What are Sustainability-linked debts ?
Sustainability Linked bonds (SLBs) can be issued by any public or private entity. They provide a strong incentive for issuers to deliver on their impact commitment.
“When the cost of financing is linked to sustainability performance targets and indicators : Game on”
In June 2020, the ICMA provided voluntary guidelines with the first version of the Sustainability-linked Bond Principles (SLBP). Therefore, this aims to further develop the key role that debt markets can play in funding and encouraging companies that contribute to sustainability.
These principles emphasize on the transparency, accuracy and integrity of the information provided by the issuer and disclosed to all stakeholders. Thus, issuers should establish clear processes including :
What are the different components of SLB ?
Key Performance Indicators (KPIs)
One or more KPIs should be measurable and material to their sustainability strategy.
Sustainability Performance Targets (SPTs)
One or more SPTs for each KPI demonstrating the level of ambition of the issuer
Financial impacts and triggering events
They can change the debt characteristics depending on whether or not the KPI has reached the SPT. Coupon variation is the most common example.
Regular and updated reporting
To assess the issuer’s performance compared to an SPT leading to potential debt adjustments.
Independent and external verification
Certify the performance level against each SPT for each KPI by a qualified external reviewer.
All processes should be disclosed to investors before the issuance of the bond, in the framework document for instance.
A glance at the market and the players
This debt format has been in use in the lending markets for some years, while it is new to the debt markets. We are in its early stages with only US$7 billion issued in 2020, mainly by European issuers. To stay ahead of the sustainable bond market, we provide a data visualization tool to witness the evolution of sustainability-linked bonds.
The first issuance was carried out by ENEL, an Italian energy company issued in 2019, a $6 billion Euro Commercial Paper program linked to the achievement of a renewable energy installed capacity percentage equal to or greater than 60% of the total installed capacity by December 31, 2022. This SDG7 Target Guaranteed ECP Programme is something that will be done more and more in the future.
A number of other players such as LafargeHolcim, Novartis, Chanel and Suzano were the early movers. The targets were linked to environmental, social or governance (ESG) considerations and the impacts could go beyond the coupons and be linked to other characteristics of the bonds, such as maturity.
Many other issuers are likely to join this market in the coming months and years. The ECB has made all sustainability-linked debts eligible for asset purchase programs and as collateral since the beginning of 2021.
What are the main challenges today ?
This sustainability debt instrument is currently experiencing two main challenges, expressed by several market participants.
How do you set sustainability KPIs and targets that are ambitious enough ?
With this target-linked format, KPIs and targets must be achievable and consistent with the issuer’s own performance over time. They should demonstrate a material improvement over the “Business as usual” trajectory.
A good starting point for issuers could be to elaborate KPIs and targets in collaboration with sustainability experts, such as the Science-Based Target initiative (SBTi) that provides a clearly-defined pathway for companies to reduce greenhouse gas (GHG) emissions.
How to go beyond only penalty provisions against issuers ?
All SLB issuances to date have had higher coupons when sustainability targets are not met. Fixed income investors are still cautious about incorporating coupon reductions for an SLB format. This is not yet a reality in the market. Issuers are not rewarded with a lower coupon if they meet targets. It will attract even more issuers to this market.
What are the key benefits of Sustainability-linked Bonds ?
Sustainability-linked debt instruments have the opportunity to become a complementary tool in sustainable finance. They offer :
Flexibility
There is no need for the issuer to assign the proceeds to a specific green or social activity. What matters is the achievement of sustainability targets and KPIs.
A broader spectrum of issuers
Private and public entities can access sustainable funding even if they are too small, new to sustainability, or operating with only a small portion of assets.
Stronger incentives
Issuers choose their own targets and are encouraged to achieve them at the issuer level, not just at the activity level. There is an overall commitment to delivering tangible outcomes, very much appreciated by investors.
Protection against defaults
A higher coupon protects investors if targets are not met. It provides greater confidence in the issuer’s long-term commitment and fits with investors’ interests.
What’s next for this debt market ?
Issuers should explore sustainability-linked debts as an alternative approach to structuring debt financing related to sustainable development. This format goes beyond what exists in the market by creating a direct financial incentive within the structure of the debt instrument.
This debt instrument format could be issued by any entity having access to the capital markets. Sustainability-linked Euro Commercial Paper has already been issued by leading players on the markets and it could work with many different applications.
Good examples are the Sustainability-linked Euro private placement made by Groupe Bel or the sustainability-linked Revolving Credit Facility (RCF) made by Sanofi.
