability transition. An issuer that ties a significant portion of its financing cost to its SLB targets is less likely to abandon those targets.

However, pinning down SLBs that meet the standards for an uplift in our ESG framework⁶ is difficult. In 2020, the International Capital Markets Association (ICMA) released its Sustainability-Linked Bond Principles,⁷ with detailed best practice guidelines for structuring SLBs. Later, ICMA also published over 300 recommended KPIs.

ICMA’s KPIs are detailed, but their uptake has been patchy. Many bonds get several things right, but most fall short of an uplift in our ESG framework for one or more reasons.

To illustrate: a large metals and mining company structured an SLB that we reviewed with a coupon step-up penalty of 0.50 percentage points (pp). This SLB’s KPIs were material to its operations, and its sustainability targets were ambitious. They required steep reductions in scope 1,2, and 3 emissions,⁸ aligned with the Paris Agreement’s goal of limiting global temperature increase to below 2°C.

At first glance, this 0.50 pp step-up is a meaningful financial penalty, compared to the paltry market standard step-up of 0.25 pp. However, the step-up would kick in for only three payments towards the end of the bond’s lifetime, two years after the target observation date. As a result, the increased interest expense would be minimal. And even if the step-up kicked in immediately, it would be a small percentage of the issuer’s interest expense, given its high debt.

The financial penalty of this SLB was therefore trivial. As a result, we considered it a non-factor in incentivizing management to achieve its sustainability targets. SLBs like these, with material KPIs and ambitious targets, almost fit the ticket but fall short of the gold standard. That gold standard is, admittedly, almost nonexistent in the market today.

At Worst

There is another potential downside. Increasing an issuer’s focus on its sustainability targets, by tying their achievement to financing costs, can discourage that issuer from raising its ambitions or from focusing on more material KPIs that are harder to address.

According to ICMA, companies should select KPIs that are “relevant, core and material to their overall business, and of high strategic significance to their current and/or future operations.” Unfortunately, many SLBs fail to meet these basic standards.

For example: a food producer’s recent SLB had a 0.25 pp coupon step-up penalty, linked to reducing scope 1 and 2 emissions. But over 96% of this issuer’s emissions come from upstream scope 3 sources, so the KPI was hardly material. In addition, the SLB’s sustainability target lacked ambition, because the decrease in emissions that it required was slight.

Moreover, many outstanding SLBs have vague caveats and carve-outs for M&A and force majeure events. To date, just two index-eligible SLBs have had their step-up features triggered after missing a target: Polish refiner PKN Orlen, in November 2021, and Greece’s Public Power Corporation, in March 2023. Many step-up events are scheduled from the end of 2023, so they remain untested to date. It’s unclear to what extent issuers might invoke caveats and carve-outs by then, to avoid interest penalties.

Several SLBs also have call provisions with call dates before their target observation dates. We haven’t seen it yet, but issuers of such SLBs could call the bond to avoid the reputational risk associated with missing the target.

Room for Improvement

SLBs best suit issuers that don’t have eligible green or social investment projects but still require a sustainable transition. In their current form, however, we mostly view these instruments as marketing tools, to – sometimes cosmetically – boost an issuer’s sustainability credentials, at best.

At worst, an SLB’s ESG label can deliberately distract from an issuer’s inadequate transition plans. Such SLBs may even discourage issuers from setting more ambitious targets, for fear that they publicly miss them.

Ensuring that KPIs are material, ambitious, measurable, transparent, and part of a broader sustainability strategy is key to our assessment. SLBs deserve a seat at the table in the family of ESG-labeled debt, but their impact is set to remain capped if the market doesn’t evolve.

1 For a critical review of GSS bonds issued by banks and real estate firms, please see our earlier blogs “Green Bank Bonds: Abuse of Proceeds?” and “The Surprising Lack of ESG in ESG-Labeled Real Estate Bonds”.
2 “Why Enel turned to sustainability-linked bonds.” Environmental Finance, 14 June 2022.
3 In practice, issuers typically use general cash, in an amount equal to what they raised with GSS bonds, to finance eligible green and social projects.
4 KPIs are the quantitative performance metrics, like % of renewable installed capacity, that an issuer is setting targets against to measure its sustainability performance.
5 We already capture an issuer’s vanilla bonds’ sustainability targets and performance in our forward looking ESG Impact Ratings.
6 For an overview of our uplift process for GSS bonds, please refer to our Green Bond Framework.
7 International Capital Market Association (ICMA). Sustainability-Linked Bond Principles. June 2020.
8 In essence, scope 1 emissions are those that a company produces itself, scope 2 emissions are produced on its behalf to generate the electricity it purchases, and scope 3 emissions are those for which a company is indirectly responsible along its value chain.

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