Sustainability-linked bonds

Introduction

In September 2019, ENEL launched the world’s first sustainability-linked bond (“SLB”) (see ENEL Case study below). Whilst, sustainability-linked financing has begun to grow in recent years with companies such as COFCO International and Electricite de France SA making use of financing facilities with interest rates linked to sustainability targets, ENEL is the first issuer of bonds which are explicitly linked to a sustainability objective.

What are Sustainability-linked Bonds?

SLBs are bonds whereby the proceeds from the issuance are not ring-fenced to green or sustainable purposes (unlike “use of proceeds” green bonds or sustainable bonds) and may be used for general corporate purposes or other purposes. Instead, the SLBs are linked to the performance of certain key performance indicators (the “KPIs”) in achieving pre-defined sustainability performance targets (the “SPTs”), and depending on whether this is achieved, certain characteristics of the SLBs may vary (e.g. coupon ratchet). Therefore, issuers are committing explicitly to future improvements in sustainability outcomes with a pre-defined timeline. SLBs are a forward-looking performance-based instrument.

The SLBs are meant to complement green bonds, and should enable more issuers to access the sustainable financing market. Traditionally, issuers of green bonds have been issuers with heavy capital expenditure requirements in the green areas, such as renewable energy, utilities, green buildings and rail (such issuers must use the proceeds of green bonds exclusively for green purposes but do not need to achieve any pre-defined green targets). However, corporate issuers which do not have readily available such green expenditures may find it more challenging to tap the green bond market. They could, nonetheless, tap the SLB market since the use of proceeds are not restricted to green projects or uses only. Instead, what is significant to investors is that such issuers have an overall sustainability or ESG strategy and are achieving pre-agreed milestones to successfully implementing this. This increases issuer-investor engagement, and provides relevant data, on the subject where it might otherwise not occur.

Sustainability-linked Bond Principles

The International Capital Market Association has published the Sustainability-linked Bond Principles (the “SLBPs”) in June 2020. Like its predecessors, the Green Bond Principles and the Social Bond Principles, the SLBPs are voluntary in nature and constitute recommended market best practice in order to promote market integrity and transparency in sustainable finance.

The SLBPs consist of five core components:

1. Selection of KPIs
2. Calibration of SPTs
3. Bond characteristics
4. Reporting
5. Verification

1. Selection of KPIs

Key to SLBs is the selection of KPIs (which could be external or internal) which are credible and material.

The KPIs should be:

• Relevant, core and material to the issuer’s overall business, and of high strategic significance to the issuer’s current and/or future operations
• Measurable or quantifiable on a consistent methodological basis
• Externally verifiable
• Able to be benchmarked (as much as possible using an external reference/definition to benchmark the level of the SPT ambition).

Issuers are encouraged to communicate to investors the rationale in selecting the KPIs, to provide clear definitions (e.g. scope, calculation methodology) and to provide relevant baseline or historical data (in order to facilitate benchmarking against the historical performance of the relevant KPIs).

2. Calibration of SPTs

In order for the SLBs to fulfil its purpose, the SPTs should be ambitious but also realistic (and those that an issuer is prepared to commit to).

The SPTs should be ambitious, i.e.:

• Represent a material improvement in the respective KPIs and be beyond a “business-as-usual” trajectory
• Be compared to a benchmark or an external reference (where possible)
• Be consistent with the issuer’s overall strategic sustainability/ESG strategy
• Be determined on a pre-defined timeline set before (or concurrently with) the issuance of the bond

The target-setting exercise should be based on a combination of approaches:

The issuer’s historical performance

• The issuer’s peers
• By reference to science or official country/regional/international targets or to recognised best-available-technologies or other proxies

The SLBPs also recommend that issuers appoint an external reviewer to confirm the alignment of the SLB with the five core components of the SLBPs (e.g. via a second-party opinion). It is also encouraged that external reviewers assess the relevance, robustness and reliability of the selected KPIs, the rationale and the level of ambition of the proposed SPTs, and the credibility of the strategy. If there were any material change to the perimeter or KPI methodology or SPT calibration, issuers are encouraged to ask external reviewers to assess these changes.

3. Bond characteristics

The key feature of a SLB is that its financial and/or structural characteristics may vary depending on whether the selected KPIs achieve the targets set by the SLBTs (this will form the trigger event(s) for such variation).

The variation of the bond financial and/or structural characteristics should be commensurate and meaningful in order to place significance on the issuer to achieve the set SLBTs.

