Sustainability-linked bonds still useful if flaws can be fixed

FROM the end of 2020, through all of 2021 and then the first half of 2022, sustainability-linked bonds (SLBs) were all the rage. In the fourth quarter of 2021, SLBs made up more than half of new ESG bond issuance in South-east Asia, according to Refinitiv data.

But just like that, SLB volumes have dried up. There were no new SLBs issued in South-east Asia in the first half of 2023. Their share of the ESG bond market in the rest of the world has also declined.

It’s what happens when enough people have played with the shiny new toy and realised that it is not as awesome as it looked in the commercials and in the hands of that kid on the bus. SLBs have become the fidget spinners of ESG bonds.

There are generally two classes of ESG bonds. The first are use-of-proceeds bonds, which get the “green”, “social” or “sustainability” bond labels only if the proceeds will be applied to activities that meet “green”, “social” or “sustainability” standards.

SLBs form the second class. The proceeds of SLBs can be used for pretty much anything. However, the borrower is subject to sustainability-related targets that affect the interest that the borrower has to pay on the bond. As an example, Singtel subsidiary Optus has a 4.577 per cent SLB due 2028. If Optus fails to meet an emissions target by 2025, the coupon on the SLB will step up by 25 basis points.

The first SLB was launched in 2019 by energy group Enel. It was only around the end of 2020 that it really started to take off in South-east Asia.

Folks were excited about SLBs because they seemed to have the potential to induce decarbonisation at an entity level. A green bond might help a coal power company to build a solar farm, but the company could still continue to run its coal plants. With an SLB, however, the same company would need to lower its overall emissions to benefit from the structure.

In South-east Asia, in particular, that was an enticing prospect, because of the need to decarbonise vast swathes of the economy. Not every business in Indonesia is going to build a solar plant, but many of them could decarbonise by switching to renewable energy, reducing waste and consumption and various other measures.

The market has become more cautious with regard to SLBs. One major criticism has been with the targets, many of which in the early days had questionable levels of ambition. The industry has been trying to move towards science-based targets, but adoption has been slow.

A recent study by BloombergNEF also found that a quarter of SLBs allow borrowers to redeem the bonds before penalties are triggered. This would mean that borrowers who are about to miss their targets have an escape route.

It’s not surprising that a relatively new structure like the SLB will have some growing pains. Unlike fidget spinners, however, SLBs are still valuable because of their ability to generate entity-level impact. One indicator of this is that sustainability-linked loans, which also apply target-linked margin adjustment mechanisms, are still getting done despite somewhat similar concerns about targets. SLBs could yet stage a comeback if the industry can address the early criticisms.