Navigating sustainability-linked bonds: friends or foes (of the transition)?

A notable trend in sustainable finance that has garnered both attention and criticism is the steady growth of ‘sustainability-linked’ bond instruments (SLBs). Since 2019, these have complemented the diverse landscape of ‘sustainable’ financial instruments, including green bonds, social bonds and social impact bonds, among others.

SLBs are debt securities which raise finance for the pursuit of sustainability-related targets. Unlike green bonds, which are tied to specific ‘green’ projects, SLBs stand out because of a link between such targets and the financial conditions of the bonds. In other words, issuers pledge to attain certain environmental or social ‘performance outcomes,’ such as reducing their GHG emissions, measured with specific key performance indicators (KPIs). They also undertake to pay a penalty, like a step-up in the coupon, if they fail to meet these targets.

The Italian electricity company Enel pioneered SLBs in 2019 by committing to achieve a minimum percentage of installed renewable generation capacity or otherwise to increase the interest rate. Since then, the SLB market has grown significantly in size and diversity, reaching a cumulative volume of 42.5 USD bn in issuances at the end of 2023. Sovereign states like Chile and Uruguay have also entered the market, expanding its reach beyond companies, financial institutions and multilateral development banks (MDBs). Some issuances have also supported social aims alongside environmental ones, like the ethical and social aspects of companies’ supply chains.

Versatile and promising financial instruments

Like the other aforementioned ‘sustainable’ financial instruments, SLBs can attract capital market finance for sustainability goals. Their unique advantage, however, lies in their flexible design, which enables issuers to tailor the targets and mechanisms to their resources, capabilities and internal strategies.

While green bonds require a specific ‘green’ project, SLBs are suitable for a broader range of actors, provided that they demonstrate a commitment to improve their sustainability performance. Therefore, it comes as no surprise that this format has proven particularly popular among companies in ‘hard-to-abate’ sectors like oil, gas and energy utilities. It can also be attractive to sovereign states navigating the challenges of public spending, most notably ring-fencing proceeds for a specific ‘green’ project. In a recent Recommendation the EU Commission has also identified SLBs as a crucial tool to catalyse transition goals.

On the demand side, SLBs can appeal to investors marketing their portfolios as aligned with sustainability goals (like the so-called Art 8 and Art 9 funds in the EU). The automatic penalty mechanism can in principle ensure monetary compensation for investors if the targets are not met. In contrast, non-implementation of ‘green’ projects opens the door to limited enforcement avenues under green bond documentation as it does not constitute an ‘event of default’.

Several outstanding open questions

However, the flexibility which should guide the design of SLBs also acts as a double-edged sword. Academic research and empirical studies have identified a number of challenges (which some have described as ‘structural loopholes’) and risks.

A critical question relates to the actual added value of SLBs in the context of issuers’ progress toward sustainability goals. A study of a sample of bonds found that the majority of targets had been announced before the issuance and would have been pursued regardless.

SLBs have also faced frequent allegations of ‘greenwashing’ due to a lack of ambition or immateriality of the sustainability-related targets. Empirical evidence indicates that several issuers choose weak or ‘easy to afford’ penalties, making it more convenient to pay than to pursue the targets. In addition, SLB marketing material may present an overly optimistic or misleading picture of the commitment of issuers to environmental matters while obfuscating other non-sustainable practices. Market research has shown that 19% of the 100 largest SLB issuers between January 2022 and September 2023 were also involved in parallel sustainability-related controversies.

Ensuring credibility in a rapidly evolving market

Despite these challenges, checks and balances exist to mitigate some of the threats arising from the issuance of SLBs.

The leading framework for labelling bonds as SLBs is a set of principles published in June 2020 and updated in 2023 by the International Capital Markets Associations (ICMA). The association brings together capital market participants and has already been heavily involved in similar standard-setting activities in the sustainable finance landscape. The SLB Principles crystallise best practices concerning the selection of KPIs, the calibration of targets, bond characteristics, reporting and verification.

