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Sustainability bond market stumbles as investors get picky

The market for a class of bonds once touted as the future of green investing is flagging, as investors worry that the debt does not impose sufficiently stringent penalties on companies for missing their climate targets.

Last year, $60bn of so-called sustainability linked bonds (SLBs) were issued around the world, a 37 per cent decline on 2021’s total. Dwindling sales came as a disappointment to analysts who expected rapid growth that would eclipse longer-established market for green bonds. Barclays had expected 2022 issuance of more than $200bn.

Sustainability linked debt aims to tie companies to their climate promises by punishing them with higher interest rates if they miss environmental targets. Investors have frequently viewed them as preferable to green bonds, which allow issuers to raise cash for specific green projects but do not impose any obligations on the company as a whole to meet goals such as cutting emissions or water usage or overhauling their supply chains.

In practice, however, the “step-up” in coupon payments embedded in the bonds’ terms have been too small to provide much incentive to issuers to clean up their act, analysts say. Meanwhile, some environmentally conscious investors simply do not want to hold debt issued by companies at risk of reneging on their green promises.

“Both myself and the market are quite concerned about the quality of these instruments [SLBs],” said Charlotte Edwards, head of ESG fixed income research at Barclays. Investors will probably be a bit more “picky” about what they are buying in 2023, she added.

Column chart of SLBs issued by companies since the birth of the instrument showing Sustainability linked bonds have not surged as expected

A symptom of market dysfunction for some is that SLBs have not so far benefited from the elusive “greenium”, a lower borrowing cost that companies hope to achieve when they issue bonds with a sustainability label.

While Barclays’ analysis of hundreds of green bonds and their vanilla equivalents suggests green bond yields are 0.05 percentage points lower, representing a cheaper borrowing cost for issuers, it has not observed any comparable spread for SLBs.

This might be because the reward promised to investors for an issuer’s climate failure is not particularly high: generally 0.25 percentage points, lower than the typical 1.25 percentage point penalty built into some bonds to protect investors in case of a fall in the issuer’s credit rating.

Polish oil refiner PKN Orlen’s became the first SLB issuer to pay a coupon step-up last year, the interest payments on its two bonds worth 2bn zlotys (£368mn) rising by one-twentieth and one-tenth of a percentage point respectively, after its sustainability rating was slashed by data provider MSCI.

Some policymakers worry that the bonds are giving a free ride to companies to burnish their green credentials. Paul Tang, a lawmaker leading the European parliament’s efforts to bring sustainable debt instruments into regulation, said that SLBs in their current form were a “greenwash machine”.

Esma, the financial sector regulator for the EU, warned earlier this month that SLBs could be considered a “free lunch” for issuers, for example because of the widespread use of call options, which means issuers could recall a bond before a step-up takes place, as well as low step-up rates.

“We are not against the instrument itself but it needs work,” Tang said, highlighting EU proposals to make companies tie step-up objectives to formal transition plans.

As companies currently set their own targets, accountability for slow progress is low. Most issuers who tie SLBs to emissions targets, like the supermarket Tesco, exclude big chunks of their carbon footprint from scope. Brazilian meatpacker JBS was hit by an SEC complaint by an NGO last month for issuing $3.2bn of SLBs tied to a tiny part of its emissions. JBS has rejected the premise of the claim, and said the bonds’ focus on direct emissions was a reflection of poor data availability. Others like Sembcorp, the Singaporean power provider, have simply moved high-emitting assets off balance sheet after issuance.

Julien Lefournier, a lecturer in green finance at Paris universities and former Crédit Agricole banker, compared the practice of SLB issuers choosing their own objectives to the French televised singing contest École des fans, in which children give each other marks and every contestant is awarded first place. “They called this the democratisation of green finance, it was meant to be open to everyone — but it has become a big joke,” he said.

A test of the market’s maturity could come later this year and next year, when Barclays’ Edwards expects a flood of coupon step-ups for index-eligible SLBs.

Italy’s state-owned energy company Enel, which issued the first SLB in 2019 and 27 others since, could be responsible for many of these. One SLB is linked to a target of 60 per cent renewable installed generation capacity, which it fell short of in its latest results, and which Italy’s turn to coal since the start of the Ukraine war may have pushed out of reach. This target is for 2022, based on data due to be published in April or May.

Enel said it was on a clear trajectory to achieving net zero emissions by 2040. If it did fail to meet the objective this would be as a result of the gas crisis and the Italian government’s decision to temporarily maximise production from coal-fired power plants, Enel added.

More step-ups could turn out to be a good thing if they give investors confidence the market is capable of making issuers pay for climate failure. A Morgan Stanley report last month recommended issuers start setting goals that are trickier to meet, “otherwise the bond’s impact is de minimis”.

An enduring catch-22 is that when step-ups do happen, they can look bad for investors who buy SLBs in part to hit green financing targets. “If you’re a sustainable investor you don’t want the step-up to be triggered,” Eric Pedersen, head of responsible investments at Nordea Asset Management, which manages €239bn, said. “It would be a sad extra dollar if the coupon were raised for that reason.”

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