Sustainable finance has played a pivotal role in enabling organisations to raise capital to fund environmental and social initiatives. This is seen with green bonds being the most widely used to finance environmental projects and social bonds issuance has drastically increased by sevenfold in 2020, as investments in healthcare and employment generation surged due to the COVID-19 pandemic.
An emerging and growing debt instrument, but less commonly used, are sustainability-linked bonds (SLBs). These bonds are usually linked to sustainability key performance indicators (KPIs) and measured against a set of sustainability performance targets (SPTS). The issuer must meet these predefined ESG targets within a given timeframe or they risk paying a higher coupon interest rate if they underperform.
To ensure transparency, accuracy and integrity of information the International Capital Market Association has outlined the following sustainability-linked bond principles:
1. Selection of Key Performance Indicators
Firms issuing SLBs must align these KPIs to their sustainability and business strategy to address pertinent ESG challenges that their sector is currently facing. For example, the fashion industry is synonymous for its heavy carbon footprint therefore a firm might choose to focus one of its KPIs on reducing Scope 1 and 2 emissions by 70% by 2040. Furthermore, issuers are encouraged to share relevant metrics from the previous years with investors.
2. Sustainability Performance Targets
SPTs are fundamental to structuring sustainability-linked bonds as they enable all parties to keep track of KPIs. Each KPI set by the issuer must be comparable to an external benchmark such as the organisations’ previous performance or scientific metrics, which are predetermined at bond issuance.
3. Bond characteristics
If the issuer fails to meet its sustainability linked targets, then the characteristics of the SLB will change as they will be expected to pay a higher rate of interest to investors. Furthermore, SLBs should include a fall-back mechanism in the circumstance that the issuer is unable to measure their performance against an ESG metric. This would only occur in extreme instances such as a change in regulation.
4. Reporting
To keep investors and other stakeholders updated on the organisations’ progress they are required to release an annual report outlining their latest performance data in relation to their KPIs and any update to their strategy.
5. Verification
Issuers are expected to seek external verification from experts such as auditors or environmental consultants, to evaluate their performance level against SPTs for each KPI and publicly report this information.
The rise of sustainability-linked bonds
The Italian power utility and natural gas company Enel played a key role in the rise of SLBs as they raised this idea with investors in 2019. Initially, Enel issued a $1.5bn five-year SDG-linked bond with a 2.6% coupon which was linked to two of the UNs Sustainable Development Goals (SDGs) –13 on Climate Action and 7 on Affordable and Clean Energy. The first KPI that Enel set was to reduce direct greenhouse gas emissions by 64% by 2030, and 80% by 2030, using 2017 emissions as their baseline. Additionally, Enel set a target of increasing its renewable capacity by 65% by the end of 2023.
The demand for SLBs is still on the rise and has been growing across various sectors such as retail. More recently, H&M issued a $606 million SLB back in 2021, garnering a great deal of interest among investors as it was oversubscribed by 7.6 times. The retailer aims to use these funds to achieve the following targets by 2025:
· Increase recycled material usage by 30%
· Reduce Scope 1 and 2 emissions by 20%
· Reduce Scope 3 emissions across its entire value chain by 10%
This increased uptake in SLBs can be attributed to the fact that issuers have no restrictions on how the proceeds can be used unlike with conventional green and social bonds. Therefore, making it possible for a greater number of organisations that might not have adequate green or social capital expenditure to issue a sustainable use-of-proceeds bond or lack sufficient infrastructure to track metrics, to obtain sustainable finance.
A growing opportunity
With the sustainability-linked bond market projected to reach $220 billion this year, which is an 135% increase from 2021 it is evident that investors are more willing than ever to invest in sustainable initiatives. This presents an opportunity for organisations to start addressing pressing issues across their business and sector such as reducing Scope 3 emissions. Therefore, doing so will not only benefit organisations financially but it will help accelerate attaining wider environmental and social goals set by the government such as reaching net zero by 2050 in the UK.
Moreover, there still remains a low uptake in SLBs among national and sub-national governments due to the perceived complexity of structuring SLBs relative to use-of-proceeds (UOPs) instruments for example, green and social bonds. Despite this drawback, Chile issued the world’s first sovereign sustainability-linked bond for $2 billion in March 2022. The country aims to reduce its carbon emission down to 95 metric tons by 2030, and that 60% of electricity production must be derived from renewable energy by 2032. Therefore, the UK should consider following suit as issuing SLBs to tie interest payments to the country’s net zero goals will not only prove to be cheaper than green gilts but the prospect of financial penalties being imposed if the targets are missed would further incentivise the Government’s commitment to decarbonisation.
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