The SLBPs have not sought to define or delineate what such financial and/or structural characteristics might be in order to allow market innovation and appropriate issuer/transaction-specific solutions, but potential variation of characteristics may include the step-up/step-down of coupon, or the change in maturity date of the bond.

4. Reporting

• Issuers should publish and keep readily available and accessible:
• Up-to-date information of the performance of the selected KPIs
• A verification assurance report (in respect of performance against SPTs and related impact, and timing of such impact on the bond’s financial and/or structural characteristics)
• Any information enabling investors to monitor the level of ambition of the SPTs (e.g. any update in the issuer’s sustainability strategy, or information relevant to the analysis of the KPIs and SPTs).

This should be published regularly (and at least annually) and for any date/period relevant to assessing the SPT performance leading to a potential adjustment of the SLB’s financial and/or structural characteristics.

5. Verification

Issuers should seek independent and external verification of the KPIs’ performance against the SPTs by a qualified external review with relevant expertise. This should be effected at least once a year and for any date/period relevant to assessing the SPT performance leading to a potential adjustment of the SLB’s financial and/or structural characteristics.

Such post-issuance verification should be made publicly available and is a necessary element of the SLBP (in contrast with any pre-issuance external review, such as a second party opinion, which is recommended but not mandatory).

ENEL sustainability-linked bond case study

ENEL’s September 2019 issue totalling US$1.5 billion took place in the US market and was over-subscribed by almost three times, with around 70 percent of investors having a ESG-aligned strategy. The significant interest generated meant that the bond was priced at 125bp over US Treasuries which ENEL believes is 10bp through its curve as opposed to a conventional bond without the sustainability element which ENEL believes would likely have been priced at 10bp over.

The proceeds raised from the bond issue can be allocated to any project by ENEL or, as ENEL have indicated will be the case, used for its everyday corporate financing needs. There is no requirement that the proceeds be explicitly allocated to a green project and ENEL can make use of the funds in the over half of its power-generating business which is not green.

In terms of the sustainability aspect, the $1.5 billion five-year bond is linked to ENEL’s target to have renewable energy account for 55 percent of its installed electricity generation capacity by 2021. ENEL’s capacity as of the first half of 2019, was 45.9 percent. An auditor will sign off on whether the target has been met or not at the end of December 2021. ENEL believes that the sustainability element of its bond has saved it 20bp when compared to a traditional bond.

If the 55 percent target is not achieved by December 31, 2021, the ratchet mechanism will be used to increase the coupon paid by ENEL to its bondholders by 25bp as a penalty for not reaching the required sustainability standard. ENEL have stated that the use of the sustainability-linked bond highlights ENEL’s commitment to substantially increasing the share of renewable energy in the global energy mix by 2030.

In addition, to this, in October 2019, ENEL raised a further €2.5 billion by issuing a sustainability-linked bond listed on the Irish Stock Exchange, linked to the UN's Sustainable Development Goals including those on affordable and clean energy and taking urgent action in order to combat climate change. The bond was almost four times oversubscribed, attracting orders of €8.5 billion.

The 4.7- and 7.7-year tranches are, like ENEL’s September issuance, linked to ENEL’s renewable energy target while the 15-year tranche is instead linked to ENEL Scope 1 greenhouse gas emissions from electricity generation which it will need to reduce from 411 g/kWh as of 2017 to 125 g by December 31, 2030. The 13-year target is driven by ENEL’s Science-Based Target which is to cut carbon emissions to a level compatible with global warming of under 2 degrees Celsius (in accordance with the Paris Agreement). ENEL will also be required to pay a 25bp step-up on the coupon if it fails to meet this target. ENEL has chosen a longer-term for its longer-term 15-year bond.

The future of SLBs

Are SLBs a newer better alternative to green bonds? They do help in the achievement of green objectives via the pre-defined KPIs and SLBTs, but that is also what green bonds do in a more direct, simplistic way via use of proceeds. What is clearer however, is that SLBs open the gateway to more issuers to tap the sustainable finance market. Depending on the issuer, SLBs could be the appropriate product to help finance a sustainable business generally, albeit not on a specific green project basis.

Although the SLB market is still a nascent and developing one, it has enormous potential to expand the sustainable finance universe and players, and may soon grow to become of equivalent size and stature to its sibling green bonds. Any expansion of the sustainable finance family is a welcome one as we accelerate towards a more sustainable world.