The ICMA recommends, among other things, anchoring SLB issuance to issuers’ broader transition strategies (Principle 2, ICMA, 2023) and regularly reporting to investors on the impact of SLBs. It also invites issuers to obtain external verification, which generally takes the form of a ‘second-party opinion’ ahead of the issuance. These processes culminate in assessments by external market providers on the level of ambition and robustness of SLB targets and of issuer strategies. More importantly, a core recommendation relates to the need to obtain post-issuance verification of progress on targets (ICMA, Principle 5). Alongside the principles, ICMA has also developed a KPI registry to guide issuers in the identification of sufficiently ambitious targets and of robust methodologies.

The main obstacle to the uniform application of such Principles is their voluntary nature. In practice, issuers generally publish a ‘framework’ outlining how SLBs comply with the ICMA framework, yet reviewers will be the main actors assessing the substance of such documentation. Review processes also raise several further questions of comparability, conflicts of interests and potential ‘greenwashing’ in review statements.

Further technical standards for the issuance of SLBs are also expected at the EU level. Building on the recently approved Green Bond Standard, the Commission should issue guidelines and templates for market actors to draw on when designing SLB documentation or when reporting (Art 20, 21 Regulation (EU) 2023/2631). These will operate on an optional basis. Therefore, they may fail to fully standardise issuances in the EU market.

Concluding remarks

SLBs have the potential to mobilise resources and drive market actors in all sectors toward transition goals. Careful drafting of bond documentation, reporting and external reviews can significantly enhance the reliability of these securities. However, the legal principles underpinning issuances should represent the key bedrock, ensuring that SLBs make a meaningful contribution and drive systemic change. In this context, the upcoming EU guidelines represent a crucial opportunity to further specify the best practices for the design and management of SLBs, and to elevate the ambitions of issuers.

 References

• Agostini, F. (2022) From “green bond principles” to “green bond clauses”: mitigating greenwashing through contract law. In: Heidemann, M. and Andenas, M. (eds.) Quo vadis Commercial Contract? Reflections on Sustainability, Ethics and Technology in the Emerging Law and Practice of Global Commerce. Springer (Springer 2023).
• Azevedo Rocha P, Rathi A , and Gillespie T, ‘Empty ESG pledges ensure bonds benefit companies, not the planet,’, Bloomberg, 4 October 2022.
• Cerrato Garcia E, Agostini F, The green bonds market in the light of European Commission’s proposal : implications for greenwashing liability. in In Ramos Muñoz D , and Smoleńska A (eds), Greening the Bond Market : A European Perspective, Palgrave MacMillan (2023) EBI Studies in Banking and Capital Markets Law https://doi.org/10.1007/978-3-031-38692-3_6.
• Chanel, Sustainability-Linked Bond Framework (2020).
• Climate Bonds Initiative, State of the market – Q3 2023.
• ENEL, Enel launches the World’s First “General Purpose SDG-Linked Bond,”, Successfully Placing A 1.5 Billion U.S. Dollar Bond On The U.S. Market (2023).
• EU Commission, Commission Recommendation 2023/1425 of 27 June 2023 on facilitating finance for the transition to a sustainable economy   (2023).
• ICMA, ‘Sustainability-linked bond principles – voluntary process guidelines’ (2023).
• ICMA, Green bond principles’ (2023).
• ICMA, Market integrity and greenwashing risks in sustainable finance (2023).
• Imtiaz Ul Haq and Djeneba Doumbia, Structural Loopholes in Sustainability-Linked Bonds (2023)   World Bank Policy Research Working Papers.
• Kolbel, Lambillon, ‘Who pays for sustainability? An analysis of sustainability-linked bonds’ (2023).
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• Public Debt Office of the Ministry of Finance of Chile, Chile’s Sustainability-Linked Bond Framework (2022).
• Regulation (EU) 2023/2631 of The European Parliament and of the Council of 22 November 2023 on European Green Bonds and optional disclosures for bonds marketed as environmentally sustainable and for sustainability-linked bonds
• Sovereign Debt Management Unit, Ministry of Economy and Finance of Uruguay, Uruguay’s Sovereign Sustainability-Linked Bond Framework (2023).