Where We Are On... Sustainability-Linked Bonds

Spoiler alert – lots of potential but not living up to it just yet

?By Matthew MacGeoch , Transition Analyst, Climate Bonds Initiative [email protected]

Sustainability-linked bonds (SLBs) first joined the green, social, and sustainability (GSS) bond family in 2018, but they are different from green/social bonds because they don’t fund green/social projects. Instead, they are linked to sustainability targets and there is a financial penalty or reward structure based on the achievement/failure of these targets. Issuers are free to use the proceeds as they wish, but these bonds serve as a commitment from issuers to investors against the targets set.?

The opportunity: SLBs can be a huge lever for entities, particularly in hard-to-abate sectors, to support the costs of transition. In hard-to-abate sectors such as cement, steel, and basic chemicals, the journey to net zero will, at least partially, rely on untested technologies which cannot be financed easily with green bonds. By issuing an SLB an entity switches on its green light, in other words, sends a signal to investors that it is identifying and addressing climate related business risks.

The problem: To date, SLB issuers have been criticised for a variety of reasons, leading to some hesitancy from investors and issuers about the format.

Some SLB issuance however has been very credible, and so to reinforce the credibility of SLBs we have found 3 key features that underpin all credible SLBs:

1. Strong underlying transition plans

SLBs must be underpinned by robust transition plans.

What is a robust transition plan, you may ask?

A robust plan is one that meets Climate Bonds 5 Hallmarks of a credibly transitioning company which are: to set Paris-aligned targets, set robust plans to meet them, show evidence of implementation, set up monitoring, and report back.

We assess the ambition and credibility of entity transition plans against our ‘Five Hallmarks ’ – see this report as an example where we assessed ten transition plans from ASEAN entities using this framework.

2. Ambitious targets

Note: Key performance indicators (KPIs) are the data points chosen (e.g., Scope 1 GHG emission reductions), while sustainability performance targets (SPTs) are the targets or objectives that are set on those KPI’s (e.g., 20% reduction).

SLBs must include ambitious SPTs to establish credibility. ?

Ambitious targets…

…include all material scopes of emissions

We all know that Paris-aligned targets should be linked to a 1.5°C sector-specific pathway.

But what is not always clear is that this means GHG targets must include scope 1, 2, and 3 emissions.

However, by end of November 2022, SLBs with targets addressing all three emission scopes represented just 14.4% of SLBs or just USD29.1bn of the USD201.7bn captured.[1] ?

Scope 3 emissions are clearly the big issue here given that they are not, by definition, in the company's control. By including them in targets, entities are forced to phase out those parts of the business that cannot be decarbonised because of high scope 3 emissions.

For the avoidance of doubt, any SLB from an agrifood company or oil and gas issuer must include scope 3 emissions. Scope 3 emissions can represent 85-100% of the emissions of such entities. However, as of Nov 2022, just three out of 22 oil and gas SLB deals had included scope 3 targets.

It is true that scope 3 emissions are not always material and if this is the case, they are not required but we note that this is an exception.

… are based on Science-based metrics (this means… no economic intensity targets)

Credible SLBs utilise absolute GHG emission targets, science-based sector decarbonisation pathways, or GHG emission intensity targets with a unit of production as the denominator.

Economic intensity targets are not considered to be robust: they can vary based on the performance of the company and the overall business cycle. Instead, absolute GHG targets and physical intensity targets (intensity targets with the denominator being the unit of product produced) should be used.

To date, SLBs with GHG economic intensity targets represent 5.2% of SLB volumes.

3. Strong structures reinforce commitment to targets

The strongest SLBs are clear and consistent in their structure. Investors tend to prioritise stronger structures as they reinforce targets.

Here are a few poor structural elements we have seen in SLBs:

KPI dates don’t line up with the bond dates – specifically, bond call dates are sometimes prior to KPI observation dates which means that issuers can call the bond before the KPI has been assessed, allowing issuers to avoid paying the penalty if they will miss a target. Currently, 8.5% of SLB debt (USD17.2bn) has a first call date before the KPI observation date with an average of 1.8 years between the first call date and KPI observation date. Climate Bonds has seen one bond called before its KPI observation date.

We encourage issuers to place first call dates after the KPI observation date or include provisions in legal documentation that apply the coupon step-up if the bond is called before the KPI observation.

Step ups that only kick in at the end of the bonds term => this mean that issuers avoid the financial impact of missing their target. SLBs where the step-up may only apply to one or two coupon payments represent 15.1% of total SLB issuance. Encouragingly, step-up structures that apply to five or more payments represent 45.7% of SLB debt.

In Summary…

SLBs are only as good as the underlying transition plan, include ALL material sources of emissions, and reinforce the issuers’ commitment through credible bond structures.

Best,

Mathew MacGeoch

Note from the Editor: Join us on April 13 for an exclusive webinar exploring the new Company-Level Certification offered through the Climate Bonds Standard and Certification Scheme, providing a range of valuable benefits to the corporate applicant. This Certification will help legitimise the climate credentials of the corporate, providing a shortcut to issuance and certification of a range of green/sustainability financial instruments, including Unlabelled bonds, Sustainability-Linked Bonds, and Sustainability-Linked Loans.

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• Matthew is our Climate Bonds Transition Analyst, working in the Market Intelligence Team to collect and analyse SLB data and put together research and engagement on the topic. A native of Hong Kong, Matthew is also fluent in Mandarin, Cantonese, Persian, and proficient in Turkish.
• Data used in this analysis references Climate Bond’s SLBDB as of 09 November 2022. The Database and associated methodology will be released in 2023.

[1] AS captured in the Climate Bonds Sustainability-Linked Bond Database (SLBD)