Issuers of sustainability-linked bonds have fallen short on setting performance benchmarks, according to a study from Sustainable Fitch.
The study reviewed deals concluded between 2019 and mid-2020 by the world’s first 30 SLI bond issuers and their bonds’ key performance indicators (KPIs).
They found that only 47% included a KPI considered core to their business under the International Capital Market Association (ICMA)’s KPI registry while around 20% had a KPI deemed secondary.
Another 18% had a core KPI that was only partially fulfilled, such as reducing only greenhouse gas emissions from sources owned or controlled by the issuers. The recommendation is to also include emissions from activities not under their control, such as consumption of their products.
The study also revealed that around 15% of the issuers had KPIs that are neither core nor secondary. Examples include targets on cutting sulphur oxide instead of carbon dioxide emissions, and investing in non-green but lower-emitting vehicles.
The findings suggest that in certain SLB deals, the environment, social and governance (ESG) benefit may not be as big as investors expect.
Energy and utilities comprise the largest single category at 28% of the total, of SLB issuance.
For these issuers, KPIs are typically clear and easily verified, as they mainly relate to the measurement of reductions in greenhouse gas emissions, in contrast to other possible performance targets.
Fitch notes that the assessment date to see how an issuer has progressed towards its performance targets can be set close to the maturity dates of the bond, “which means step-ups are paid on few coupon payments”.
“The data indicates that while some issuers have ensured relevance in their KPI selection, many others still need clarification,” said Nneka Chike-Obi, head of Asia-Pacific ESG research at Sustainable Fitch. “This is especially important for non-emissions targets in cases where companies are looking into the effect of other environmental and social factors on their business.”
The findings are significant given the dramatic growth of the SLB market. Although still a small portion of the total green bond marker, these bonds went from accounting for 1% at the end of 2020 to 10% at the end of the first half.
Last year, issuance climbed to $91.2 billion via 154 deals from $8.3 billion through 16 transactions in 2020, according to financial data provider Refinitiv. So far this year, the figure reported was $52.9 billion.
Europe corporates dominate the market with more than half of all SLBs issued in 2021 and H1 2022 while the continent also becoming the largest sustainable bond market in the world.
Overall, SLBs have become an increasingly popular tool for financing decarbonisation projects and meeting climate goals. They go beyond the traditional use of proceeds model and link ESG performance to financial performance through KPIs and science-based targets.
“This flexible structure has allowed for more companies across different sectors to gain access to sustainable financing, particularly those that are not able to allocate large amounts of funding to dedicated green or social assets,” according to Fitch.
The ratings agency added that “failure to reach set targets will result in a penalty for the issuer, usually in the form of the ‘coupon step-up’.
This describes the obligation on the issuer to pay a premium on top of the coupon already due on the bond in question.
This brings two problems, according to Fitch. The first is that the majority of SLBs, despite their many differences, pay a step-up penalty of about 0.25%.
“Our analysis finds almost no correlation between an issuer’s credit rating and the coupon step-up< ” said Fitch. “There is also no indication that step-ups are structured based on the ambition of the targets or on the cost required to achieve them.”
Fitch also noted that the very flexibility in setting targets that has appeal for issuers is putting off some investors.
The ratings agency said, “Asset manager Nuveen disclosed in 2021 that it had passed on investing in SLBs from a US high-yield issuer and an Indian cement company because it felt the structure allowed the issuers too much ‘latitude’ to invest proceeds, and penalties did not provide enough incentive to significantly improve their carbon footprint.
The lack of clear guidance on the suitability of performance targets at the product’s launch creates a knowledge vacuum for both issuers and investors.”
The first SLB is generally considered to have been issued by Italy’s ENEL in September 2019 and most follow the Sustainability-linked Bond Principles established by the International Capital Markets Association in June 2020.
In June, the ICMA published a registry of 300 KPIs for SLBs alongside resources and guidance, partly driven by a rapid take-up by issuers looking to finance efforts to reduce their CO2 emissions.
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