A coupon step-up structure is regarded as the market standard
Investors not only have to assess the ambitiousness and materiality of KPIs and SPTs; they also have to consider the financial characteristics of SLBs. When ENEL issued the inaugural sustainability-linked bond in 2019, it included a coupon step-up of 25 bps as a financial penalty if the company’s SPTs were not met. Since then, using coupon step-ups as a financial characteristic has become the market standard in the SLB space. However, a number of issuers have included other types of failure effects in their SLBs, including a higher redemption price, coupon step-downs, purchases of carbon offsets and donations to charity.
Our survey shows that most investors seem satisfied with the coupon step-up structure. However, some highlight the problematic reversed incentive, as investors benefit from issuers not meeting their sustainability goals. One investor concluded that:
“The most important necessary change in structure is to switch from reward to bondholders in case of miss towards an ESG friendly utilization.”
The reversed incentive is one of the biggest problems for the SLB format. Etihad Airways solved this incentive problem by committing to buy carbon offsets of an amount corresponding to between 5-25 bps on the notional amount of the bond, depending on the performance on the target. While carbon offsets could be a great solution for investors to ensure positive climate impact from their investments, the quality and quantity of carbon offsets are the critical factors. Furthermore, carbon offsets could also be seen as a way for companies to buy their way out of having to make actual progress on sustainability and reduce their emissions.
Moreover, all investors are not comfortable with issuers stepping away from the usual coupon step-up structure. Asset manager PIMCO in December 2020 released its own guidance document for sustainable bond issuance, stating that they prefer coupon steps structured like “typical bond covenants” and payments to investors rather than charitable donations.
The focus should be on ensuring that the financial characteristics of SLBs incentivise tangible positive climate impact.
Ensuring positive climate impact
We believe that, as the market grows, we are going to see harmonisation on the financial characteristics, reinforcing coupon step-ups as the market standard. However, the focus should be on ensuring that the financial characteristics incentivise tangible positive climate impact. In the case of a company using carbon offsets as a financial penalty for an SLB, the company should make sure to close the emissions gap between the target and their performance, as that would guarantee investors the positive climate impact they have invested in. Furthermore, the flexibility in financial characteristics should be utilised by issuers in a way that is relevant for the overall bond structure, regarding the targets and maturity of the bond. For example, an issuer setting targets matching the maturity of the bond should consider a higher redemption price rather than a coupon step-up.
The SLB market is still very young, and investors and issuers are still trying to figure out how to use the format in an efficient way. Investors are positive but have concerns about assessing the ambitiousness and materiality of the KPIs and SPTs. As the market grows, clearer market standards are likely to emerge, and hopefully, we will see increased demand from investors for the use of science-based approaches in the selection of KPIs and SPTs. We believe the sustainability-linked bond format, tied to material and ambitious KPIs and SPTs, is a great instrument to help issuers make their sustainability transition.
Jacob Michaelsen, Nordea Sustainable Finance Advisory
Oskar Hagman, Nordea Sustainable Finance Advisory