By Josephine Richardson – Anthropocene Fixed Income Institute: Capital investment to transition to a net-zero economy is currently falling well short of the $2.7 trillion required annually to deliver on the 2050 target. For the $120 trillion fixed income market to play its part, there is a need to maximise volumes of all available sustainable debt products to achieve the necessary scale. 

Sustainability-Linked Bonds (SLB) are a relatively new entrant to the capital markets and becoming a useful tool for companies and governments that need to finance the transition of their operations and economies. Unlike green bonds, which designate investment into discrete projects, SLBs focus on results. The credit product links investor returns to the issuer’s performance against sustainability key performance indicators (KPI), which can range from carbon or deforestation reduction to diversity improvements. 

There has been a fair amount of negative comment on SLBs in the past year or so, with observers questioning the ambition of issuers’ targets, and whether the financial incentives at play are sufficient to influence material behavioural change. Given the potential environmental impact of a well-functioning SLB market, the Anthropocene Fixed Income Institute has looked hard at how the market is functioning and what tools investors can use to maximise the impact of their investments.

In reviewing the market to date, we have found that SLBs are already reaching a broader range of sectors, companies and regions than other types of sustainable debt.

This includes hard-to-transition industries that find it difficult to attract more traditional ‘green’ capital but must be able to finance operational change if they are to meet climate objectives. Issuers with lower credit ratings, including high-yield, tend to use SLBs more than others, which suggests that the market is demanding that these companies deliver sustainability commitments to access the capital markets. SLBs are gaining popularity in emerging markets, increasingly for sovereigns, where there are challenges in having sufficient eligible projects for green issuance.

Financial value derived from sustainable KPIs

So, there is already much more to be positive about than the debate around SLBs may suggest, but there is one feature in particular that is often overlooked, which should be of interest to those running active strategies.

An SLB can be thought of as a financial derivative on its KPIs. Its value relates directly to its performance in delivering on those commitments, as it is structured to pay a step-up coupon (or step-down) if they are not (or are) met. The ESG reporting of an issuer is therefore financially material, and investors have a direct financial claim on this disclosure.

This is a unique quality of SLBs. It gives bond investors the right to demand a standard of transparency and reporting on sustainability performance more equivalent to what is expected under general financial reporting obligations, which is unfortunately not yet the norm. 

Could do better

We have spotted several cases where the lack of reporting has had implications for bondholders, and where they have the power to demand more.

The first is a case of shifting emissions from visible operational accounting to more opaque financed emissions, while claiming to have achieved a reduced carbon footprint. This is a key theme in global sustainable finance and poses important questions around investors’ role as providers of capital. 

Singaporean infrastructure/energy owner and SLB issuer Sembcorp sold its subsidiary Sembcorp Energy India Limited (SEIL) to a private equity consortium, arguing that the transaction would allow it to immediately de-consolidate its thermal coal assets’ carbon footprint and reduce its overall carbon intensity.

However, Sembcorp lent the consortium the money to do the deal, using a loss-absorbing structure, so it is still financing those same emissions. This approach was chosen rather than a true decarbonising strategy, replacing coal with renewable energy. 

Sembcorp was explicit in its communication that a key benefit of the transaction was the avoidance of coupon step-ups on its SLBs. In this instance, bondholders could have argued that the sustainability performance targets in Sembcorp’s SLB should have included both operational and financed emissions. If it had, this would have made it more likely that investors would have received a coupon step-up for emissions reduction targets not being reached.

Meat producer JBS has issued three SLBs, with a step-up linked to emissions intensity commitments. JBS has gone on to restate the parameters of its emissions accounting each time they have reported. The company acknowledges the changes but gives no details or justification.

SLB investors have an opportunity here to challenge JBS to justify its restatements and improve transparency on its environmental impact. Without reliable reporting, investors cannot make informed decisions, and issuers cannot be held accountable for their environmental impact. 

Chemical company Nobian’s 2022 sustainability report showed a significant drop in emissions and as such, the company avoided paying a coupon step up to its SLB bondholders. However, it is unclear how this emissions reduction has been achieved. 

The SLB includes two KPIs with targets at the end of 2022: Scope 1 + 2 absolute emissions, and a percentage of energy from renewable sources. Emissions reportedly reduced by 25% year-on-year, far in excess of the targeted fall of 4% in two years. Detailed analysis of the sustainability report suggests this was delivered partly by generating power from an alternative energy source, Municipal Waste Incineration (MWI). Yet Nobian counts no emissions from this source. It is difficult to imagine that burning rubbish is an emission-free exercise.

Given the SLB structure, Nobian’s bondholders have a right to raise questions regarding this irregularity, using the SLB as a tool to provide greater transparency. Removing rather than accounting for these emissions represents a kind of footprint arbitrage that undermines the realisation of true carbon neutrality, with a direct impact on the coupon received by investors. This is a notable example of where the SLB instrument is throwing light into corners that may otherwise have remained hidden from investors. 

It is true that SLB issuers should set robust sustainability targets and AFII’s research has shown that by doing so, companies and governments can benefit from an attractive cost-of-capital. It is just as true that investors have been given an opportunity here to transform the status of ESG accountability, and we encourage them to use it.