Climate action requires huge capital inflows. To meet global climate objectives, investments are short by roughly $100bn (£82bn) each year.
The financial markets have a crucial role to play in innovating new financial instruments to match capital flows with investor demand and sustainable needs.
The market for green, social and sustainable (GSS) bonds has grown rapidly, reaching $2.9tn in mid-2022. Within GSS fixed income, a notable growth area is in sustainability-linked bonds (SLBs), which experienced a 900 per cent increase in issuance between 2020 and 2021, and accounted for 10 per cent of new GSS bonds issued year to date.
While GSS bonds must be specifically used to invest in green and/or social projects, SLBs have less stringent remits. SLBs can be used for general corporate financing but with a potential ‘step up/down’ – increase/decrease in coupon payment – or increased redemption prices, which are linked to broader sustainability key performance indicators.
So, SLBs do have the potential to be an effective tool in enabling a sustainable transition from a broader range of issuers to raise necessary capital to finance their climate efforts.
Greenwashing
However, it was found that corporates issuing SLBs benefit on average a sustainability premium of 29 basis points at issuance, a pricing advantage of issuing SLBs versus ‘vanilla’ corporate bonds.
This means the nascent SLB market is also vulnerable to being co-opted for greenwashing.
To avoid this, SLB issuers should select KPIs that are material and relevant to their sustainability strategy. Targets should not simply be material, but also ambitious, with materiality of the areas targeted also comes the strength of the KPIs themselves.
Corporate issuers of SLBs may not be targeting the most material challenges to their industry in their SLB-linked KPIs.
The potential for greenwashing makes detailed and robust analysis essential.Reducing greenhouse gas emissions are undeniably an important part of achieving the climate goals set at the Paris Agreement. However, emissions are more of a pressing issue depending on the sector, for example in the construction sector more than in telecommunications.
Our analysis involves an industry materiality matrix to determine if the given KPI is dealing with the most pressing issues facing the sector the issuer is situated in.
We would regard a KPI linked to greenhouse gas emissions focused purely on scope 1 (emissions directly created by business operations) as being weaker than a KPI targeting scopes 1, 2, and 3, which incorporate direct and indirect emissions, including those created along the supply chain.
Main Street Partners’ research shows that in the first half of 2022, 58 per cent of SLB issuances were tied to greenhouse gas emission KPIs, but only 28 per cent of these covered all three emissions scopes.
Step-up bonds
A ‘step-up’ bond typically pays a lower initial interest rate but allows for rate increases at periodic intervals. The number and extent of the rate increase, as well as the timing, depends on the terms of the bond.
SLB issuers choose the date of their sustainability performance targets, which are tied to their reported KPIs. If they meet these KPIs, the SLB increases the coupon payment.
The market standard for coupon step-up payments is 25 basis points, with an average step-up of 26.6 basis points (though there is no official market consensus). If the issuer fails to meet these KPIs, the SLB automatically triggers a financial penalty or self-imposed ‘fine’.
Another challenge for investors can be comparing SLB issuers' performance against stated targets.Analysis at Main Street Partners considers both the number of periods an issuer is exposed to a change in financial characteristics, as well as the magnitude, as one of the inputs into calculating an SLB’s rating.
The ‘penalty’ feature of SLBs can be mitigated by an issuer, where an early redemption is applied. If they exercise the call option early when sustainability targets are not met, this undermines a key feature of SLBs for investors.
According to the World Bank, as much as 65 per cent of all SLBs hold callable options, a portion of which have a low penalty, far exceeding the proportion of callable features in green and conventional bonds – at 23 per cent and 12 per cent respectively.
Main Street Partners’ SLB model penalises callable features, ultimately leading to a reduction in the ratings based on the magnitude of the financial penalty, and the time exposed.
Another challenge for investors can be comparing SLB issuers' performance against stated targets. Without standardised reporting across the market, investors are left to piece together data from annual reports, sustainability reports and verification statements.
SLBs can be a valuable source of capital supporting issuers’ green transitions.Rebasing of targets in the event of significant changes like merger and acquisition events for the issuer are also not always clearly stated, further complicating SLB performance reporting.
SLBs are a welcome addition to the GSS bond market. They can be a valuable source of capital supporting issuers’ green transitions, especially corporates with a limited number of actionable green, social or sustainability projects, providing them with access to support their transition.
Sovereigns such as Chile and Uruguay, which recently issued SLBs, have to follow more stringent reporting and verification standards, thus setting goalposts for private issuers to aim for.
However, the potential for greenwashing makes detailed and robust analysis by an independent, non-partisan ESG provider essential.
Jaime Diaz-Rio Varez is a research analyst at Main Street Partners
