Sustainability-linked bonds falter amid credibility concerns

IN AN era of higher scrutiny for sustainable investing products, green bonds are proving to be the tried-and-tested sustainability choice for fixed income investors as more esoteric offerings falter.

Global green bond issuance has remained steady – the total in the first four months of this year was US$232 billion, equal to the issuance in the same period in 2023, according to a report from Morgan Stanley.

However, in the case of sustainability-linked bonds – a newer product that has come under fire from environmentalists – issuance was down 51 per cent in the first four months, compared with 2023, to just US$12.5 billion.

These newer sustainable investing products have been launched on the back of the success of green bonds, which have entered the mainstream over the past decade.

Green bonds are issued by countries or companies to pay for environmental projects. But sustainability-linked bonds (SLBs) tie a company’s debt interest payments to its climate promises – by punishing the company with higher interest rates if it misses environmental targets. At first, their use grew rapidly. More recently, though, experimentation with SLBs has mostly flopped due to credibility concerns, leaving investors to refocus on green bonds.

SLBs had initially enjoyed a splashy debut. Back in 2019, Italian energy group Enel became the first entity to issue an SLB, to raise money for general corporate purposes. This was possible because, unlike green bonds where proceeds are restricted to a specific use, SLBs focus on outcomes – allowing the issuing company can decide how to use the funds raised, as long as they hit their sustainability objectives.

So Enel’s bonds were not tied to specific green projects – which marked them out from traditional green bonds. Instead, the company agreed to pay an additional 25 basis points of interest if it failed to meet its own green targets.

At the time, the deal was praised as a way for traditional fossil fuel companies to issue a type of green debt.

Companies raced to copy Enel and SLB issuance surged in 2021. But, last month, Enel announced that it had failed to meet a 2023 goal to cut emissions by more than a third, compared with 2022, largely because it did not decommission coal power plants on schedule.

The company says this was due to government obligations to maximise coal-fired electricity stemming from the war in Ukraine. As a result, its bondholders will receive millions of euros in additional interest payments.

However, not all investors are in favour of this approach. SLBs have faced criticism due to the lack of aggressive green improvements made after they are issued, according to a report last month by rating agency Fitch.

The trigger date for an SLB to incur higher interest is also often set close to the bond’s maturity date — which means the financial penalty incurred for missing sustainability goals is not enough to incentivise greener behaviour, the report said.

SLBs have suffered a “significant drop in issuance”, reports Christa Clapp, head of sustainable finance market analytics at S&P Global Ratings.

By contrast, she notes: “The green (bonds) label, especially, has survived the (past) 24 months remarkably intact. Not all the labels have survived with such robustness.”

Ten years ago, the International Capital Markets Association (ICMA) established the Green Bond Principles — voluntary guidelines that have helped the green bond market grow to where it is today. 

“Green has been the most favoured and straightforward label,” says Anne van Riel, head of sustainable finance capital markets Americas at BNP Paribas, pointing to how stable the issuance of global green bonds has been so far this year.

While she has seen “a decrease in US dollar volumes”, van Riel points out that there is healthy demand overall, with US companies and institutions issuing green bonds in other currencies — such as euro and Swiss franc.

“The label that has received the most scrutiny is the SLB label,” she says. Companies risk losing money on SLBs if they do not meet commitments, and “investors have a choice to buy the bond. It is a very transparent structure”.

However, one of the biggest challenges for sustainable debt issuance has been US politics. After US President Joe Biden won the White House in 2020, Republicans friendly with oil-and-gas companies ramped up their attacks on environmental, social and governance (ESG) investing. This criticism has typically focused on asset managers selling ESG products — most notably, BlackRock — but it has also rocked the fixed-income space.

“Politics continues to be a challenge in the US for ESG-labelled bonds,” says Anthony Trzcinka, a senior portfolio manager who runs core bond strategy at Impax Asset Management. Often, companies have projects ready to go, he says, but there is “no pressure from investors and the political climate is not conducive to issuing. There seems to be no downside to waiting, and I expect that to remain the same until after the US elections in November.”

Still, some companies are forging ahead with green bonds. In March, Baltimore-based energy company Constellation issued US$900 million of green bonds to finance nuclear projects. This is the first US green bond to be used for nuclear, the company said in a statement. In February, Dow Chemical issued its first green bond, raising US$600 million.

Meanwhile, countries with less hostile ESG politics have continued to innovate. Japan, in February, issued its first “transition bond”. This debt funds investments that are not necessarily “green” but should result in lower emissions from polluting economic sectors, overall. Japan’s 1.6 trillion yen (S$14.5 billion) transition bond forbids any proceeds being put towards gas-fired power generation, according to the non-profit Climate Bonds Initiative, which endorsed the deal and had previously been wary of transition bonds.

“This bond shows clearly how governments, and others, can raise funds to invest in that transition,” Sean Kidney, chief executive of the Climate Bonds Initiative said in February. “It marks a significant milestone in transition finance.”

As sustainable debt evolves, investors will continue to be more sceptical of the credibility of ESG debt, says Trzcinka. “In my experience, when ESG-labelled bonds were first issued years ago, investors were more willing to accept looser terms,” he says. “Now, investors expect more.” FINANCIAL TIMES